Changes to Monetary and Fiscal Policy Help Explain Price Inflation

Over the past six months or so, many people have started to notice prices rising across the economy. Whether it be the housing market, cost of lumber, gas prices, or the cost of groceries, a dollar doesn’t go as far as it did a year ago. While current inflation can seem drastic when comparing it to recent history, it is important to understand that inflation is normal, and a rate of 2% per year is targeted by the Federal Reserve, the nation’s central bank. Much of the increases we notice in prices can also be explained by current events, including expansionary monetary and fiscal policy enacted in recent years.

Macroeconomics: Aggregate Supply and Aggregate Demand and Their Effect on GDP

Macroeconomics focuses on understanding large-scale economic factors like national productivity. One of the most widely used measures of productivity is GDP (Gross Domestic Product); the total value of goods produced, and services provided. GDP can be visualized by the point at which the aggregate supply and aggregate demand curves meet.

The aggregate demand curve (AD) shows total demand for goods and services within the economy. The downward slope highlights the negative relationship between price level and the quantity purchased in the economy – as the price of goods and services increase, the quantity demanded decreases.

The aggregate supply curve (AS) shows the total supply of goods and services available in the economy from producers. The upward slope shows the positive relationship between price level and real GDP in the short run; as price level for output increases, the opportunity for additional profits encourages more production, increasing GDP.

Impact of Recent Expansionary Monetary Policy on GDP

In the United States, the Federal Reserve has been delegated the responsibility for controlling monetary policy. The Federal Reserve controls the monetary base with the ability to alter the money supply and credit conditions for investment.

  • Historically Low Interest Rates: In the past 10 years we have seen the lowest interest rates in modern U.S. history. Low interest rates make it easy for individuals and businesses to borrow money to increase investment and expansion. This expansion can be seen with purchases of homes or financing the construction of new factories and equipment to increase output. The increased demand for investment (building materials and labor) shifts the aggregate demand (AD) curve to the right, increasing GDP and price level.

Impact of Recent Expansionary Fiscal Policy on GDP

Fiscal policy impacts aggregate demand and supply through changes in government spending and taxation. Both government spending and taxation directly affect household income, which impacts consumer spending and saving (investing).

  • Tax Cuts: The Tax Cuts and Jobs Act (TCJA) was the largest overhaul of the U.S. tax code since 1986. Enacted in December 2017 following a 9-year bull market when the S&P 500 index traded at approximately 2,700 (up from the market bottom of ~735 in December 2008), the Act focused on widespread tax cuts for individuals and corporations. From an economic perspective, lowering taxes raises disposable income, allowing consumers to spend additional sums. This positive demand shock shifts the AD curve to the right, increasing both GDP and price level.
  • Tariffs and Sanctions: The past few administrations have seen several adjustments to trade deals, tariffs, and sanctions imposed (or planned to be imposed) on foreign countries. This is a reversal from the policies of the 1980s to early 2000s which focused on lowest-cost, just-in-time global supply chains. These are widely enacted in the form of taxes imposed on imported goods, paid by the U.S. consumer, to make the cost of these imported goods higher than or comparable to domestically produced products. The result of this is a leftward shift in the supply curve, increasing price but slightly decreasing GDP.
  • Government Spending: At the time this article was written, the Government has spent over $6 trillion on stimulus packages since the start of the pandemic. (This includes the CARES Act with $2.2 trillion in April 2020, the Omnibus Spending Bill with $2.3 trillion in December 2020, and the American Rescue Plan with $1.9 trillion in March 2021.) This is the largest Government stimulus in recent history, significantly higher than the approximate ~$900 billion stimulus during the 2007-2009 financial crisis. As would be expected, the Government stimulus paid to businesses and individuals during this time would raise disposable income. This creates a positive demand shock, and shifts the AD curve to the right, increasing both GDP (to offset reduced productivity) and prices.

Impact of COVID-19 Shutdowns

While Government-enacted expansionary monetary and fiscal policy has played a role in recent price inflation, it is important to note that the business environment as a result of shutdowns resulting from the COVID crisis have also played a significant role in price inflation. During the past year many businesses and producers were required to shut down or scale down their output. Reduced output leads the aggregate supply curve to shift left, decreasing GDP but increasing price.

In Conclusion

These current events and recent policy have influenced the increase to price inflation that we as a country, and the world, have noticed in the past year. While the media has talked about concerns of hyperinflation, a period where both price and GDP increase, it is important to note that all of the aggregate supply changes that increase price actually decrease GDP, moving the economy towards stagflation and a more balanced GDP.

The events of the global economy over past two years highlight that no one can truly predict the future or how the market will react to global events. This leads to the question – how should these recent changes that have impacted prices change my investment portfolio? The simple and obvious answer is, they shouldn’t. Inflation: the long, slow decline of purchasing power is the reason we are equity investors. Inflation isn’t a signal to flee equities, it is the reason we invest in them. Over full market cycles, mainstream equities have been the most efficient protection of wealth from inflation ever created.

As always, if you have concerns or questions about your financial goals or investment portfolio, please do not hesitate to reach out to our team for assistance.