Federal Reserve’s Response to the Policy
In Aug 2021, the Federal Reserve chair Jerome Powell declared the Fed could start tapering of monetary policy easing by November 2021, though he also said, it won’t be a hurry to begin to raise interest rates thereafter. One of the rationales behind declaring tapering had been the labour market’s clear progress, and the second was that the economy has now met the test of substantial progress and putting significant pressure on prices, which could jeopardise inflation targets.
The Federal Reserve on Wednesday (Nov 03, 2021) announced as a first step towards pulling back liquidity from the market by reducing the pace of its bond purchase. The decision will be executed by reductions of $ 10 bn in Treasury and $ 5 bn in mortgage-backed securities, a total of $ 15 bn each month from the current $ 150 bn a month that the central bank is buying. The interest rates are likely to be unchanged since 2023 or earliest by late 2022.
What is more interesting is the Fed has altered its views on inflation, acknowledging that price hikes have been more rapid and enduring than the central bank had been forecasting earlier. Earlier its stand of inflation being ‘transitory’ has been slightly modified. The statement released says ‘ Supply and demand imbalances related to the pandemic and the reopening of the economy have contributed to sizable price increases in some sectors.’ It also says ‘our baseline expectation is that supply chain bottlenecks and shortages will persist well into next year and elevated inflation as well.’
The policy rate does not flow to the other interest rates in the economy fully, and whatever little percentage flows through to the credit rates takes a longer time.
The future expectations, on account of a future policy rate hike, affect medium and long-term rates to a greater extent. The likelihood that contractionary policy will be adopted in the future after a dovish stand makes banking and non-banking financial institutions risk-averse to lend. These phenomena suppress the impact of policy.
The statements released by the Fed depict the change in the stance of the central bank to shift from inflation to be pure ‘transitory’ to ‘transitory but persistent’, which is linked to supply failures. This also means that the price rise due to an increase in liquidity is limited as compared to supply-chain disruption.
Credit Channel and its Effectiveness
In the last article, I discussed how monetary policy struggles to adjust macro parameters of the economy right. Transmission of monetary policy narrates how changes made by RBI by slashing down the policy rate flows through the bank rates, credit rates, economic activities, and price change. The first interaction of change in the policy rates is about how it affects other rates in the economy by successfully bringing them down. Nevertheless, it should be kept in mind that policy rate is not alone determinant of price change, other factors such as maturity of the financial market, the risk associated with different loans, prospects for the businesses, the financial soundness of the banks, and willingness of consumers to borrow have a significant impact on credit rates.
The whole premise of the policy discussed was that a change in lending and deposit rates should affect the saving, consumption, and investment decision of the households and firms. Lower interest rates in accommodative policy make it attractive for firms to take loans for expansions and Greenfield projects. Lower interest rates also promote households to borrow more for consumption.
Consequently, for the most part, the money generated for economic and household units to generate extra demand and create supplies to boost the economy has been devoured by stock markets.
The stockholders whose value of assets goes up to become wealthier due to a decrease in interest rate may consume more. At the same time, the increase in asset price enhances the value of collaterals allows households to borrow more. All these factors result in an improvement in aggregate demand.
We have seen that the policy rate does not flow to the other interest rates in the economy fully, and whatever little percentage flows through to the credit rates takes a longer time. The future expectations, on account of a future policy rate hike, affect medium and long-term rates to a greater extent. The likelihood that contractionary policy will be adopted in the future after a dovish stand makes banking and non-banking financial institutions risk-averse to lend. These phenomena suppress the impact of policy.
Financial Markets and Monetary Policy Intertwined
In this section of the article, I would walk through how the financial markets are important for a policy rate cut to stimulate the economy to create an environment of ample jobs and robust growth. In a capitalist economy, the financial markets have an important role in furthering policy transmission by creating liquidity for businesses and apportioning resources efficiently. The market expectations are sparked off by the policy interventions and financing environment in the economy. This happened through a mechanism of security products that create an opportunity for those who have excess funds – investors and lenders- to invest in and make these funds available to those who need money – individuals and businesses -as a borrower for investment and consumption.
The Reserve Bank of India may adopt an expansionary policy for a longer period in the apprehension of muted and slow transmission of it could be dangerous, and it has the potential to aggravate the situation for another recession.
It has been found in various studies that transmission is relatively fast and full in financial markets. In the developed economies where financial markets are fully developed interest rate transmission happens efficiently to the sectors of the economy. In emerging markets like India, a bank’s lending channel plays an important role. But, in India, the commercial banks are parking funds with RBI to a record high under reverse repo rate, which is more than Rs 7 lakh crore per day, in turn; this testifies the tendency of banks of not lending to the businesses and household though being flooded with the cash. An increase in cash in the market has created a propensity for people to save more for the future and spend less in present. Ample availability of cash in the economy and uncertainty of the future has diverted money to risky assets in want of higher returns.
The stocks are soaring to new highs; the NIFTY index has surged from 8584 to 17934 on November 04, 2021, a 109percentabove from the 1st April 2020 level. The data suggests, around 14.2 million new DEMAT accounts have been opened in FY21 which is three times the accounts opened in the previous year FY20, from a number4.9 million. Unfortunately, the reason for this could be traced to the fact that policy has been quite successful in giving confidence to investors and speculators to be attractive towards riskier assets in search of higher yields. Consequently, for the most part, the money generated for economic and household units to generate extra demand and create supplies to boost the economy has been devoured by stock markets.
Indian financial market including the stock market is not fully developed and a few companies are listed on the stock market. Also Indian economy is more flooded with small and medium enterprises which neither have easy access to credit nor are listed in the market. The companies listed with the stock market can raise funds quickly to alleviate cash problems or to expand their businesses; in a way, only a few firms have been the beneficiaries of raising funds for new investment. As a consequence, a large chunk of firms that generally bank on credit finance through financial institutions, especially those which are small and medium-sized, are deprived of this facility.
Nevertheless, Fast transmission of policy through the financial markets has been beneficial for the government in raising funds at a lower cost, through monetisation of treasury bonds. The bond yield of a 10-year treasury bond is raging from 5.7 to 6.2 percentage in the last 18 months as against the 6.5-7.9 percentage in the last few years before the pandemic. These funds utilised to propel economy through various fiscal initiatives such as PLIs and infra spending.
These initiatives may induce confidence in households and firms to consume and produce more. The demand boost assurances can propel firms to make investment decisions in anticipation of demand sustainability out of future earnings.
The financial market distresses, low confidence of market agents, adverse balance sheet adjustment have caused impairment of the policy. The interest of market agents, firms and households, in risky assets during the policy implementation has resulted in excessive risk-taking behaviour and fear of asset price bubble formation. The Reserve Bank of India may adopt an expansionary policy for a longer period in the apprehension of muted and slow transmission of it could be dangerous, and it has the potential to aggravate the situation for another recession.
The economists believe if other fiscal policy measures are taken along with the monetary policy can help mitigate some of the adverse characteristics developed by the complex interaction of the policy and the economy. The fiscal measures could include employment generation schemes, a financial support system for MSMEs, benefits to the small and medium businesses for maintaining the previous level of employment, infrastructure spending, etc. These initiatives may induce confidence in households and firms to consume and produce more. The demand boost assurances can propel firms to make investment decisions in anticipation of demand sustainability out of future earnings. In sequence, the monetary policy could be more powerful to significantly alleviate financial distress and stabilise prices. In conclusion, it is crucial to define a policy mix to stabilise and put the economy on the right path.
