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Understanding Stimulus Packages and Their Tapering Effects

In September, Jamaica’s inflation spiked to 8.2%, well outside the Bank of Jamaica’s (BOJ) 4-6% target range. The global supply chain challenges (inability to supply demand due to bottlenecks and low productivity) resulted in a spike in inflation as the prices of food, materials, etc increased. The BOJ responded by increasing interest rates by 100bps. The Debt Management Unit of the Ministry of Finance entered the market by issuing bonds, to a greater extent than they had done in the preceding months, allowing investors to bid for the interest rate they wanted via an auction. The action taken by the BOJ & government is intended to drain excess cash from the economy, contain inflation and stem the depreciation of the local currency. The BOJ went a step further by increasing the interest rate offered to deposit-taking institutions by 50 basis points to 2.00 per cent per annum in November. These measures were taken to limit the second-round effects of shocks and to guide inflation back within the target range.

At the onset of the pandemic, the U.S. central bank, known as the Federal Reserve (Fed), took a massive expansionary stance in order to stir activity in the economy. The Fed started by decreasing interest rates, as well as implementing a quantitative easing programme by buying securities/bonds from the market, such as  Treasuries and mortgage-backed securities. This was further enhanced when the Fed opted to include Corporate Notes and Exchange Traded Funds to its balance sheet through the government’s Troubled Asset Relief Program (TARP). Most importantly, in every speech he gave, Federal Reserve Chairman Jerome Powell reiterated that the Fed stood to support the economy during this period.

Both Jamaica and the U.S. implemented a combination of monetary and fiscal policy stimulus, but to different degrees, based on their capacities. A stimulus package is a tool used to increase economic activity by reversing or preventing the effects of a recession. Different central banks across the globe have enacted some form of stimulus package to aid in the recovery of the economy amid the pandemic. Stimulus packages may take two forms namely fiscal and monetary policies.

Monetary Policy refers to the actions taken by a central bank to control economic growth and money supply. Monetary policy can be broadly classified as either expansionary or contractionary. An expansionary policy is used to increase economic activity such as providing liquidity to the market – the central bank would buy bonds from the market which, in effect, provide liquidity (money) to the market, also lowering bank reserve requirements, which gives the banks more funds to lend. The increased money supply will encourage citizens to borrow monies to start a business, to purchase a house, etc, while a contractionary policy stance is used to slow down the economy when it is overheating – employment is above full capacity, prices are high and a lot of spending is happening. The effect of a contractionary policy is to reduce the liquidity/money by issuing attractive bonds for investors to buy, with the aim of taking excess liquidity out of the market. Excess liquidity pushes demand upward and fuels inflation. The central bank may also increase interest rates, increase the bank reserve requirement, etc, to drain the excess liquidity.

Fiscal policies, on the other hand, are implemented by the government. This is done mainly by adjusting government spending levels and tax initiatives. Fiscal policies can also take the form of contractionary or expansionary. Examples of fiscal contractionary policy are government cutting spending on capital projects such as the building of major bridges and roads. The government may also increase taxes on higher income taxpayers.

How does all of this aid in the recovery of the U.S. economy? The method used is no different based on the country and is expected to bring about similar results – enable the environment to get the economy out of recession. As stated, a decrease in interest rates is expected to entice consumers or business owners to borrow more and increase spending. By the Fed (central bank) increasing its balance sheet, buying assets, it is increasing the supply of money in the economy. The Fed does not print money but creates electronic dollars that are added to the reserves of large banks. These banks then have an incentive to increase lending.

Just like the Federal Reserve, the U.S. government acted in a manner to increase economic activity. Most recently, a US$1.9 trillion coronavirus relief package was passed. This relief included Federal jobless benefits as well as tax relief:

  1. Direct stimulus of US$1,400 for individuals making up to US$75,000 annually.
  2. Funding to State and Local Government for lost tax revenues during the pandemic
  3. Tax break for the first US$10,200 for families earning under US$150,000.
  4. Assistance to small businesses with an allocation of US$25 billion for restaurants and bars.

At its peak, the Fed was buying at minimum US$120 billion worth of bonds monthly. This month it will commence tapering/ reducing its bond buying programme, buying US$ 15 billion less in bonds monthly, that is a US$10 billion reduction in United States Treasuries (UST) and a US$5 billion reduction in asset-backed securities. The Federal Open Market Committee (FOMC) will determine when further reduction is needed as the economy is assessed periodically. With inflationary concerns plaguing the global space, the Fed’s desire to decrease the supply of money in the economy is understood. Its taper puts it in a position to respond to accelerated inflation by hiking interest rates.

The market is monitoring the inflation data releases and Fed’s posture surrounding the data. While the Federal Reserve maintains that inflation is transitory, investors remain cognizant of its effects on the market and actions the Fed may take to correct this, including increasing interest rates. This could see borrowing costs increasing and long dated and emerging market asset prices decreasing (when interest rates increase, bond prices decrease).

How can investors navigate this market? The key is to build a strong, diversified portfolio based on the underlying value of a company or, in the case of sovereign bonds, the strength of the economy. It also would not hurt to add some inflation linked notes to your portfolio.

Kerice Gray
Snr Trader
VM Wealth Management Ltd.

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