A new era of monetary and fiscal policy or back to the future? What investors should know

Shifts in monetary and fiscal policy are reshaping inflation, central bank independence, and markets—investors must understand these dynamics to anticipate growth, risk, and rate changes.

Markets don’t move in a vacuum—and neither does policy. For investors, understanding the interplay between monetary and fiscal policy isn’t just academic. It’s essential for understanding where growth, risk, and rates may be headed.

History offers clues about how shifts in policy priorities have shaped economic outcomes before. And similar patterns are resurfacing now, ones that could carry important implications for investors.

How policy priorities flipped: From labor’s boom to capital’s reign

In the postwar period, monetary policy has tended to favor either labor or capital. During the three decades following World War II, it leaned toward labor, driving the creation of—and subsequent boom in—the middle class.

Post-World War II policy: Favoring labor

From the 1950s to the 1970s industrial production surged, creating millions of jobs and fueling strong, consistent GDP growth. Union membership expanded, helping to ensure that prosperity translated into higher wages, pensions, health benefits, and job security for the broader population. Fiscal policy reinforced this trend, as progressive tax rates helped to redistribute wealth and New Deal programs like Social Security and unemployment insurance stabilized employment through retirement.

Tighter alignment between monetary and fiscal policy prioritized shared prosperity across business, labor, and government. As a natural consequence, central bank independence lessened. Political influence contributed to delays in tightening and encouraged premature easing in the 1970s, contributing to a sustained period of high inflation.

1980s onward: Capital takes the lead

Growth continued in the 1980s, but social and policy priorities shifted toward capital. Acknowledging the inflationary risks resulting from political interference, central banks were empowered to operate independently. Price stability became the mantra.

Union membership dropped sharply, driving a decline in wage growth and eroding job security. Manufacturing sector dominance was supplanted by growth in technology and services. Globalization and overseas competition drove the outsourcing of labor and manufacturing to lower-cost countries.

Both in the US and elsewhere, a new political consensus favored tax cuts for higher earners, deregulation, and an emphasis on shareholder value over worker welfare. As a result of these influences, productivity rose but the benefits accrued primarily to companies and their shareholders. Wealth concentrated and the middle class shrank.

The output gap: A window into policy’s winners and losers

These generational shifts between labor and capital can be observed through the output gap—a measure of the difference between an economy’s output today and its potential output at full employment with stable inflation.

• Positive output gap means the economy is running above capacity to meet strong demand, boosting employment and wages, but putting upward pressure on prices. Labor wins and the middle class becomes wealthier, reducing income inequality. Monetary policy tends toward loose (lower rates). 
• Negative output gap means the economy is underperforming, and the excess supply restrains prices and wage growth. Capital wins and income inequality widens. Monetary policy tightens to preserve price stability.

The postwar period between 1950 and 1975, when central banks were more closely tied to fiscal policymakers, saw positive gaps and labor-friendly policies. From 1980 until Covid, negative gaps dominated, favoring capital (Figure 1).

Current trends: Deficits, inflation, and central bank independence

Where are we today? Deficits are rising. Populism is ascendant. Political appetite for fiscal restraint is minimal. With little political will to address the problem directly, the temptation may be to “inflate away” the debt burden. While not actually that easy to do, politics are aligning to promote employment and wage growth at the expense of lower inflation or price stability.

Inflation has been well above target for several years, labor markets are tight, and wage growth is strong. Migration controls could further constrain labor supply, adding upward pressure on wages. The erosion of central bank independence is a logical consequence of these dynamics, as politicians seek lower rates to reduce debt service costs and spur economic growth—even at the cost of higher inflation.

Evolving policy dynamics and market impacts

Monetary and fiscal policy dynamics

• More deficit spending and tax cuts targeting manufacturing, immigration enforcement, infrastructure (especially energy), and defense; little near-term focus on budget balance 
• Pressure on the Fed to keep rates low—echoing the 1970s—both to spur the economy and keep debt service costs down
• Tolerance for modestly higher inflation, consistent with a shift to focus on wages and growth versus price stability
• Potential restocking of the Fed monetary policy committee to prioritize administration priorities—a new and more direct attempt to influence monetary policy
  

Potential market impacts 

• Lower short-term rates
• Structurally higher inflation
• Steeper yield curves
• Possible return of financial repression to influence the long end of the yield curve and offset the impact of “bond vigilantes” seeking to drive interest rates higher when they believe monetary policy is too loose.

Implications for investors

History offers a guide: As policy tilts toward labor and growth—even at the cost of inflation running hotter—investors may want to:

• Reassess fixed income strategies given potential curve steepening and higher inflation—how much will the Fed tolerate before intervening?
• Position for inflation resilience through real assets and sectors likely to benefit from fiscal expansion
• Stay alert to policy signals, especially around fiscal priorities and central bank independence
  

We’re entering a period where politics, policy, and markets are converging in ways that are likely to shape investment outcomes for the future. Understanding these dynamics is critical for investors seeking to position portfolios for what’s next.

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