Central Bank Policies Assessment

Have Central Banks Learned from Past Mistakes? Over the past six months, there has been a growing sentiment among investors that the Federal Reserve (Fed) may be making a mistake in its monetary policy approach. This is reflected in Google Trends data, showing a noticeable increase in searches for terms like "policy error" and "Fed mistake." The declining confidence in central banks raises the question of whether this skepticism is justified. The record of central bank performance, particularly over the last 50 years, suggests that they have indeed learned valuable lessons from past missteps. While it's easy to point to the turbulent 1970s as an era when central banks failed to effectively manage inflation, subsequent decades have demonstrated a more consistent and effective approach to monetary policy. Lessons from the 1970s In the 1970s, central banks struggled with policy inconsistency, frequently changing course and failing to apply sufficient pressure to control inflation. This led to a loss of credibility and market confidence. Inflation spiraled out of control, and unemployment remained high, creating economic instability. Modern Monetary Policy However, central banks, including the Federal Reserve, have since adopted more structured and aggressive approaches when dealing with inflation. The chart referenced in the original text, which illustrates changes in policy rates, inflation/CPI, and unemployment rates, supports this perspective. It shows that in each of the four periods of significant inflation increase after the 1970s, central banks took strong action, creating a substantial buffer between policy rates and inflation before pausing. This strategy helped stabilize inflation while maintaining a relatively stable labor market. In the current cycle, the Fed's policy rate hikes have brought inflation down to a more manageable level—around 3%—without relenting, despite lingering uncertainties. This approach has not only reduced inflation but also kept unemployment rates relatively steady, indicating a balanced strategy. Future Outlook Looking ahead, the Federal Reserve is likely to maintain its "high for longer" strategy, prioritizing inflation control while fostering economic stability. Although some investors remain skeptical, the Fed's consistent policy actions suggest that it has learned from past mistakes and deserves the benefit of the doubt. This analysis, supported by the referenced chart, indicates that central banks, particularly the Fed, are adapting and refining their monetary policies based on historical lessons. This adaptation demonstrates a capacity for learning and a commitment to stabilizing the economy.

Central Bank Policies: Their Effect on Bank Treasuries The policies set forth by central banks play a pivotal role in shaping the strategies and operations of bank treasuries. Understanding these policies and their implications is crucial for treasury professionals, as they directly influence key aspects of banking operations, including liquidity management, interest rate risk, and overall financial stability. Central bank policies often revolve around controlling inflation, managing the money supply, and stabilising the financial system. One of the most significant tools at their disposal is the setting of interest rates. Changes in interest rates can have profound effects on a bank's profitability and investment strategies. For instance, a rise in interest rates typically increases the cost of borrowing, which can reduce loan demand and affect a bank's interest income. Conversely, lower interest rates can stimulate borrowing but may squeeze the interest margins. Another critical aspect of central bank policy is liquidity requirements. Central banks often set reserve requirements and other liquidity regulations to ensure that banks maintain adequate liquidity to meet their short-term obligations. These requirements influence how much capital banks must hold and thus impact their ability to lend and invest. Moreover, central banks often intervene in financial markets through open market operations, purchasing or selling government securities to influence liquidity and interest rates. These actions can affect the value of assets held by bank treasuries and must be carefully monitored to manage portfolio risks effectively. However, the impact of central bank policies is not limited to direct financial implications. These policies also signal broader economic trends and central banks' outlooks on economic conditions. For example, a central bank's decision to raise interest rates may indicate concerns about inflation or an overheating economy. Treasury professionals must interpret these signals to make informed decisions about risk management and strategic planning. Furthermore, central bank policies can vary significantly between countries, adding a layer of complexity for banks operating in multiple jurisdictions. This requires a nuanced understanding of different regulatory environments and economic conditions. In conclusion, central bank policies are a critical factor in the management of bank treasuries. These policies influence interest rates, liquidity requirements, and broader economic conditions, all of which have direct implications for bank operations. Treasury professionals must stay abreast of these policies and adapt their strategies accordingly to manage risks effectively and capitalise on opportunities that arise in the ever-changing financial landscape.

