Powell'sinterviewandmonetaryframeworksthroughfirstprinciples

Global markets these days follow the central bankers closely. Every interaction, statement is parsed to find any clues on their thinking. Fed Chief Jerome Powell’s appearance on television news last night was no exception, after all he presides over some of the most important market moving decisions. He said that “he sees the economy at an inflection point with widespread vaccination, strong fiscal and monetary support. The outlook has brightened substantially”. Now this is a relatively optimistic tone compared to his statements in the last few weeks. This sentiment in theory should aid the Dollar and firm up US yields. However, both the Dollar Index and US 10-year yields have stayed put in the trade today post his remarks. The Asian stock markets like Hang Seng and Nikkei are currently trading in red. The Indian Rupee traded beyond 75 for first time since August 2020. Indian 10-year benchmark bond trades around 6.01.   

After discussing the RBI’s MPC decision and FOMC minutes threadbare last week, today let’s take some time out to discuss these policy decisions and frameworks from a first principles basis. When the RBI vows to support the fragile growth alongside keeping a grip on inflation or the Fed’s FOMC keeps the rates low to fulfil its dual mandate (stable prices and maximum sustainable employment) what are the underlying principles behind their actions. What are the central banks trying to do and in what capacity?

The CBs in any country are primarily entrusted with governing the flow of money and setting interest rates to keep the economy in shape (low inflation, high growth, full employment etc). Here it is important to recognize that they are working with nominal instruments (i.e. money or interest rates) but are trying to influence production of real goods and services. Real defines something tangible i.e. goods and services which we can ultimately consume or utilize. Let’s get more clarity by the following example, one can create an infinite amount of money at “will” but can’t create infinite supply of goods. The real goods require real resources in form of labour, capital etc to get created. Hence there is a limit to using nominal variables to impact real economy. Money created by CB on itself serves three basic objectives i.e. it acts as a store of value, a means of exchange and a reliable measuring tool. The store of value part of money will start getting evaporated as the public will see more supply coming in without the corresponding increase in the size of economy (more real goods and services getting created).

Now let’s come to the “framework” part. A framework is something which defines the constraining factors on the actions of central banks. In the book Macroeconomics for Professionals, IMF economists Leslie Lipschitz and Susan Schadler detail the importance of explicitly defining a framework if monetary policy has to be effective. They write that a framework is not just targeting inflation through regular rate decisions. It also involves having a stated policy regarding other important components like exchange rate regimes and openness to international financial flows. The author duo finally concludes that not all central banks are given same set of choices to define their monetary framework. The policy options available at central banks in a small economy are very constrained compared to a large country with a multi-faceted economy. In our later notes we will discuss that what different kind of frameworks exist now or have existed in the past and how the modern finance with untethered capital flows are shaping a more unequal world.