00:00:00
There have been so many questions in the last several months, because there's so much focus around the Fed, on monetary policy. But there should be even
00:00:11
some questions being looked at about fiscal policy and the types of reactions you get
00:00:16
when there are shocks thrown into the mix. Some research looks at that component,
00:00:22
and a pleasure to be joined by Courtney Wiegand, who's an assistant professor of finance
00:00:26
here at the Wharton School. Courtney, great to have you with us today, thanks very much for your time. Thank you for having me, happy to be here.
00:00:33
What was it that had you interested in looking at this component of fiscal policy
00:00:38
rather than the monetary side? Yeah, so after I graduated college, I worked for two years as a research assistant at the Federal Reserve Board, and one of the
00:00:48
responsibilities of the section I was in was to look at the real-time financial market response
00:00:53
to various monetary policy shocks. So how is financial markets responding to monetary policy statements, press releases, things like that. So I always thought it would
00:01:03
be really interesting to do a similar thing, but with fiscal policy, because in my mind,
00:01:08
fiscal policy is one of the main macroeconomic policy levers in the United States, but our
00:01:14
understanding of how it affects financial markets in real time is rather limited.
00:01:19
And so I thought it'd be really cool to try to answer that question. And I was able to sort of
00:01:24
leverage my understanding of how Congress formulates this policy from my time interning on the Hill.
00:01:31
So I interned a few times at the Hill, specifically my time at the House Budget Committee was helpful
00:01:36
because that's where I learned about the budget resolution reconciliation process,
00:01:40
and so I was able to use that process to understand how to formulate shocks, essentially, and then study their effects on financial markets.
00:01:47
Is it safe to say that where we are right now around deficits is really an area that is going
00:01:56
to be, it's focused on, but it's going to be focused on even more because of some of these
00:02:01
dynamics at play? Yes, exactly. So we see like there are these growing concerns about rising
00:02:08
debts, debt-to-GDP ratio, rising federal deficits, and that this is kind of like a persistent and
00:02:14
even growing concern more recently. So one thing that I find is like these effects on financial
00:02:21
markets is persistent over time. So even going back to the 80s and 90s where deficits were much
00:02:25
lower, there's still these significant effects of deficit news on financial markets, but I find that
00:02:33
bigger shocks essentially leads to bigger responses in financial markets. So now we're
00:02:37
seeing this current climate, like larger shocks. And so the extent to which larger shocks have
00:02:42
larger effects on financial markets, I think we're seeing even more like commentary about that.
00:02:47
So give us an idea of a shock that you used in this research and the kind of impact that it
00:02:52
ended up having. Yeah, so very broadly, the way I construct these shocks is looking at these
00:03:00
budget resolution documents. There are these outlay ceilings, so essentially how much, you know,
00:03:04
can Congress spend for the next few fiscal years? These revenue floors, how much they're trying to
00:03:10
collect in revenues over the next few fiscal years, so the difference between those being a
00:03:15
deficit target. And so I use changes in these deficit targets as the budget process unfolds
00:03:20
to identify the timing and the magnitude of deficit news. And so a recent example would be the
00:03:26
One Big Beautiful Bill. So this was the result of the budget resolution reconciliation process,
00:03:32
and one of the effects of the One Big Beautiful Bill was this tax cut. So this essentially like
00:03:38
decreased in this revenue floor. So we're finding that this has significant effects on deficits,
00:03:45
increasing them going forward. So then with that reaction, what ends up being the impacts
00:03:52
that you see with these types of shocks on things like the bond market or on Wall Street?
00:03:59
Yeah, so I find that news of higher future expected deficits leads to an increase in nominal
00:04:06
yields. And so looking at this response, I find that about one-third of this increase is in
00:04:11
break-even inflation, and about two-thirds is in real yields. So indeed there is this, you know,
00:04:16
inflationary effect of higher future deficits, but it's not the full story. And then looking at the
00:04:23
real yield side, looking at the full like maturity spectrum, I find that there's both this increase
00:04:29
in short-term rates, which is often used as like a proxy of monetary policy going forward, as well
00:04:35
as when we look at long-term rates, about half of the effect, the increase in yields, is in this
00:04:41
model estimated term premium component, which is essentially measuring the extra compensation
00:04:45
investors are demanding for holding interest rate and inflation risk. So essentially news of higher
00:04:51
future deficits makes this debt riskier, and not necessarily riskier in terms of default risk,
00:04:56
but in terms of greater uncertainty about the future path of inflation and interest rates.
