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Fed Policy, Fiscal Policy and What’s Ahead

How do the Fed’s monetary policy and the government’s fiscal policy work together?

09/11/2023

Key Takeaways

Monetary policy and fiscal policy together can influence the economy.

Fed policy doesn’t appear to be impacted by election-year cycles.

Fed policy can lead to higher fiscal budget deficits.

Interest Rates and Presidential Election Years

With uncertainty around Federal Reserve (Fed) rate hikes and the upcoming presidential election cycle, clients often ask whether there’s a relationship between the two. Is the Fed more or less likely to change interest rates during presidential election years?

Our analysis found little evidence of an election-year effect on Fed monetary policy either up or down. We looked at 50 years of data covering 13 presidential elections. On average, there does seem to be a bit less rate interference during election years than other years. But the difference is not statistically significant.

Further, we see no evidence of a bias towards rate hikes or rate decreases in election years versus non-election years. This suggests that monetary policy decisions are based on economic necessity and are apparently independent of politics, based on these findings.

Policy Impacts on the Government’s Financial Health

Monetary policy (Fed actions) and fiscal policy together have important implications for the government’s financial health.

For weeks, we’ve been writing about monetary and fiscal policy and how their lagged effects are important for the economic soft-versus-hard-landing debate. But their relationship is also significant for what it says about the sustainability of the government’s debt and deficit burdens going forward.

To provide some context, we’re going to turn to an interesting recent report by Francois Trahan of Trahan Macro Research.* He points out that Fed tightening cycles typically lead to larger fiscal budget deficits.

That’s important because the national debt today is as high as it’s been since World War II. And the annual budget deficit has never been this wide heading into an economic slowdown—hard or soft. That puts us in uncharted economic territory.

Fed policy can lead to higher deficits for three reasons:

  1. Higher interest rates translate directly into higher government borrowing costs. The impact is contingent upon the pace of rate hikes and the government’s borrowing needs. This time around, the size and pace of rate increases have been dramatic. Meanwhile, the annual budget deficit is around 6% today.

  2. Fed tightening typically reduces tax receipts. The Fed’s actions can raise unemployment and slow economic growth, potentially lowering tax revenue.

  3. When the economy slows, the government increases spending. The federal government steps up spending in a whole range of areas to support jobs and growth. According to Trahan’s math, a 1% rise in the unemployment rate typically leads to a 4% rise in government expenditures.

Trahan points out that you can already see the effect of higher rates on government borrowing in the fact that interest payments on U.S. debt just surpassed the annual military budget, which is around $800 billion. These are huge numbers in absolute terms and relative to gross domestic product (GDP).

These considerations are another reason why we continue to monitor the labor market closely for signs of weakness. One implication of current debt levels is that fiscal policy could well be much more constrained this time around than when entering past economic slowdowns. Add it all up, and we believe the risks of a hard landing are rising.

Author
Richard Weiss
Richard Weiss

Chief Investment Officer

Multi-Asset Strategies

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Trahan Macro Research. “On the Odds of a Financial Crisis,” August 24, 2023.

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