Mount30k,BrexitandMonetarypolicytrilemma

The Dow Jones finally scaled up the mount 30k. Hopes on the effective vaccine ably supported by the intravenous medicine of money supply keeps the markets in a cheerful mood. Minor blips like a less than expected NFP number was not able to make any dent in the cheer. Dow futures are in green during the Asian trading session. The Dollar Index has been on a downward trend trading currently at 90.70 levels which were last seen in April 2018. US 10 year yields though have been going up and are trading around 0.96 now. The market focus has now shifted to the senate election in Georgia where in the case the democratic candidate wins it could trigger another round of risk on as it gives democrats control of senate.

Brexit negotiations are still going on and phrases like “significant progress”, “hangs in balance”, “cliffhanger” are being bandied around in abundant supply in the financial press. The UK PM is slated to call the European Commission President today. The Euro and Pound though have stood their ground trading 1.2130 and 1.3420. In other news Japanese PM Suga will unveil the new economic stimulus package on Tuesday.

Domestically the rupee trades at 73.70 and the 10 year benchmark bond yield trades at 5.92. With the MPC policy released last week the data point to watch out for will be the CPI data. WSS report shows Fx reserves in a mild decline of half a billion dollars for the week ending 27^th Nov.

Now lets come back to last week’s RBI policy where it was reiterated that the policy stance will be kept accommodative for some time to come. It would be interesting to discuss the policy choices which a policy maker has for its disposal and the implications of the same in a bit more detail 

In macroeconomics, central banks often encounter the impossible trilemma of monetary policy decision making. What it essentially mean is that a central bank cannot over time fix the exchange rate, maintain openness to the financial markets and pursue an independent monetary policy (i.e. set interest rates that are different from the structure of interest rates in the global market). If you allow the flows to travel in and out unrestricted then the exchange rate will move up and down and in case you want to keep the exchange rate stable then the central bank would end up building up ( or depleting) reserves. The reserves which are created by mopping up the supply of dollars and providing local currency would result in an increase in money supply, lowering the local interest rates below the central bank anchor.

Former IMF economists Leslie Lipschitz and Susan Schadler write in their book, Macroeconomics for Professionals,  that their IMF experience shows that any country trying to ride on all the three horses at one time ultimately meets a disaster. The juggle for the policy makers essentially is to decide which path they want to pursue depending on the prevailing situation. We can see the trilemma in play in the light of the recent events in Turkey and India where in Turkey the CB was forced to hike the rates amid free fall in the currency and continuous depletion in reserve, and in India, where the overnight rates in the interbank market are trading below the policy reverse repo rate. But the authors point out that this constant juggling actually sends mixed (confused) signals to the market playing havoc with their expectations of the future course of policy. This makes the whole set up more volatile which the central bank wanted to control (or smooth) to start with.