monetary policy: As Fed tightens monetary policy, US government debt market heats up

The forcefulness and urgency of the policy shift have been welcomed by analysts and the market alike, and are being seen as a signal of RBI’s renewed commitment to fighting inflation via aggressive monetary tightening in the coming months. The current account should hopefully see some improvement over time, with the weakening of the rupee this year. Additionally, unless the strategy is to pray for an eventual drop in crude oil prices, we must make ‘Make in India’ and ‘Make for India’ operative.

  • First, in the aftermath of the IL&FS default and subsequent scare around fund, NBFC and HFC liquidity and asset quality, any possibility of needless panic in credit markets needs to be put to rest.
  • Once the repo rate is announced, the operating framework designed by the Reserve Bank envisages liquidity management on a day-to-day basis through appropriate actions.
  • 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.
  • 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.

Faster Fed rate could rattle financial markets and tighten financial conditions globally especially in emerging market economies like India. For instance, an aggressive monetary tightening would raise US yields and strengthen the US dollar against EM currencies like rupee. 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 sudden stops and reversal of capital flows will lead to depreciation pressures on emerging market currencies like rupee. When foreign investors invest in equities, bonds and other financial assets in EMEs, they measure financial returns in the US dollar and other foreign currencies.

What policy instruments has the RBI proposed to tackle this situation?

Foreign institutional investors have already sold over Rs 2 lakh crore worth of Indian equities since October 2021. The US Federal Reserve is facing a tough job of walking the tightrope between controlling the red-hot inflation and supporting growth.

tight monetary policy

A ‘neutral stance’ suggests that the central bank can either cut rate or increase rate. The central bank typically adopts an accommodative policy when growth needs policy support and inflation is not the immediate concern. The share of NDTL that a bank is required to maintain in safe and liquid assets, such as, unencumbered government securities, cash and gold. The interest rate at which the Reserve Bank absorbs liquidity, on an overnight basis, from banks against the collateral of eligible government securities under the LAF.

ClearIAS Study Materials for UPSC Mains (Paper-wise)

Since mid-2021, several large emerging market economies have also raised interest rates primarily to contain domestic inflationary pressures and avert capital outflows. Additionally, central bank interventions are considered most effective when conducted for a brief period . Otherwise, central banks risk depleting substantial forex reserves without significant impact, as seen in China and Turkey ( ). As the Fed sets the tone for global monetary policy, other systemically important central banks will follow suit. Except for the European Central Bank and the Bank of Japan, all major advanced economies’ central banks have either already raised policy rates or intend to do so in the first quarter of 2022.

It involvesmanagement of money supply and interest rateand is the demand side economic policy used by the government of a country to achieve macroeconomic objectives like inflation, consumption, growth and liquidity. In 2020, six countries – Argentina, Ecuador, Belize, Lebanon, Suriname and Zambia – defaulted on their sovereign debt. Tight monetary policy is an action undertaken by a central bank such as the Federal Reserve to slow down overheated economic growth. Central banks engage in tight monetary policy when an economy is accelerating too quickly or inflation—overall prices—is rising too fast. Higher interest rates in the US usually lead to foreign investors pulling their money from emerging markets like India back to the US for safer, and more secure returns leading to capital flight. Even if the RBI and its monetary policy committee decides to hike headlines policy rates, CRR cuts and large scale OMOs can dent monetary and currency credibility, as some emerging markets have discovered.

What is Monetary policy?

Recently the Monetary Policy Committee of the Reserve Bank of India’s noted that the central bank’s accommodative policy stance may fail to comply with the Inflation target (upper limit of 6%). Market analysts predict that the upcoming reduction in asset holdings will be more aggressive, likely totalling $750 billion per year. On December 15, Fed ChairmanJeremy Powell announcedthat the Fed would reduce monthly asset purchases by $30 billion.

We bring you the most exclusive news from the power corridors of Rajasthan, Delhi & Uttar Pradesh along with the best of national, international and sports news from across the world. Earlier this month, the rating agency, though, lowered India’s economic growth forecast for 2022 to 7.7 per cent from its earlier estimate of 8.8 per cent. Second, India’s negative net international investment position of $331 billion as of September 2021 is a cause for concern if sudden stop events materialise.

tight monetary policy

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. Recent developments indicate that the Fed is adopting an aggressive stance toward its monetary policy and is eyeing interest rate hikes early this year. An earlier and faster normalisation of monetary policy by the US Fed increases the risks to macroeconomic and financial stability in emerging markets and low-income countries. In the absence of international policy coordination, EM policymakers must make full use of the available policy levers to strengthen macroeconomic fundamentals and policy frameworks. Over the last two years, the CBRT has conducted unannounced currency market interventions, spending tens of billions of dollars of its foreign exchange reserves to shore up the lira.

