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Economy
Mahesh

09/08/24 08:42 AM IST

Monetary policy and financial markets

In News
  • The recent rapid turnarounds in global markets have come on the back of attempts by central banks to combat the problems of inflation and repressed economic activity using the tool of interest rates
Threats of recession
  • The current consensus regarding monetary policy is to assume a trade-off between unemployment and inflation. Central banks raise interest rates as inflation rises, reducing investment and hence slowing aggregate demand.
  • This leads to a reduction in the demand for labour, reducing the ability of wage-earners to push for higher wages, and ease inflationary pressures.
  • There is, of course, a lot to debate regarding the proper conduct of monetary policy.
  • Several have criticised the normal conduct of monetary policy, stressing that solving inflation by increasing unemployment represents an unfair burden being placed on workers everywhere, who are already grappling with a cost-of-living crisis.
  • Instead, they argue, inflation could be better tamed by forcing companies to reduce their profit margins and by breaking monopolies.
  • The release of a jobs report that showed a less-than-expected increase in employment led to fears of a recession, and caused a rapid sell-off of equity stocks.
  • This, coupled with concerns regarding the less-than-expected performance of big tech giants, led to a rout in the stock markets. 
  • The rise in unemployment rates triggered the “Sahm rule” which mandates the automatic disbursal of unemployment checks to households when the increase in unemployment rates breaches a certain threshold.
  • This measure is not an indicator that the economy has entered recession, but is correlated with one.
  • However, correlation does not always indicate certainty; the economy may be displaying the potential for recession, but the threat of a future recession was enough to spark fear amongst investors. 
Situation around the world
  • On the other side of the world, Asian markets were rattled by the increase in interest rates by the Japanese Central Bank following long periods of low rates.
  • A long period of economic slowdown in Japan has led to central banks keeping interest rates at levels close to 0.
  • Low Japanese interest rates have led to what is known as the “carry trade”, where foreign investors take advantage of low rates to borrow from Japan and invest in foreign markets.
  • The increase in interest rates caused a disruption in this form of trade, leading to investors selling stocks in other markets to deal with higher borrowing costs.
  • This, it has been said, has added to selling pressures in other markets.
  • This represents an added complication for policy. Low interest rates in Japan to combat a decades-long slowdown indirectly subsidised the activities of foreign capital.
  • Domestic policy imperatives of certain economies exercise undue effects on other economies through the action of global finance.
  • This is not the first time the actions of global finance caused difficulties for domestic policy in other countries. Interest rates in the U.S. were low following the great recession in 2008.
  • This led to investors borrowing at cheap rates in the U.S. and investing in other markets like India.
  • As interest rates in the U.S. rose following a resumption of growth, capital flew out from India, leading to pressure on its external account: this was called “taper tantrum”. 
Source- The Hindu

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