00:05:01
So a lot of times when we're talking about deficits, we are talking about negative,
00:05:06
and we're seeing increases. What then, if we were to see positive news about deficits,
00:05:12
cutting them back, how would that impact? Would it be exactly the reverse? Yeah, it's a really good question. So I do indeed find this like symmetric response. So
00:05:22
news of higher future expected deficits leads to this increase in rates. News of lower future
00:05:27
expected deficits leads to a decrease in rates. And this is actually, I think, really a good
00:05:32
question because we do see this increase in deficits over time. But what I find is really
00:05:37
important is what you expected. So if you expected higher rates, and then they actually are higher
00:05:43
deficits, and then you get a negative shock, so you then have a revision of your expectations to
00:05:49
lower expected deficit rates, that this would lead to a negative response in yields. And so having a
00:05:56
measure that allows for both positive and negative, I find is really important. What do you think then should be the response, or I guess more so the impact,
00:06:04
on fiscal policy and how they think about it and how it's put forward when you see research like this and these shocks that obviously come into play?
00:06:15
Yeah, so I think that it's really a question of like how your decisions today can impact you going
00:06:23
forward. And so we see, for instance, with these shocks coming from the budget resolution
00:06:29
reconciliation process, I think one of the reasons why they get so much attention is because they do
00:06:34
have these long-term impacts. Because, for instance, let's say one example is like the Tax Cuts and
00:06:39
Jobs Act of 2017. So there are these tax cuts that were legislated for 10 years. So that's why you
00:06:44
often hear like, oh, these tax cuts are expiring. What is Congress going to do next? So we find that
00:06:50
there are these effects on financial markets, but also it's likely that it's constraining
00:06:54
potentially what Congress can do going forward since this legislation is so impactful.
00:07:00
You also mentioned in the paper that there are instances where a fiscal shock can have an impact on monetary policy as well. So there is a crossover.
00:07:09
Yes, there is indeed like this kind of like interaction between fiscal and monetary policy.
00:07:14
That was actually one of the first questions I had, one of the original like motivations for
00:07:19
studying this. And so I find that when the Fed is constrained at the zero lower bound,
00:07:26
then the effects of these deficits and news shocks are much more attenuated. So essentially,
00:07:31
when Congress can't decrease rates any further, and they're unlikely to increase rates in response to
00:07:37
news of higher deficits when they're at the zero lower bound because they're trying to stimulate
00:07:40
the economy. So when they get news of higher future deficits kind of in the direction of
00:07:44
policy they would like, that the response in bond markets is much more attenuated.
00:07:50
And this actually leads to a significant increase in equity markets. And so to the extent that
00:07:56
there is this kind of like coordination between fiscal monetary policy, I find that they're
00:08:00
separate institutions with their own mandates and incentives, but it also depends on the
00:08:05
like overall environment. So we see like even let's say in the 90s or 80s, Chair Greenspan
00:08:11
talking about in a testimony to Congress about how, well, what the FOMC is going to do is going
00:08:17
to depend on what Congress does with its budget resolution. So there can be some coordination.
00:08:22
Right. So there is that correlation between how the Fed reacts to what we see go on in fiscal
00:08:27
policy. Maybe we don't correlate it as much as we probably should though, right?
00:08:33
Right. And I think it too can depend on the overall like economic environment as well. So
00:08:38
you could think about a really large negative economic shock like COVID, you'd think, OK,
00:08:44
the Fed's going to lower rates and Congress is going to try to stimulate the economy. So that
00:08:47
could be an example of where there's a kind of predictable correlation between the directions
00:08:53
of these policies. And that's why I think it's really crucial too to have a shock measure that
00:08:58
exists outside of these big negative economic shocks as well, because both policies are
00:09:04
always happening even outside of recessions. And that's why I think that this fiscal policy
00:09:10
measure can be unpredictable because it's always happening and Congress is very difficult to
00:09:14
predict. What do you hope is the big takeaway from doing this research? And on top of that,
00:09:20
is there a next logical step where you would like to take this research into the next level?
00:09:27
That's a good question. Yeah, I think some goals I have with the paper is just to improve our
00:09:32
understanding of how Congress makes its fiscal policy and also to then understand, OK, what are
00:09:40
the effects on financial markets from that? I think why that's really important and why I'm
00:09:45
interested in digging into that further is because what Congress does, the legislation it passes,
00:09:52
has a direct determinant on the overall deficit level. And then the overall deficit level
00:09:56
has a direct impact on the overall Treasury supply. And Treasury supply is like the largest
00:10:03
bond market in the world and the safe haven and often uses like the risk free rate in our model.
00:10:07
So to the extent that Congress affects this very large and important financial market,
00:10:12
I think that's really important and something I'm interested in pushing on further as well.
00:10:16
Courtney, great to talk with you. Thanks very much for your time. I look forward to chatting
00:10:19
again down the road. Thank you. Great talking to you as well. Thank you. Courtney Wiegand,
00:10:24
who is an assistant professor of finance here at the Wharton School.