Expansionary vs Contractionary Monetary Policy

Indonesia has experienced increased exchange rate volatility in previous episodes of global financial tightening, including the global financial crisis , the “taper tantrum” , and the COVID-19 crisis . Turkey’s economy is particularly vulnerable to increased currency volatility and sudden stops due to its heavy reliance on foreign financing. While Turkey’s government debt is low by international standards, the majority of it is denominated in foreign currency, primarily the US dollar. The Turkish lira has lost nearly 40 percent of its value against the dollar since November 2021. The lira’s depreciation has exacerbated Turkey’s external vulnerabilities, as foreign currency debt now accounts for 60 percent of the central government’s debt, up from less than 40 percent in early 2018. The recent spikes in COVID-19 infections are concerning in emerging market and developing economies with significantly lower vaccination rates than the global average.

  • The Fed intervened by pledging to buy unlimited quantities of government bonds and taking measures to boost the corporate debt market to stabilise the falling markets.
  • Until now, the Fed has shown no willingness to extend these mechanisms to EMEs and LICs that do not have access to swap lines or a sufficient quantity of US Treasury securities to use the FIMA repo facility effectively.
  • Turkey’s economy is particularly vulnerable to increased currency volatility and sudden stops due to its heavy reliance on foreign financing.
  • Market analysts predict that the upcoming reduction in asset holdings will be more aggressive, likely totaling $750 billion per year.
  • The ability to trade and invest in the US government debt has reduced to its lowest point ever since March 2020.

Increased funding costs would be disastrous for domestic corporations that borrow in US dollars from offshore bond markets without hedging their foreign currency exposure. For instance, Indonesian media and real estate firms borrow funds in US dollars, but their revenues are in rupiah. If foreign currency exposure is not hedged, the rupiah depreciation will negatively affect such firms’ liquidity and profitability. In such a scenario, Indian non-financial corporates with substantial US dollar debt must also watch out, as their share of the country’s total external debt is a whopping 36.9 percent. Indian corporates that have not hedged their foreign currency borrowings may face higher foreign currency funding costs, as well as liquidity and solvency risks.

ClearIAS Study Materials for UPSC Prelims and Mains

This year, EMEs will continue to grapple with higher food and energy prices, persistent inflationary pressures, and supply-chain disruptions. During such a phase, the central bank is willing to hike interest rates to curb money supply and thus reduce the demand. India’s external debt worth $256 billion will mature over the next 12 months, according to theSeptember 2021 data released by the Ministry of Finance. To put this in context, India’s total external debt maturing until September 2022 accounts for 40% of the country’s forex reserves.

  • As the COVID-19 pandemic enters its third year, emerging market economies will continue to struggle to improve their financial resilience in the face of numerous domestic and global headwinds.
  • To step back, Indian equity markets have seen a linear rise since the bottom touched in March 2020.
  • It attributed the lowering of the growth estimate to rising interest rates, uneven distribution of monsoons, and slowing global growth.
  • The Finance Minister said, the announcement of National Manufacturing Policy has been an important policy action to accelerate manufacturing growth.
  • To put this in context, India’s total external debt maturing until September 2022 accounts for 40% of the country’s forex reserves.

Even if the global economy performs broadly in line with expectations, EMEs will face new challenges this year in bolstering their growth impulses and overcoming financial vulnerabilities. For the eleventh time in a row, the Reserve Bank of India has decided to keep the main policy rate – repo rate – unchanged at 4%. It has also retained its accommodative stance, but indicated it will engage in a gradual and calibrated withdrawal of surplus liquidity to rein in inflation. The central bank has now decided to focus on inflation over growth by sucking out money from the system in a multi-year time-frame. The stability levy penalizes carry trades, in which banks borrow short-term foreign currency in order to convert it to Korean won and invest in domestic assets. From a financial stability viewpoint, the levy is intended to rein in excessive foreign borrowing and encourage banks to seek longer-maturity offshore debt, thereby mitigating the risk of shocks caused by rapid capital inflows and outflows.

Popular in Markets

In an ideal world, swift international policy coordination would manage the spillover effects of monetary policy normalization in the US and other advanced economies. Policy coordination among emerging and advanced economies one piece sengoku would also help avoid spillbacks to advanced economies. Secondly, EMDEs and LICs with a large stock of foreign currency debt and low forex reserves will be particularly vulnerable to tightening global financial conditions.

Unlike other Asian EMEs, Indonesia has been increasingly issuing foreign-currency bonds in the international capital markets in recent years. In 2020, six countries — Argentina, Ecuador, Belize, Lebanon, Suriname, and Zambia — have defaulted on their sovereign debt. The US Fed has committed to maintaining interest rates near zero until inflation averages 2 percent over time, and maximum employment is achieved.

Which monetary policy is used most often?

The most commonly used tool of monetary policy in the U.S. is open market operations. Open market operations take place when the central bank sells or buys U.S. Treasury bonds in order to influence the quantity of bank reserves and the level of interest rates.

Industry experts have provided many specific medium term suggestions around this. Also, given the nature of our external balance, high GDP growth and high consumption are not good news for now. Unpopular as it sounds, we may have to sacrifice growth for now with high interest rates, demand curbs and fiscal austerity. Indonesia should reconsider its policy of allowing higher foreign participation in LCBMs.

Deja una respuesta

Tu dirección de correo electrónico no será publicada. Los campos obligatorios están marcados con *