‘Turning pitch’ for monetary policy; RBI says open to OMO sales • The MPC expectedly kept the repo rate unchanged at 6.5% and retained the stance of monetary policy at ‘withdrawal of accommodation’ • The vegetables-driven spike in inflation in July-August 2023 has abated. However, elevated global yields, uneven distribution of monsoon and volatile oil prices pose an upside risk to inflation. Taking cognizance of this, the policy statement noted that monetary policy needs to remain ‘actively disinflationary’. Also, the Governor during his address stressed on the 4% inflation target, giving the policy a hawkish tone. • The MPC upped Q2FY24 projection to 6.5% from 6.2% previously and cut Q3FY24 projection to 5.6% from 5.7% in the Aug 2023 review. Projections for Q4FY24 and Q1FY25 were retained at 5.2%. On balance, FY24 inflation forecast remains unchanged at 5.4%. In a separately released Monetary Policy Report (MPR), the RBI projected CPI to average 4.5% in FY25 and 4.3% in Q4FY25 • The MPR also showed that supply shock was the predominant driver of inflation in Q2FY24, accounting for as high as 70% of the inflation during the quarter. On the other hand, policy shock (monetary tightening) and demand shock (lower aggregate demand) shaved off inflation during the quarter. This further gives credence to the MPC’s decision to stay put on rates this time. • Transmission of previous rates is still incomplete. Out of the cumulative repo hike of 250bps, weighted average lending rate on fresh loans and outstanding loans have increased by only 196bps and 112bps. However, the cumulative monetary tightening seems to have succeeded in anchoring inflation expectations as households’ inflation expectations have fallen to single-digit since the Covid pandemic. • The committee kept the full-year growth forecast unchanged at 6.5% (ICICI: 6.2%). The quarterly growth profile (6.5% in Q2, 6% in Q3 and 5.7% in Q4FY24) has also been retained. Domestic demand remains resilient, led by urban markets while industry indicators remain robust. Rising imports of capital goods and external borrowing for capex imply strong investment demand. • The liquidity conditions have seen a sizable change since the last policy. While 50% of the amount absorbed under I-CRR has been reversed, robust advance tax collections in September and active FX intervention by the RBI to support the INR resulted in a sizable deficit in system liquidity. In addition, the RBI conducted OMO sales worth ~INR 62bn in September which was an indication that more OMO sales (through auction process) are likely in the future to keep liquidity conditions tight. While the conclusion of I-CRR and month-end government spending will increase liquidity in the near term, pick-up in currency demand and OMO sales are likely to offset the impact and keep liquidity constrained • Given a more hawkish Fed and slow disinflation trajectory, the monetary easing cycle is likely to happen later than initially expected

The Monetary Policy for the fiscal year 2024/25 -   Policy Stance and Objectives The NRB has maintained a cautiously accommodative monetary policy stance, emphasizing the need to support economic recovery while managing inflation and ensuring financial stability. The central bank targets inflation around 5% and aims to maintain foreign exchange reserves sufficient to cover imports for at least seven months. The weighted average interbank rate among financial institutions is used as the operating target for monetary policy, with a growth rate of broad money (M2) kept at about 12% and a private sector credit growth target of 12.5%.    Monetary Policy Transmission Channels 1. Interest Rate Channel: The transmission of monetary policy through interest rates has been less effective. The review highlights that while the impact on the short-term money market is immediate, the medium-term money market shows less responsiveness. Despite reductions in policy rates and the interest rate corridor's higher limit, the broader transmission to the credit market remains weak.   2. Lending Rates Channel: The effectiveness of monetary policy transmission through lending rates is limited. The readiness and health of the banking system significantly affect this channel. Issues within banks or their unwillingness to lend result in ineffective rate cuts, which fail to stimulate demand as intended.   3. Asset Price Channel: This channel is also noted to be ineffective. Despite lower interest rates, there has not been a significant increase in asset prices, such as real estate, due to subdued lending growth and low market confidence.   4. Exchange Rate Channel: The exchange rate channel has not been effective either. Lower domestic investment returns due to interest rate cuts have not led to substantial foreign capital inflows, impacting the domestic currency and trade balance.    Policy Responses and Measures - Capital Adequacy: The NRB plans to review the capital adequacy framework and introduce new instruments to alleviate pressure on core capital. It also aims to allow regulatory reserves to be included in Tier 2 Capital up to 100% of Tier 1 Capital.   - Foreign Exchange: The policy includes measures to simplify foreign exchange processes, maintain the exchange rate peg with the Indian currency, and expand the list of available foreign currencies. Additionally, the spending limit from domestic foreign exchange accounts has been raised.   - Asset Management and Transparency: The NRB intends to establish an asset management company and integrate tax office submissions with the banking system to improve transparency. Provisions related to asset quality grading and working guidelines have been relaxed to support financial stability.