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U.S. Fiscal Stimulus Driving Financial Markets

October 14, 2020 By Mircea Vasiu

In the couple of weeks left until the U.S. elections, financial markets focus on the size of the second fiscal stimulus package. What’s at stake is not the question of whether there will be more fiscal easing, but the size and the timing of it. 

In the case of a “Blue Wave,” meaning Democrats win the Senate too, a huge fiscal package is planned with good news for the materials or infrastructure sectors. In the case of a Republican win, the focus shifts to further tax rate cuts. In fact, shortly after the 2016 elections, the Republicans delivered one of the most anticipated rate cuts (i.e., corporate tax). This time, the preparations are made for a more pronounced tax rate cut on different levels and of a bigger magnitude.

However, no one knows if the markets will have a fiscal package on the table until or after the elections. Moreover, what happens if the result of the election will be disputed? Effectively, it means that any fiscal package will be postponed, and that is what will send markets on a tear lower if it happens.

For this reason, any news out of the U.S. fiscal space is met with sharp stock market indices moves. Because of that, traders and investors are better off by understanding at least some of the basics of fiscal policy and the implications of fiscal decisions for the overall economy.

Fiscal Policy as a Complement to Monetary Policy

A central bank reacts by tightening or easing the monetary conditions in an economy. When the official rate (i.e., federal funds rate in the United States) is above the neutral economic rate, the central bank applies a contractionary monetary policy. Conversely, when it is below, it is said that the central bank applies an easy or expansionary monetary policy. The challenge, of course, is to estimate the average growth and to apply the expected inflation to reach the neutral economic rate.

The same is valid in the fiscal space; only this time, it is the government and not the central bank that is responsible for contractionary or expansionary policies. Fiscal policy measures affect the budget – the difference between income and expenses. When the government uses an expansionary fiscal policy, the tax rate cuts, for example, leave more disposable income available to spend, and the hope is that the consumer will react by investing in new businesses or increase consumption.

This is just one example of the effect of an expansionary fiscal policy measure, but along the same lines, we have investments in infrastructure, education, health, etc.

Any fiscal easing comes to complement the already easy monetary policy. It means another reason why the stock market will likely remain bid as long as the fiscal stimulus negotiations remain on the table.