When the COVID-19 pandemic sent the U.S. economy off a cliff in the spring of 2020, the government, appropriately, opened its wallet. In doing so, it ushered in a new era in which fiscal policy came to dominate the economic landscape—bringing about the higher inflation that monetary policy had been unable to achieve over the previous decade.
But while this policy has kept the economy buoyant, what happens when the tide goes out? Here’s what investors need to know about potential risks to the economy in the coming year.
What Happens If Government Spending Pulls Back?
Fiscal stimulus worked so well at keeping the economy afloat during the pandemic lockdowns that the government decided to double and triple down on the strategy, with an additional $3 trillion of fiscal spending in the first quarter of 2021. With this, the growth of the money supply resulting from fiscal policy exploded to a record level of ~25% annually in early 2021. This paved the way for the inflation that central banks had been trying so hard to achieve following the Great Financial Crisis in 2008, when the money created by quantitative easing remained trapped in bank reserves rather than flowing into the real economy.
However, the dynamic has been very different during the most recent policy regime, which has swung between two extremes. First, the Fed had to be overly supportive and help to fund the government’s near-record deficits in 2020 and 2021. Then, with the arrival of generationally high inflation, the Fed responded with the most aggressive tightening in 40 years.
This is the very definition of fiscal dominance—and it comes with risks.
Recently, fiscal policy has allowed the economy to grow faster than forecast, giving rise to the consensus view that the risk of a recession has faded considerably. But if fiscal policy is showing such little constraint in good times, what happens to the deficit when the next recession arrives?
In fact, the U.S. government has rarely ever had such large deficits when the unemployment rate is so low, and with the recent lifting of the debt ceiling until 2025, this aggressive fiscal spending could continue. However, there are limits to such fiscal policy, which increases the supply of Treasury notes and bonds needed to fund these expenditures; this is one of the reasons that ratings agency Fitch recently downgraded its U.S. debt rating.
Furthermore, if fiscal spending must be curtailed due to higher political or funding costs, the unfinished earnings decline that began last year is more likely to resume. Here’s where we find ourselves today—and why are concerned that stock valuations are rising higher even as the possibility of an earnings recession looms larger.
