BS Number Wise: Working in tandem on monetary policy

Central banks of the world are implementing coordinated rate reduction but such convergence is neither new nor permanent

In July 2019, as the US Federal Reserve cut the Federal Funds Rate, the Reserve Bank of India responded with a repo rate cut. The trend continued in October and December 2019, with the two central banks reducing policy rates in tandem. Between March 2020 and May 2020, central banks of all major economies reduced policy rates to battle the economic slowdown caused by the coronavirus pandemic.

After nearly a year and a half of low policy rates, the US Fed in December 2021 accelerated its cycle, announcing multiple hikes in 2022. The Bank of England went a step ahead and increased its policy rate. India may be looking to do the same this year, experts said. A new wave of Covid infections could delay plans though.

Such coordination among central banks witnessed during the pandemic is likely the envy of European policymakers. The purpose of a single European Monetary Union was to bring all European economies on par and align monetary policies and interest rates across countries. The EU has achieved the goal of common interest rates, but that has created another problem as countries are at different levels of development.

Policy coordination among world economies may continue in 2022 due to inflation. During its commentary in the December policy meeting, the Federal Reserve highlighted wage hikes leading to inflation as a cause for a shift in policy stance. The Bank of England announced a 15 bps rate hike to combat inflation. In India, inflation is on the higher side, as global prices and higher food prices have fed into the domestic cycle.

Are countries set for long-term monetary policy alignment? In 2008, a paper found little correlation between Indian rates and the US Fed policy. When growth took a beating in the global financial crisis, central banks around the world aligned their monetary policies. A cut in the interest rates by the US Fed was accompanied by a reduction in the repo rate by the Reserve Bank of India. Later, as countries charted a path to economic recovery the monetary policies diverged again.

Till the global prices rise and wages increase, central banks’ policies may remain aligned. However, once there is a return to normalcy, countries may witness a slight deviation in policies. Analysis shows that the policy rate differential between India and the US has declined in the last two decades. The era of high policy rate differentials may well be over.