ECON101: FISCAL VERSUS MONETARY POLICY

As promised in my last blog, ECON101: MACROECONOMICS VERSUS MICROECONOMICS, this piece will address the interesting topic of Fiscal and Monetary Policy. Yes, the adjective “interesting” might be subjective, but I believe it is a good ‘next step’ in establishing the foundation for my ECON101 series.

Let’s start with the understanding that there are three main economic goals that are shared globally. These are: growth, high employment, and price stability. There are, what we call, economic indicators that provide information as to how the economy is doing relative to these three goals. Because there are so many indicators, typically most professionals follow a select few. I will take a closer look at each of the goals and key statistics in future blogs.

Collectively individual’s decisions on how they allocate their resources, such as how much to spend versus save, can affect an economy just like similar economic decisions made by corporations can have an important impact. But rarely does an individual corporation or household affect large economies on their own. However, government policy does have the power to affect the macroeconomy and financial markets. And, government policy would be enacted in an effort to attain one or all of the three main economic goals.

So how exactly does the government intercede to meet their three main economic goals? There are two policies they have access to, they are: monetary policy and fiscal policy.

The predominant goal of monetary and fiscal policy is to create an economic state of steady and positive growth as well as stable and low inflation. This is accomplished by guiding the economy in a way to minimize periods of great volatility to include big economic booms followed by lengthy slumps. Stability is important, it provides individuals and corporations the security needed to be able to make spending, investment and saving decisions.

Monetary Policy

Monetary policy refers to activities carried out by central banks, i.e. the U.S. Federal Reserve, aka “Fed”. These activities are primarily concerned with the management of interest rates and the quantity of money in circulation. These actions can either stimulate an economy or slow an overheated economy.

Three tools the Fed frequently has used are:

Participate in open market operations. This is typically done on a daily basis and is the act of the Fed buying and selling U.S. government bonds. The Fed does this to either add money into the economy or remove it from circulation.

Change the reserve requirement. The Fed controls the reserve requirement (aka reserve ratio). This is the percentage of deposits banks are required to keep in reserve; i.e. unable to lend out. If this is higher banks are unable to lend as much, but if the percentage is decreased, they can lend more which puts more money into the economy.

Establish the discount rate. The discount rate is the interest rate the Fed charges on loans it makes to banks/financial institutions. Obviously, the lower this is the more a financial institution is interested in borrowing and thereby injecting dollars into the economy.

Fiscal Policy

Fiscal policy represents the government’s decisions about taxation and it’s spending. In the United States this is determined by the executive and legislative branches of the government.

Generally, the purpose of most fiscal policies is to affect the total amount of spending, the way it is spent, or both in an economy. This can be accomplished by changing government spending policies or government tax policies.

Spending Policies

If an economy is lacking business activity, the government can step in and increase the amount of money is spends (i.e. fix the roads). This is referred to as stimulus spending. Sometimes a municipal’s tax receipts are limited and the government has to borrow money to pay for the expenditures. The government does this by issuing vehicles like bonds thereby accumulating debt. This is known as deficit spending.

Taxing Policies

Basically, the government can increase or decrease taxes. By increasing taxes, they pull money out of the economy resulting in slowing business activity. If they lower taxes or offer tax rebates the government is keeping or putting more money in the pockets of individuals or corporations. The hope is that the result is increased spending by these individuals or corporations sparking economic growth.

In comparing the two, monetary policy is used in an effort to have an immediate impact to the money supply sparking economic activity. Fiscal policy typically has a greater impact on consumers since it can lead to increased employment and income. Applied together they can have great influence over a country’s economy and its participants.

As I did in my last blog please provide feedback or if you have a specific topic you’d like me to address via https://maximawealth.com/contact/. The feedback I received in the past has been helpful in guiding my future blogs. Thank you!

Look for my next ECON101 discussion during the 4th Quarter where I’ll begin to look into each of the global economic goals.  

ECON101: MACROECONOMICS VERSUS MICROECONOMICS

I don’t know if you noticed or not, but it seems that there has been a lot of discussion around the subject of economics. Right now, specifically it is about the U.S. Economy and how it will fare amid COVID-19.

Given all the talk and the fact that I really enjoy the study of Economics, I thought it would be valuable to embark on a series of blogs that address this very topic. I hope you enjoy! At the end of each blog I will provide a link for you to provide feedback or if you have a specific topic you’d like me to address.

Let’s start with what Economics is. I want to start here because there are some misconceptions out there (of which I will address too).

Economics is the study of how we choose to allocate limited resources, why we allocate them in a particular way, and the consequences of those decisions. It analyzes the production, distribution and consumption of goods and services. In today’s environment there are four elements that make up economic activity; they are: land, labor, capital and enterprise.

Economics is not the study of the stock market, money or how to run a business. Many times the performance of the stock market or the value of an investment becomes a reference point as to the state of the economy. While the stock market and certain statistics may be a prediction of the health of the economy, it is important to recognize that in and of itself, it is just ONE variable.

There are two disciplines of economics: macroeconomics and microeconomics.

Macroeconomics

Macroeconomics studies the part of economics that is concerned with the aggregates and how they interact in the economy as a whole. It focuses on broad subjects such as growth, inflation, interest rates, unemployment, government deficits, levels of exports/imports and taxes. When there’s a discussion about the Federal Reserve raising interest rates or the national unemployment rate is 7.5%, the discussion is about a macroeconomic topic. In a future blog I will discuss how different policies can affect the variables looked at to assess the macroeconomic health of an economy.

