FOMC, CB tools and the importance of price

Yesterday we had written that how the world has completed its one-year anniversary of the panic driven unscheduled Fed meeting where it reduced the Fed funds target rate to the logical lower bound of monetary policy that is the zero rate. This was the time when the news of infections was rising in China and the other parts of the world were waking to the reality that the virus has already entered their borders and is likely to manifest in unknown fashion.

Fast forward one year, the latest controversy in Europe around the side effects of the vaccination program indicates that uncertainty still lurks around. The US though continues with the vaccination program. On the markets front, we await the FOMC statement due tomorrow. The economic assessment of the US economy along with the dot plots by the members will be released. This will indicate when they see the first hike happening, median estimate is still expected to be in 2024 only. Markets will only react in case anything else happens. The US 10-year yields trades around 1.6% mostly unchanged from yesterday levels as of now.

Now let’s focus on FOMC and discuss the tools available to any central bank to achieve their objectives. Lowering short term or overnight interest rates is the most straightforward tool. The interest rate in the economy are anchored to the central bank policy rate as other borrowers must pay a credit spread over and above it, so it essentially becomes a floor for their borrowing. Also, the long-term rates should be higher compared to short term in an upward sloping yield curve scenario so there also the overnight policy rate provides an anchor. This is what we know as conventional monetary policy tool. Anything below zero (though tried by some CBs like BOJ, ECB) takes the ship to unchartered waters where the behaviour of system agents becomes highly unpredictable. How a saver would behave when it has to pay for savings is a volatile thought itself. Will he pre-pone the consumption or will he gravitate towards risky investment options, can hardly be answered.

Even without negative rates, the central bank policy tool kit is neither short of ammunition nor of imagination. Apart from the policy rate they can embark into bond buying which increases the money supply in the system. The money thus generated is primary money and due to the fractional reserve banking concept, the banking channel can leverage it multiple times further. As money flows in the system the credit becomes readily available and interest rates go down. However, the credit creation is not a given as the banks might choose to be extra cautious given the default risk. Readers would remember the freeze in the interbank lending market post the GFC in 2008. Lastly the central banks can also choose to target a certain portion of yield curve through yield curve control by buying/selling bonds of particular maturities.

But now to wrap it all up we come to the fundamental question of all. With all this supposedly being altruistic adjustments isn’t the signalling value of prices getting altered. Price as defined in the economic texts is the equilibrium value where the demand and supply clear out each other voluntarily. This price signals the market participants and the choices they need to make. What products to manufacture and what to consume, whether to consume them now or to delay. In a managed system these signals get garbled up and wrong choices are made. Bubble creations are nothing but the consequence of the wrong choices.