Monetary Policy vs. Fiscal Policy: Why the Fed Can't Fix the Economy Alone

Everyone hears on a regular basis about how committee members of the Federal Reserve Bank meet to discuss economics and whether to change the inter-bank lending rate. It would seem media commentators wait with baited breath to see what the Fed will do and what that will mean for the greater economy. I think people tend to assume the Fed is responsible for the economic well-being of our country, but that is only partly true.

The Federal Reserve principally exists to soundly manage the money supply, which is what we refer to as monetary policy. However, over time, the Fed’s mission has been tweaked, and now they are also tasked with trying to keep the economy at full employment.

To understand how the Fed has some, but not all, responsibility for the economy, starts with the study of macroeconomics. This branch of econ concerns itself with three economic measures: unemployment, inflation, and “output” better known as GDP. The issue is, these three indicators don’t move in harmony. If GDP growth is high and unemployment are low, inflation tends to be high. If inflation is kept low, that tends to keep unemployment high. So the Fed has this interesting task of trying to manage the money supply (keep inflation low), but also trying to keep unemployment low at the same time.

While this all sounds complex and like the work of highly educated central bankers, it really boils down to a simple idea. The Fed is there to manage, not so much to lead; and yet people bemoan when the Fed isn’t doing more or can’t do more to spur on economic growth. We must step back and ask ourselves, is it really their responsibility to generate economic growth in the first place?

If it is not the Fed’s responsibility, then whose could it possibly be? Another thing you must understand about macroeconomics is GDP = Consumer Spending + Investment + Government Spending + Net Exports. It is hard to imagine the Fed is somehow responsible for consumer spending patterns, people’s decisions to invest, how taxes are spent or the export/import environment. There is, however, a body of government that concerns itself with all of these things, and it’s called the US Congress.

How money is spent is fiscal policy, and that is the responsibility of Congress. The real challenge with economic growth is if there is no plan on how money is spent by the government nor what can be done to increase consumption in certain industries. Because of this general uncertainty and malaise over laws that govern business, GDP remains stuck in the mud. The Fed, on the other hand, is trying to do what it can with monetary policy, but it is fiscal policy that will bring any sort of real change to the economic environment.

The gridlock in Congress, leading to a complete lack of fiscal policy, is far more likely to blame for the mismanagement of the economy. In fact, it is leading people to pressure the Fed to do more. Then the Fed gets blamed for engaging in risky new policies out of pressure to create economic growth, but the blame should lie in the lack of any fiscal help, which is what is needed most at this time. If Congress could do more to encourage economic growth, the Fed could stop trying unproven methods in the hopes of not causing more harm than good.