Tight Monetary Policy

The recent spikes in COVID-19 infections are concerning in emerging market and developing economies with significantly lower vaccination rates than the global average. Access to vaccines continues to be a stumbling block for most of these economies, leaving their populations more vulnerable to new virus variants. The economic consequences of relatively low vaccination rates in these economies are all too clear, with increased economic and financial crisis risks. During the COVID-19 crisis, the US Fed offered temporary currency swap lines to only two EM central banks .

The tapering process began in December 2021, with monthly asset purchases reduced from $120 billion to $105 billion. Surprisingly, within two weeks, the Fed decided to double the pace of tapering in response to rising inflation and a stronger economic recovery. On December 15, Fed Chairman Jeremy Powell announced that the Fed would reduce monthly asset purchases by $30 billion.

The funds raised through the levy are meant to provide emergency foreign currency liquidity to banks in times of distress. South Korea’s regulations on forex markets are worthy of consideration to protect the domestic economy from speculative hot money flows. Based what is nfo file on lessons learned from two severe financial crises — the 1997 Asian financial crisis and the 2008 global financial crisis — the Bank of Korea began implementing a series of measures to mitigate forex vulnerabilities and taming volatile capital flows in 2010.

The impact of tight monetary policy

The empirical estimates suggest significant asymmetric behaviour of call rates, commercial paper yield and short term treasury bill yield to changes in policy rates during the deficit liquidity conditions vis-a-vis surplus liquidity conditions 16. The instantaneous pass-through of policy rate changes to call money rate during deficit liquidity conditions is nearly 75 basis points in response to a percentage point change in policy rate. Before embarking on empirical analysis of the transmission mechanism, it would be pertinent to understand the degree of integration of prices of various financial assets.

As a result, the Fed’s net new bond purchases will be completely phased out in March 2022, three months ahead of the previous schedule. For most EMDEs and low-income countries , output and employment continue to be below pre-pandemic levels. Due to their currencies’ low credibility, EMDEs and LICs have limited fiscal space in comparison to advanced economies. They, therefore, are unable to launch long-term https://1investing.in/ recovery programs such as the EU’s Recovery and Resilience Facility and the US’s Build Back Better. The RBI has said it will engage in a calibrated withdrawal of the accommodative stance over a multi-year time frame in a non-disruptive manner beginning this year. The objective is to restore the size of the liquidity surplus in the system to a level consistent with the prevailing stance of monetary policy.

The second stage of monetary transmission involves propagation of monetary policy shocks from financial markets to goods and labour markets, which are ultimately reflected in aggregate output and prices1. Thus, clarity about the first stage of monetary transmission is vital to understanding the transmission to aggregate output and prices. This is vital in the direction of understanding the market behaviour and bringing about more clarity of the transmission channels. The key question that we attempt to examine in this paper is the existence of asymmetries in the transmission of monetary policy rate changes to financial market prices. More precisely, adopting an agnostic approach, we examine how the same magnitude of policy rate change causes varied impact on financial asset prices during different phases of policy cycle, varied liquidity conditions and across the spectrum of maturity. Section II sets out a brief theoretical context to understanding the propagation of monetary shocks to financial markets.

UPSC Question from the topic Expansionary/Contractionary Monetary Policy

As a result, US- based foreign portfolio investors/Foreign institutional investors investing in countries like India would pull money out from here and invest in “safe heaven” US assets and thus leading significant capital flight from India. The results from a VAR analysis of policy rate and liquidity shocks suggest that the quantity channel operates along with the interest rate channel towards the short end of financial markets and both liquidity and interest rate shocks seem to be equally persistent. It is the interest rate channel of monetary policy transmission that is dominant towards the long end with persistence varying from 4 to 10 months. Thus, the dominant impact of interest rate channel in affecting long term interest rates brings out the stabilisation role of monetary policy.

“Indeed, the spike in commodity prices makes it even more likely that we will see headline US inflation touch 8% in the next couple of months,” it added. Alongside oil, commodities such as metals, wheat, barley, palladium, have been seeing price rise, which is expected to go up further. Russia is the second largest exporter of oil, while Ukraine and Russia are top producers of commodities and agricultural goods. In 2011, the BoK implemented a levy on banks’ non-core foreign exchange liabilities, requiring banks to pay a 0.2 percent foreign exchange stability levy on the balances of non-deposit foreign currency liabilities with a maturity of less than one year. The levy is applied uniformly to domestic banks and local branches of foreign banks operating in South Korea.

Capital flight may increase the interest cost of firms with existing External Commercial Borrowings (ECBs).

In 2022, EMEs will face difficulties managing macroeconomic and financial stability in a highly unsettled global economic environment. This year, EMEs will continue to grapple with higher food and energy prices, persistent inflationary pressures, and supply-chain disruptions. Provisional CPI data for February released by the NSO on March 14 showed that headline CPI inflation (year-on-year) for February 2022 edged up to 6.1% from 6% cent in January. The rise in oil and commodity prices and supply disruptions due to the war have led to a global rise in inflation. Retail inflation, which is considered a trigger for the RBI’s interest rate hikes, rose to 5.59% cent in December 2021 from 4.9% in November, 4.48% in October, and 4.35% in September.

