What is Monetary policy? How does it effect the financial markets?
Have you ever noticed how volatile the stock markets are when the Fed (RBI in India) cuts rates? If you have been following news recently, I bet you have heard about ‘Monetary policy’ a lot. For the uninitiated, monetary policy refers to the set of policy decisions taken by a country’s central bank in order to achieve optimal economic growth.
India’s central bank RBI has two motives with its monetary policy — to maintain price stability and to achieve higher employment levels. The first goal, ‘to maintain price stability’ may seem ambiguous. RBI mandates price stability as keeping the Consumer Price Index(CPI) inflation under 4 per cent. RBI can achieve these objectives by playing with several instruments, but often only three of those instruments are used as they are most powerful. This article will discuss these three — REPO rate, open market operations, and cash reserve ratio effects the financial markets.
REPO rate is the interest rate at which the reserve bank provides overnight loans to banks. Open market operations includes purchase and sale of government securities (and currency securities sometimes) by the central bank. Cash reserve ratio is the cash balance that a bank is required to maintain with the reserve bank as a share of its deposits.
Whenever the central bank wants to tighten the economy, its monetary policy turns hawkish. The central bank then raises the interest rates to prevent higher inflation. Rising interest rates make borrowing more expensive, and thus spending and investments slow down. Dovish monetary policy is the opposite, when the central bank decides to loosen the monetary policy by cutting interest rates with the aim of stimulating a stagnating economy.
Money Supply
The money supply of an economy is the total value of the currency and all other liquid instruments(includes bank deposits). Money supply may also be referred to as liquidity sometimes. The total money supply plays a major role in determining the prices of all products in the economy. Suppose there are only two products in the economy (say rice and wheat). When the money supply increases, both the prices would also tend to rise simultaneously. It is because the amounts of rice and wheat that can be produced are limited, but the central bank can create money at its own will.
Generally, RBI tinkers with money supply by buying government securities to increase liquidity and selling government securities to absorb liquidity. It is also possible to increase the money supply by decreasing the Cash reserve ratio. Refer to this article to understand the mechanics of cash reserve ratio. When money supply increases, most stocks tend to become bullish. This can be reasoned intuitively in two ways:
- An increase in money supply puts more money in people’s hands, so people will buy more stocks, thereby driving the stock price up.
- People would demand more goods, which in turn pushes price levels up. Higher prices mean higher profits for companies. Therefore the intrinsic value of the stock itself would rise.
It is clear from the chart that the money supply has always been increasing but at varying rates. Unsurprisingly the stock market has also kept up with the money supply, as can be inferred from the plot in the right. Note that the money supply shot up rapidly in 2020. Soon after the lockdown was imposed, RBI pumped in huge amounts of money to alleviate the effects of the economic slowdown. This partly helped the stock markets revive from the March-2020 lows and reach record highs.
Interest rates
RBI tries to adjust the yield curve in a variety of ways. Yield curve is a line that plots the yields (interest rates) of similar bonds of different maturity dates. It is also used as an indicator of future economic activity. Below is the yield curve for Indian government securities as of 7th Feb 2021.
So we know that RBI pumps liquidity by buying government bonds from the banks. Typically it is the short term bonds that are traded, and therefore more demand for short term bonds will pull the short term interest rates down.
Apart from managing liquidity, RBI is also responsible for managing government borrowing. So RBI tries to keep the long term yields down by engaging in Open Market Operations in times of government borrowing. Maintaining the long term yields at an optimum level is very important because the borrowing interest rates of both individuals and businesses depend upon government securities' long-term yields.
The evolution of the yield curve bears different effects on different stocks. Firstly, changes in risk-free interest rates would directly affect the stock price valuations, as medium-term yields are generally taken as the discount rate. Lower interest rates will benefit banks and companies with high debts. In times of higher interest rate, stock markets are generally known to underperform.
Exchange rate
RBI’s mandate does not direct it to manipulate the exchange rates. However, in the recent past RBI has conducted several Open Market Operations to keep the Indian Rupee from appreciating. Doing so benefits those Indian firms that are export-oriented. IT and Pharma stocks are the ones most likely to benefit from cheaper Rupees. If you are confused about how a cheaper Rupee will help exports, read this.
Often monetary policy is confused with fiscal policy. It is critical to understand the difference between the two. Monetary policy is carried out by the central bank, and it usually involves controlling the money supply through various instruments that are discussed above. Fiscal policy is carried out by the government. It involves changing government spending and taxation. However, both fiscal and monetary policies are aimed at achieving higher economic growth while keeping inflation under control.
Monetary policy influences the financial markets in a big way, but in a manner that is sometimes complex to understand. Understanding and following the monetary policy regularly is likely to provide key insights to any investor. Traders too can benefit from following the monetary policy as RBI may bowl a googly sometimes😜.
