Navigating through the unknown: The uncertainty channel in monetary policy transmission

The perception of uncertainty surrounding the monetary policy stance of the central bank may disrupt the traditional policy transmission mechanism. This study constructs a news-based monetary policy uncertainty index (MPU) for India and evaluates the role of MPU in monetary policy transmission to financial markets. Results from Interacted and State-Dependent Local Projection models suggest that MPU impedes the policy transmission mechanism. Under monetary tightening, MPU amplifies long term bond yields, reduces 3-month T-bill yields, moderates the recovery of stock prices after exacerbating the initial fall, and causes a longer period of currency depreciation. These findings suggest that MPU has asymmetric effects on the monetary transmission process and a low uncertainty state is conducive for effective transmission of monetary policy to financial markets. The results are shown to be robust to an alternative measure of MPU. The study provides useful insights for monetary authorities on the need for effective communication and forward guidance in managing expectations.