• Yesterday, on Friday, the United Arab Emirates became the latest OPEC+ member to state it is aligned with Saudi Arabia’s thinking on crude markets, a source with knowledge of the matter told Reuters.
• The bootstrap sample is a random sample of size T drawn with replacement from the observed data putting a probability of 1/T on each of the observed values.
• The presence of long transmission lags also make it challenging to disentangle the impact of monetary policy shocks from other exogenous shocks that may occur in the interregnum.
• One of RBI’s toughest challenges is to deal with a fuzzy thing called inflationary expectations.

Unlike in the 1980s and 90s, most emerging market borrowers nowadays raise foreign currency debt via issuing bonds in the international capital markets dominated by giant asset management companies . Due to their short-term and procyclical investment strategies, sizeable ownership of global AMCs in EME debt securities may result in significant bond price volatility and fire sales in reaction to tighter global financial conditions. Given the dominant role of the US dollar in the international monetary system, the Federal Reserve’s aggressive stance towards monetary policy tightening could spell trouble for EMEs that are inextricably linked to global financial markets. Policy tightening would have direct negative ramifications for EMEs and LICs with open capital accounts, sizeable current account deficits, and high levels of external debt. Given the dominant role of the US dollar in the international monetary system, the Fed’s aggressive stance towards monetary policy tightening could spell trouble for EMEs that are inextricably linked to global financial markets.

Join our Smart Investment Community

An IAS aspirant must be engaged in answer writing practice to do well in UPSC IAS Mains Exam. Must Read Newspaper is an Initiative by Team ForumIAS to provide Current Affairs links to the Must Read Articles of The Day from Newspaper. To maintain price stability, inflation needs to be controlled and for this the government of India sets an inflation target for every five years in which RBI has an important role in the consultation process regarding inflation targeting.

• To the extent that there exists significant wedge between the response of short term and long term interest rates to monetary policy changes, greater is the burden of adjustment on policy interest rates in order to have desirable effect on real variables.
• The RBI has now decided to focus on inflation over growth as inflation remains above the RBI’s upper band of 6%.
• Capital flight may increase the interest cost of firms with existing External Commercial borrowing .
• In this context, Capital Flight will be induced due to the tight monetary policy of the US federal reserve.
• As noted by the IMF economists, EMDEs that adopted tighter macroprudential policies and capital controls before the taper talk phase of 2013 coped better with the market pressures during the taper tantrum.

The US Federal Reserve is facing a tough job of walking the tightrope between controlling the red-hot inflation and supporting growth. Inflation is the rise in the price level of items, such as groceries or clothes, over time. Capital flight may increase the interest cost of firms with existing External Commercial Borrowings . Meanwhile, earlier in the session, both contracts had risen by over $1, supported by strong U.S. economic data a day earlier, while overall, Brent was on track for a weekly gain of around 2.2%, while WTI was set to rise 0.8%, the report said.

The ability to trade and invest in the US government debt has reduced to its lowest point ever since March 2020. It has induced tensions in people’s minds about the bond market because the Federal Reserve has tightened the money related policies. The declining trading conditions have resulted in major price fluctuations and a drop in liquidity in the US government security. Converse to accommodative monetary policy, a tight monetary policy involves increasing interest rates to constrain borrowing and to stimulate savings. The RBI implements the monetary policy throughopen market operations, bank rate policy, reserve system, credit control policy, moral persuasionand through many other instruments. 5 MIBOR represents the interbank rate at which funds are available to the borrowing banks in the call money market.

More External Sector and Currency Exchange rate Questions

“You have to raise interest rate, that’s what anchors expectations.” Regardless of the liquidity situation in the economy, then, a few doses of interest rate increases are the only way RBI could have signalled its commitment to price stability. These measures were expected to slow the rate of increase in the general price level in India. The minutes of the December meeting and comments by FOMC members suggest that the QT process may begin shortly after the rate increase cycle begins. Market analysts predict that the upcoming reduction in asset holdings will be more aggressive, likely totaling $750 billion per year.

This paper will focus on the prospect of a more aggressive normalization of monetary policy in the United States and its broader implications for EMEs in a financially interconnected world. Business Standard has always strived hard to provide up-to-date information and commentary on developments that are of interest to you and have wider political and economic implications for the country and the world. Your encouragement and constant feedback on how to improve our offering have only made our resolve and commitment to these ideals stronger. Even during these difficult times arising out of Covid-19, we continue to remain committed to keeping you informed and updated with credible news, authoritative views and incisive commentary on topical issues of relevance. Consider the following statements 1 Tight monetary policy of US Federal Reserve could lead to capita……