Monetary Policy Dominated The Last Decade, What’s Ahead?

Don’t fight the Fed, as the saying goes. But at this point, it’s reasonable to ask how much fight the Federal Reserve (Fed) has left. The Fed played an oversized role in stimulating markets over the past decade and became an indefinite backstop. But what’s the line in the sand that the Fed will not cross in terms of support for the market? And how could monetary policy influence fiscal policy, and vice versa, at his point in the cycle? For asset managers in 2020, these are essential questions following a year in which central bank support was a major factor in driving record market performance.

Below, we look at monetary and fiscal policy and the factors that could determine their trajectories. In 2020, we expect a lower level of overall support for the market than in 2019. However, we don’t expect the market’s party to end until interest rates rise meaningfully. In line with this, we expect risk assets to continue to show resilience.

The Tools to Influence Economic Activity

Monetary and fiscal policy are two sets of tools used to influence a nation’s economic activity. While they operate independently, there is the potential for monetary and fiscal policy to work together to either stimulate or cool the economy. These tools are most effective when working together.

Globally, the last decade has predominantly been focused on monetary policy. While this has provided support for markets, this has yet to be fully integrated into the real economy. Impact on the real economy is one of the main differences between fiscal and monetary policy. While fiscal policy has a direct impact on the real economy, monetary policy’s impact tends to be more indirect. Consequently, fiscal expansion during a period of supportive monetary policy could create an optimal setting where fiscal and monetary policy work together. The table below outlines the objectives and differences between these tools.

(Click on image to enlarge)

Monetary Policy Support Still the New Normal  

The 2010s featured extraordinary central bank intervention or monetary policy in the aftermath of the 2008 financial crisis. The prevalence of cheap debt and ample central bank liquidity sent markets soaring as the crisis turned to recovery. A decade-plus removed from the throes of the crisis, we can now see that markets rely on—and expect—support.

2019 showed that the market’s addiction to whatever-it-takes monetary policy is not an easy thing to kick. In October 2019, the Fed started purchasing Treasury bills at a clip of $60 billion per month due to liquidity concerns in the Repo market in mid-2019. These purchases are likely to continue into the second quarter of 2020.1 Interestingly, the Fed does not refer to this as quantitative easing (QE), given the purchase of Treasury bills rather than bonds. We find that to be semantics—the Fed is providing liquidity and the markets have reacted positively.

The scale of central bank support was one of 2019’s biggest surprises. Last year, central banks around the world collectively increased their balance sheets by about $100 billion per month. The extra liquidity boost likely affected risk-taking as it worked to reduce market volatility.2

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