Monetary Policy’s Asymmetric Transmission in Financial Markets 2023
According to an SBIE cowrap study on Monday, monetary policy’s asymmetric transmission in Indian financial markets must be taken into account in the future.
The SBI Research paper intended to analyse how the money market and corporate bond market changed in response to monetary policy. In this case, a favourable correlation between the monetary policy and the financial markets would suggest stronger transmission.
“With liquidity in the system currently operating in deficit mode, the question that we pose in the current context is whether such liquidity tightening impulse is fully and adequately reflected in the money market rates?” Soumya Kanti Ghosh, the chief economist at SBI Group, poses the question in the paper.
The Reserve Bank of India (RBI), which ordered banks to maintain an incremental cash reserve ratio of 10% in August, has caused the liquidity in the banking sector to fall into a deficit at the time the report is released.
For the 65 months that concluded in August, SBI Research utilised an autoregressive distributed lag model. The information includes both periods of rate increases and rate reductions. In its opinion, a 1% increase in the repo rate has only led to a 2-3 basis point (bps) increase in the spread for 10 year AAA corporate bonds and a 3–4 bps increase in the spread for 5 year AAA corporate bonds.
However, it led to a 31 basis point fall in the gap for 3 year AAA corporate bonds, indicating that the risk premium for these bonds is insufficient, according to the research.
In particular, SBI Research calculates that given the present market liquidity and risk premium, 10-year and 5-year AAA corporate bond rates are underpriced by at least 35 basis points. Similar results are reported for 3-year AAA and AA corporate bonds, with decreases of at least 26 and 40 basis points, respectively.
The weighted average yield on commercial papers decreased from 7.90% in March to 7.20% in July despite the fact that the policy rate remained stable throughout that time, demand was strong, and liquidity tightened. “Overall, our calculations show that the reduced CP prices have allowed the corporates to save up to Rs 5,000 crore on an annualised basis. The debt service ratio has improved significantly as a result, according to the study.
Monetary policy plays a critical role in shaping a country’s economic landscape. Central banks around the world utilize various tools and strategies to influence the overall economic environment, primarily by targeting interest rates and money supply. One of the key features of monetary policy is its ability to influence financial markets, but this influence is not always symmetrical. In this article, we will delve into the concept of asymmetric transmission in financial markets, discussing its implications, causes, and potential consequences.
Monetary policy transmission refers to the process by which changes in a central bank’s policy actions, such as interest rate adjustments or changes in the money supply, are transmitted to the broader economy. The ultimate goal of such policies is to achieve macroeconomic stability, including controlling inflation, fostering economic growth, and maintaining financial stability.
Transmission channels are the various pathways through which monetary policy impacts the economy. The primary channels include the interest rate channel, exchange rate channel, and asset price channel. Each of these channels has a different impact on financial markets, and their transmission may not always be symmetrical.
Asymmetric transmission in financial markets occurs when the effects of a central bank’s monetary policy actions on asset prices, interest rates, or exchange rates are not uniform in both directions. In other words, the market responds differently to monetary policy tightening (contractionary) and easing (expansionary) measures.
The financial markets often react more strongly to unexpected changes in monetary policy than to anticipated ones. When central banks make unexpected moves, such as sudden interest rate hikes or cuts, markets can experience heightened volatility and abrupt price swings.
In times of financial stress or crisis, liquidity constraints can amplify the effects of monetary policy. During such periods, central bank actions may have a more pronounced impact on market conditions as investors rush to adjust their portfolios.
Market participants may exhibit different degrees of risk aversion during different phases of the economic cycle. When economic conditions are uncertain or deteriorating, investors tend to be more sensitive to monetary policy changes, leading to an asymmetric response.
Central banks often use forward guidance to signal their future policy intentions. If the market perceives this guidance as credible, it can lead to anticipatory adjustments in asset prices and interest rates, affecting the symmetry of policy transmission.
Asymmetric transmission can contribute to increased market volatility, especially during periods of economic uncertainty. Sudden and unexpected policy actions can lead to sharp market reactions, making it challenging for investors to make informed decisions.
Central banks may need to adjust their policy tools and communication strategies to account for the asymmetric transmission of their actions. Recognizing that market responses may not always be symmetrical, central banks must carefully assess the potential impacts of their policy decisions.
Asymmetric transmission can affect the overall stability of the economy. If market participants respond more vigorously to contractionary policies, this could exacerbate economic downturns. Conversely, asymmetric responses to expansionary policies could lead to inflationary pressures.
In response to the challenges posed by asymmetric transmission, regulatory authorities may implement measures to enhance market resilience and mitigate the impact of abrupt market reactions to monetary policy actions.
Monetary policy is a powerful tool used by central banks to influence economic conditions and financial markets. However, the transmission of monetary policy is not always symmetric, with market reactions often varying between tightening and easing measures.
Understanding the causes and implications of asymmetric transmission is essential for policymakers, investors, and market participants alike. It underscores the importance of clear communication, prudent risk management, and adaptable policy frameworks to maintain financial stability and support economic growth in an increasingly complex and interconnected global financial system.
