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The bygone week saw central banks across the world meeting for reviewing their monetary policy. At least six major central banks held their monetary policy meetings during the week – Reserve Bank of Australia, Bank of Thailand, Reserve Bank of India, Bank of England, Czech National Bank and Central Bank of Brazil.
As many banks met for the monetary policy review, the macros across the globe became a hot topic. These monetary policy meets were crucial for central banks due to the impact of COVID-19: while some of these countries are dealing with severe bout of the third wave, others haven’t fully come out of the second wave. So, markets across the world were waiting for these banks for guidance.
But what is a monetary policy?
Monetary policy is the process of formulating the plan of actions taken by the central bank of a particular country that determines the quantity of money flow in the economy of that country and the channels by which new money is supplied. It entails the management of money supply and interest rates. The policy decision is aimed at meeting multiple macroeconomic objectives such as inflation targeting, boosting consumption, revving up growth engine, and maintain liquidity in system. The major mandate of the monetary policy is to achieve a stable rise in gross domestic product (GDP) of the country, keep unemployment low, maintain forex and keep inflation rates in a predictable range.
So how does a central bank use the tools in its kitty?
There are various tools that central bank can use. They can modify interest rate on the short-term intra-bank lending, adjust the broader interest rates in the system, buy and sell sovereign bonds, regulate the foreign exchange rates, and can also tweak the requirement to maintain reserves at the bank.
So, is there a conflict between objectives of central bank and government?
Yes, indeed there is. When central bankers sit for a monetary policy meet, probably they would be thinking ‘we can’t have the cake and eat it too’. The biggest dilemma comes from a trade off between inflation and growth. Usually, central banks resort to higher liquidity and lower interest rates for revving up the growth. However, the move increases the money supply in the economy, which ultimately lands in the hands of people. This would spike inflation rates. That is why, you might have come across several instances of central banks and governments across the globe being at loggerheads. The government wants its report card showing high growth – an aim for which they need lower interest rates. The central bank, on the other hand, needs to strike a balance between growth and inflation. Some of the famous feuds in recent years have been – former US President Donald Trump versus Federal Reserve chief Jerome Powell; and former Indian Finance Minister Arun Jaitley versus former Reserve Bank of India governor Urjit Patel.
Why does monetary policy become ineffective at times?
Well, a central bank, at maximum, can tweak the interest rates within the system. There needs to be transmission happening at lending rate, where borrowers get cheaper loans. This hasn’t been happening more often, of late. We have to realise that intra-system funds make for a miniscule portion of a banks’ source of funds. The majority of the funds comes in the form of deposits. And a change in interest rate of deposits will have a direct bearing on the interest rate of loans. Owing to the cut-throat competition, banks usually avoid slashing interest rates on fixed deposits. This prevents the transmission of lower interest rates that a central bank might have envisaged.