Microeconomics

Microeconomics focuses on the individual level within the economy. It studies decisions made by individuals and businesses regarding the choices, decisions and allocation of resources and prices of goods and services taking into account taxes, regulations, and government legislation. In a future blog I will discuss several key principles involved in microeconomics.

Microeconomics and macroeconomics should not be viewed as separate subjects, but rather recognize they complement each other. In economics, the decisions of individual businesses are based on the health of the macroeconomy. For instance, a business is more likely to increase the number of workers they hire if they experience indications that the overall economy is growing. Consequently, the performance of the aggregate economy ultimately is contingent on the decisions made by individuals, households, and businesses.

As mentioned above, please feel free to provide feedback or if you have a topic you’d like me to address via https://maximawealth.com/contact/   .

My next ECON101 discussion will address how Fiscal and Monetary policy can affect the variables we look at when assessing the macroeconomic health of an economy.

https://study.com/academy/lesson/what-is-economics-definition-history-timeline-importance.html
https://opentextbc.ca/principlesofeconomics/chapter/1-2-microeconomics-and-macroeconomics/

ECON 101: The Inverted Yield Curve

In my most recent blog I declared that I would cover the subject “Key Personal Financial Decisions” with a series of blogs. However, with so much in the news lately regarding the inverted yield curve, I wanted to take the opportunity to create an ongoing topic, called ECON 101. Given that my Major for my Bachelors degree was Economics, this will be a fun topic for me. Under this I will address a subject one might find in an Economics course. Today’s subject should come to you as no surprise, the inverted yield curve.

What Is a Bond?

Before I discuss an inverted yield curve, I think it’s important to have some understanding of the assets being plotted to track the curve.

The basic asset being tracked is a bond and to be more specific, the US Treasury Bond. In an effort to simplify the explanation of what a bond is; a bond is basically a loan made to either a government (U.S., State, or Local) or a corporation. The borrowing government or corporation promises to pay the bond back at an agreed-upon date in the future (i.e. 2, 5, 10 or 30-year). In the meantime, the borrower agrees to pay an interest payment to the bondholder (i.e. the investor).

While the borrowing organization repays the principle when the bond matures, many bondholders choose to resell them before maturity in what’s called the secondary market. Since bonds can be resold, their value could go up or down until it matures.

And, this is where the more confusing aspect of a bond comes into play. The bond’s value has an inverse relationship to the bond’s interest rate also referred to as its yield. What this actually means is the more demand there is for bonds, the lower the yield. As people are demanding more bonds, they are willing to pay more and therefore the price goes up. But the interest payment is fixed, so the rate in comparison to what they paid for the bond goes down. Typically, investors demand bonds when the stock market becomes too risky for them.

So, to recap…as bond prices go up, bond yields go down.

What Is a Yield Curve?

Ok, hold on…first I should describe what a yield curve is before I just to an inverted yield curve. I promise, this won’t take long.

A yield curve shows a snapshot of how yields vary across bonds that are similar in credit quality but differ in maturities. And, this snapshot is a picture taken at a specific point in time. Below is from the US Department of the Treasury website and shows the last trading day of September for the last three years. Mainly you see the curve upward sloping (which is normal – short-term rates lower than long-term rates), but also shown is the flattening of the curve in 2018.

What Is an Inverted Yield Curve?

An inverted yield curve is an illustration of where short-term Treasure bonds pay more than long-term.  To be more specific short-term yields are higher than long-term bonds. This happens when more people want to invest in a bond over a longer period of time. And, when demand for bonds increases, their corresponding yield decreases. Basically, their demand is so high that the organization (i.e. government) doesn’t have to provide as high of a yield to attract investors.

Below is a chart I grabbed from Morningstar and it shows two yield curves the blue one is from January 2018 and the red one represents the yields on August 13, 2019. The blue line shows a more typical yield curve. But, with the red line you can see a dip. The 3-month Treasury shows at 2% which is higher than the yields for the years following until after the 20-year. This represents an inverted yield curve.

What Could an Inverted Yield Curve Be Telling Us?

The occurrence of an inverted yield curve could be the sign of a number of different economic events. Generally, it has been thought of as a warning for the economy and markets. History has shown that a recession usually appears many months after a yield curve inversion, but it’s not a guarantee. It could depend on how long the inversion occurs because it could prove to just be an irregularity.

Another possible reason for the inversion could be related to decisions made by the Federal Reserve Board (the Fed). The market may be expressing that the Fed has kept the Federal Funds rate (the benchmark short-term rate) too high and rates need to be reduced due to the economy experiencing a slowdown.

Most recently, some think this inverted yield curve has been misleading because of the amount of foreign bonds that are paying negative interest rates. Or, it could be that we are just experiencing a new normal. And, a Credit Suisse strategist is documented to have written that while there is history of a recession after an inversion over the past 50 years; when it will reveal itself is inconsistent.  Credit Suisse’s data goes on to show that after an inversion, markets have rallied more than 15% on average in the following 18 months and a recession strikes 22 months after. 

What Should You Do If There Is an Inverted Yield Curve?

Don’t panic. Most of you know that I don’t subscribe to making dramatic changes to your portfolio just because the yield curve inverted or the market is experiencing turbulence. That being said, it’s never a bad time to meet with your financial adviser and ensure your portfolio is allocated according to your risk tolerance and time horizon. If you need a financial adviser or know someone who would benefit from one, please send them my contact information along with this blog and request a consultation!