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Fiscal and monetary policy – what (not) to expect in the Budget

Budget 2020: Equity Analyst Will Ryder looks at the differences between fiscal and monetary policy and how they could be impacted by the upcoming budget.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

William Ryder, Equity Analyst

Published on 19 February 2020

This article is more than 6 months old

It was correct at the time of publishing. Our views and any references to tax, investment and pension rules may have changed since then.

Fiscal and monetary policy are the two main tools governments can use to influence the economy. In March’s Budget they’re words you’re likely to hear bandied about a lot, but what do they mean?

Fiscal policy

Fiscal policy covers taxes and spending and is controlled by the Treasury. The government sets fiscal policy, usually once a year in the Budget.

Fiscal policy is described as ‘expansionary’, or ‘loose’, when the government increases spending by more than it increases taxes. ‘Tight’, or ‘contractionary’, fiscal policy means the government cuts spending more than taxes.

How is it supposed to work?

The theory is governments can stimulate the economy and increase employment by spending more than they take in taxes.

Government spending puts money into our pockets. We then go and spend the money, for example in shops and restaurants. These shops and restaurants will then hire more people who spend more money and so on and so on.

The government can fund this spending with borrowed money. This is known as fiscal stimulus.

Like most theories the reality isn’t always as neat as the textbooks suggest, and some economists disagree that fiscal stimulus works as advertised.

Where are we now?

In recessions people lose their jobs and spend less. As a result the government collects less in taxes. At the same time government spending on unemployment and other benefits goes up.

The end result is a budget deficit (the overspend caused by paying out more than is coming in) that grows automatically.

This is what happened during the Financial Crisis and subsequent recession, but since then the deficit’s declined, partly as a result of Austerity.

UK Government Deficit % of GDP

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Source: ONS, 07/02/2020

Monetary Policy

Monetary policy refers to interest rates and the money supply, and is controlled by the Bank of England. The Bank of England is tasked by the Chancellor with keeping inflation (the rate at which prices rise) at about 2% a year, while supporting economic growth and employment. Aside from these targets it’s independent and its decisions aren’t directly controlled by government.

The Bank of England has two main tools to achieve its aims, the Bank Rate and asset purchases.

The Bank Rate is the interest rate that banks pay to borrow money from the Bank of England. Asset purchases, also known as Quantitative Easing or QE, means creating new money to buy government debt with the intention of lowering interest rates.

‘Loose’ monetary policy means low interest rates and high net asset purchases, and ‘tight’ monetary policy is the opposite, high interest rates and few asset purchases.

How is it supposed to work?

Low interest rates make borrowing money cheaper and saving money less attractive. This encourages people to spend money, causing prices to rise and economic activity to pick up. If prices rise too quickly (above the 2% annual target) the bank can lift rates, although this also dampens economic growth, and possibly employment.

Lower interest rates also make it cheaper for businesses to borrow and invest, potentially adding to economic growth.

Quantitative Easing (QE) aims to increase the price of government bonds and therefore lower their yields. Because other interest rates are based on government bond yields, the other interest rates come down too.

Again, all is not quite as simple as it seems. Many economists disagree with the real world impact of interest rates changes and QE.

Where are we now?

In response to the Financial Crisis the Bank of England cut interest rates to historic lows, and started up the QE program - an incredibly loose monetary policy.

Markets are expecting a Bank Rate cut towards the end of the year. As inflation is currently below target the Bank does have the space for a cut, but it’s not guaranteed.

Chart showing Monetary Policy changes

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Source: Bank of England, 07/02/2020

What might we see in the next budget?

There has been some speculation, based on the Conservative Manifesto, that we could see a looser fiscal policy than we did under Cameron and Osborne.

However, while higher spending may be on the cards, so too could higher taxes. Johnson has ruled out hikes to income tax and VAT, but we may see a reduction in pension tax relief or the introduction of a mansion tax.

It’s worth remembering that, because the Bank of England is independent, we won’t see any changes to interest rates as part of the Budget. Having said that, the Bank’s Monetary Policy Committee (which sets rates) will respond to the conditions it faces, and a dramatic change in government policy might have an effect going forwards.

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