Inflation remains the top issue on investors’ minds, with many trying to determine when the relentless rise in prices will stop and whether the Federal Reserve’s aggressive interest rate hikes to try to halt the spiral will engineer a so-called soft-landing for the economy — or, instead, send us into a deep recession. Indeed, your views on the trajectory of inflation will determine your views on future Fed actions — and, therefore, how you decide to put your money to work. Central bank tightening — under the umbrella of monetary policy — is only one side of the equation when it comes to managing inflation. The other is fiscal policy, which is controlled by lawmakers in Congress. Coordinated fiscal- and monetary policy can have a compounding effect in stamping out inflation. But in the current inflationary environment, an expansionary U.S. fiscal policy — one that includes high levels of spending from Covid pandemic stimulus measures through to the recently passed Inflation Reduction Act — has been largely undermining the Fed’s efforts to rein in runaway prices. As JPMorgan CEO Jamie Dimon told lawmakers at a banking hearing Wednesday on Capitol Hill, “I don’t think you can spend $6 trillion and not expect inflation.” I don’t think you can spend $6 trillion and not expect inflation. JPMorgan CEO Jamie Dimon This phenomenon is not unique to the United State. In the U.K., the Bank of England on Thursday raised its base interest rate by 50 basis points, even as Prime Minister Liz Truss’ government on Friday unveiled sweeping tax cuts to spur consumer spending. “What is worrisome in the last 24-48 hours … is an accelerated loss of confidence in policymaking,” Allianz advisor Mohamed El-Erian told CNBC Friday. “Policymaking [is] going from being a repressor of volatility to an amplifier of volatility,” he added. Both central banks and lawmakers have two main tools they can use to impact the money supply in the economy – and every investor should be familiar with them. At a high level, these policies are used to cool an overheated economy or stimulate a stagnant one. When the goal is to put the brakes on economic activity, money needs to be pulled out of circulation to reduce the number of dollars competing for goods, and thereby limiting inflation. On the other hand, to stimulate activity requires pumping liquidity into the economy to encourage spending. Policymaking [is] going from being a repressor of volatility to an amplifier of volatility. Allianz advisor Mohamed El-Erian In the U.S., the Fed has two main tools at its disposal to achieve its dual mandate of maximizing employment and maintaining long-term price stability: interest rate hikes and open market activity. When raising its key fed funds overnight bank lending rate, the Fed is directly raising borrowing costs between banks. By raising the rate, the Fed is seeking to disincentivize borrowing to douse an overheated economy. Conversely, when the Fed reduces the fed funds rate, it’s lowering lending costs to encourage both borrowing and spending to fuel the economy. The Fed can also impact rates and the number of dollars in circulation by purchasing securities on the open market, known as open market activity. In an expansionary scenario — like the one we had in 2020 – the Fed seeks to purchase Treasuries and corporate bonds, thereby pumping money (liquidity) into the market in what’s called quantitative easing (QE). On the other hand, a more contractionary monetary policy — like we’re experiencing now — would see the Fed reduce its balance sheet by letting bonds mature without purchasing new ones, decreasing the number of dollars in circulation. On the fiscal side, the federal government’s two main tools for managing the economy are taxes and spending. If policymakers slow economic activity, they may look to the restrictive approach of raising taxes, thereby lowering consumers’ after-tax discretionary income — and, as a result, reducing their buying power. The policy has the result of effectively pulling money out of circulation. Expansionary policy implies the opposite — lowering taxes to keep more discretionary dollars in consumers’ pockets and incentivizing spending. On the spending side, if the government wants to stimulate the economy, it can spend more on public investments like infrastructure that generate jobs and sales. A restrictive policy would see spending reduced, thus lowering the supply of money coming into the economy via government contracts, with knock-on effects for workers and commerce. On the monetary policy front, we are currently getting exactly what we’d expect in a highly inflationary environment: rate hikes and balance sheet reduction, which help suck excess liquidity out of the market. But given that U.S. fiscal policy is not acting in concert with monetary policy, the Fed’s efforts to bring down inflation have become all the more complicated. In the years since the 2007-2009 global financial crisis, expansionary fiscal policy — and monetary policy for that matter — has not posed much of a problem due to overall low inflation. Indeed, the last time the U.S. implemented a true contractionary fiscal policy was during the Clinton administration when taxes were raised, spending was reduced, and the federal budget flipped from a deficit to a surplus. It is because of these seemingly contradictory policies that we have been of the view as Jim Cramer puts it: “Every time Fed Chair Jerome Powell seems to get a handle on inflation, the government throws him for a loop.” In the end, we believe the Fed will win the war on inflation. However, it may just take longer than it otherwise would have. As Powell is attempting to slam on the breaks, government spending is acting like a foot on the gas pedal — drawing out this bout of inflation. (See here for a full list of the stocks in Jim Cramer’s Charitable Trust.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. 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U.S. Federal Reserve Board Chairman Jerome Powell departs after holding a news conference after Federal Reserve raised its target interest rate by three-quarters of a percentage point in Washington, September 21, 2022. Kevin Lamarque | Reuters