Understanding how monetary and fiscal policies can work together

After the first U.S. coronavirus cases emerged early this year, 22 million Americans lost their jobs in March and April, and the economy went into a recession.¹ Since then, the recovery has been slow, choppy, and partial, with around 11 million jobs gained in the May-September period. In contrast, the stock market’s rebound has been strong, as the S&P 500 Index and the NASDAQ Composite Index both set record highs on September 2, eclipsing their prepandemic levels.

The economic pain from COVID-19 has been global; for example, India’s economy shrank by 23.9% in the three months ended June 30.² Each member of the G7—Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States—fell into recession.³

In such unprecedented times, central banks and governments have sought to modify their monetary and fiscal policies, respectively, to provide much-needed relief and stimulate economies to return to growth. Monetary policy and fiscal policy are the two main tools that policymakers can use to influence their economies.

In the United States, the monetary policy response has been massive. The U.S. Federal Reserve (Fed) cut interest rates to effectively zero and, among other things, revived its decade-old quantitative easing program, ramping up purchases of government bonds. As a result of that move, and many others, the size of the Fed’s balance sheet exceeded $7 trillion as of September 30, slightly below a record set three months earlier.⁴

While the fiscal policy response has also been huge, it’s recently stalled. In an October 6 speech, Fed Chair Jerome Powell praised fiscal measures taken this past spring by Congress and the White House, including a $2.2 trillion financial aid package, the Coronavirus Aid, Relief, and Economic Security Act (CARES Act). But he also addressed policymakers’ more recent failure to reach a consensus on additional measures such as supplemental unemployment payments and further cash payments to citizens, saying the risks of not doing enough to provide more stimulus are greater than the risks of doing too much.

“The recovery will be stronger and move faster if monetary policy and fiscal policy continue to work side by side to provide support to the economy until it is clearly out of the woods,” Chair Powell said.⁵

So what exactly are monetary and fiscal policies, and how do they differ?

Monetary policy refers to actions that a nation's central bank can take to control the money supply and pursue macroeconomic goals that promote sustainable economic growth.

In the United States, the Fed is tasked with managing financial liquidity, growth, inflation, and consumption, among other things. It does this by modifying interest rates, managing federal cash reserves, establishing foreign exchange rates, and purchasing or selling government bonds.

For example, early this year, the Fed brought liquidity to the markets through its corporate bond buying. Despite fears that the Fed risked flooding the market with liquidity and inadvertently creating a financial bubble, many economists have argued that the move has helped strengthen markets and made credit available to fuel economic recovery.

Fiscal policy is the government’s use of public spending and taxation to influence the economy. In democracies, these areas are typically the domain of elected representatives and presidents and prime ministers, rather than of nonelected appointees who guide monetary policy at central banks.

Through fiscal policy, a government seeks to exert influence to prevent its economy from growing too fast, potentially avoiding a spike in inflation, or to avoid a slowdown that could lead to a job-destroying recession. Historically, the willingness of governments to intervene in their economies has varied; periods of economic distress have often triggered greater intervention, while periods of growth and stability have typically fueled sentiment favoring a more hands-off approach emphasizing free-market economics.

In the wake of the pandemic, intervention has expanded. For example, in the United States, the CARES Act included a one-time payments of $1,200 to individuals affected by COVID-19-related layoffs, suspension of student loan payments, protection against evictions and foreclosures, aid for at-risk companies such as airlines, and federal assistance to gig workers, among other things.

But congressional efforts to take further action recently stalled, creating uncertain prospects for more fiscal stimulus prior to the November 3 election. On October 1, the U.S. House of Representatives narrowly passed a Democratic bill that proposed another $2.2 trillion coronavirus relief package⁶; however, the bill failed to win backing from House Republicans. Prospects in the Republican-led Senate remained uncertain, as did the status of related negotiations between President Donald Trump and Democratic congressional leaders.⁷

With the pandemic and resulting recession, the road to recovery for the U.S. economy and others is likely to be long and uneven. Policymakers have already gone to great lengths to embrace monetary and fiscal relief measures. The pandemic’s duration, the uncertainties that it brings, and inevitable shifts in the political winds make it likely that monetary and fiscal policies will command plenty of attention in the news cycle for a long time to come.

1 U.S. Bureau of Labor Statistics, 2020. 2 “India’s economy shrinks at the fastest pace on record,” cnn.com,  8/31/20. 4 “Covid-19 dealt a shock to the world's top economies. Here's who has fared the worst,” cnn.com, 8/28/20. 5 U.S. Federal Reserve, FactSet, as of 9/30/20. 6 “Powell says U.S. economy needs more fiscal support,” MarketWatch, 10/6/20. 7 “House Passes $2.2 Trillion Coronavirus Relief Bill in Absence of Bipartisan Deal,” the Wall Street Journal, 10/1/20. 8 “Coronavirus Stimulus Talks With White House at Impasse,” the Wall Street Journal, 10/11/20.