RBI`s assessment on Monetary Policy, after Fed cut
RBI`s assessment on Monetary Policy, after Fed cut Deputy Governor, Rakesh Mohan, at Institute of International Finance`s (IIF) inaugural Asia Regional Economic Forum, held on Sep. 20, 2007, addressed key issue of recent developments in financial markets and its implications over monetary policy.
In response to recent events in the financial markets, caused by US sub-prime mortgage crisis, he said that, central banks played pivotal role in taking mandatory actions to maintain financial stability globally.
This is evident from the fact that, during the recent US Federal Reserve turmoil, U.K. authorities had to provide liquidity to a specific institution, while giving a blanket guarantee to depositors on the safety of their deposits. Accordingly, it has become evident that, central banks do have a role beyond inflation targeting. The US Federal Reserve also slashed key interest rates in a step to save the economy from recession.
The current develo pments, which began in a relatively minor segment of the financial market, viz., the sub-prime mortgage segment, have spread far and wide across continents.
At the current juncture, the likely evolution of the current financial market turmoil and its implications for the future has evoked mixed assessments.
On one plane, the spread of contagion is drawing considerable concern, first, in view of the level of leverage; and second, on account of the nature of the vehicles that have created the leverage. On another plane, there is a view that, turbulence would be restricted to the credit market and its impact on consumer spending and overall economic growth, may be muted as credit worthiness would remain intact if, for instance, leveraged mortgage backed securities are held to maturity and not sold in distress.
According to the IMF`s assessment, the systemic consequences of the turmoil are likely to be manageable with the fundamentals supporting strong global growth. The repricing of credit risks that is underway is a healthy correction and should not lead to a more serious market crash. The IMF expects that, the re -establishment of credit discipline due to the recent prompt action by a number of central banks, should help to ensure that the adjus tment process occurs in an orderly manner. Long-term investors tend to support this view. The ongoing flight to quality (US Treasuries) and into global equity funds suggests a continuing faith in strong fundamentals of the global economy.
Recent developments carry implications in the form of heightened market discipline and a stricter regulation of financial markets. Investors who relied on credit ratings of collateralised debt obligations (CDOs) and collateralised loans oblig ations (CLOs) are likely to question the value of ratings in other markets. Moreover, leveraged buy-out activity is likely to wind down. While this could cause worries about equity valuations, it is expected that, such concerns would eventually receed so long as corporate profitability remains strong. Furthermore, it is argued that carry trade, which has been a source of financial flows, may moderate and may even go through an abrupt unwinding and this would help in maintaining global financial stability.
In this vein, it is also argued that, the recent developments will have a positive impact on the outlook for emerging market economies (EMEs) as a consequence of the diversification of portfolios of international investors and would further incentivise maintenance of good macroeconomic policies in these countries.
In the overall assessment, the adverse consequences of the US sub prime turmoil could weigh heavily on the future stability of fin ancial markets and have the potential of a wider impact on global growth with particular concerns centred on the prospects for EMEs.
If credit conditions tighten, EMEs could become particularly vulnerable to reversals of capital flows with serious implications for their future prospects.
A slowing down of the US economy, in combination with capital reversals, could also have adverse consequences for growth on a prolonged basis by affecting exports of manufactures and services, depending on the extent of linkage with the US economy.
On the other hand, the flight of capital to safety through diversification could even enhance capital flows to these countries. This could further complicate the conduct of monetary policy.
The challenge which lies ahead with the RBI is that central banks needs to differentiate between providing short term liquidity and operating medium term monetary policy and communicate the difference credibly .
The conduct of monetary policy is complicated which requires rethinking of policy options which could include coordinated interventions, assurances of liquidity, backed by timely and credible action; emergency liquidity plans, business continuity plans and disaster management strategies.
The recent gains in bringing down inflation and in stabilizing inflation expectations should support the current expansionary phase of growth cycle.
The policy challenge for Reserve Bank, now, is to manage the current transition to a higher growth path while containing inflationary pressures and focusing on financial stability
The Apex bank, therefore needs to maintain enhanced vigilance, to be able to respond appropriately to the prevailing heightened uncertainties in global financial, as well as, monetary conditions.
