The Monetary Policy Process
The Reserve Bank’s Monetary Policy Department (MPD) assists the Governor in formulating the monetary policy. Views of all key stakeholders in the economy, advice of the Technical Advisory Committee (TAC), and analytical work of the Reserve Bank contribute to the conduct of Monetary Policy.
The Financial Markets Committee (FMC) meets daily to review the consistency between policy rate, money market rates, and liquidity conditions.
- The monetary authority, typically the central bank of a country, is vested with the responsibility of conducting monetary policy. Monetary policy refers to the use of instruments under the control of the central bank to regulate the availability, cost and use of money and credit.
The goal(s) of monetary policy
- Primarily price stability, while keeping in mind the objective of growth.
- In India, subsequent to the recommendations of the Dr. Urjit Patel Committee Report, the Reserve Bank has formally announced a “glide path” for disinflation that sets an objective of below 8 per cent CPI inflation by January 2015 and below 6 per cent CPI inflation by January 2016.
- The agreement on Monetary Policy Framework between the Government and the Reserve Bank of India dated February 20, 2015 defines the price stability objective explicitly in terms of the target for inflation – as measured by the consumer price index-combined (CPI-C) – in the near to medium-term, i.e., (a) below 6 per cent by January 2016, and (b) 4 per cent (+/-) 2 per cent for the financial year 2016-17 and all subsequent years.
- Price stability is a necessary (if not sufficient) precondition to sustainable growth and financial stability. The relative emphasis assigned to price stability and growth objectives in the conduct of monetary policy varies from time to time depending on the evolving macroeconomic environment. Financial stability is important for smooth transmission of monetary policy and, therefore, regulatory and financial market policies, including macro-prudential policies, are often announced along with monetary policy under Part-B of monetary policy statements
- The framework aims at setting the policy (repo) rate based on a forward looking assessment of inflation, growth and other macroeconomic risks, and modulation of liquidity conditions to anchor money market rates at or around the repo rate. Repo rate changes transmit through the money market to alter the interest rates in the financial system, which in turn influence aggregate demand – a key determinant of inflation and growth.
- Once the repo rate is announced, the operating framework on a day to day basis is implemented through proactive liquidity management, which aims at anchoring the operating target – the weighted average call rate (WACR) – around the repo rate.
The Monetary Policy Process
- The Reserve Bank’s Monetary Policy Department (MPD) assists the Governor in formulating the monetary policy. Views of all key stakeholders in the economy, advice of the Technical Advisory Committee (TAC), and analytical work of the Reserve Bank contribute to the process for arriving at the key decision on policy repo rate. The Financial Markets Department (FMD) operationalises the monetary policy, mainly through day-to-day liquidity management operations. The Financial Markets Committee (FMC) meets daily to review the consistency between policy rate, money market rates, and liquidity conditions.
Instruments of Monetary Policy
There are several direct and indirect instruments that are used in the implementation of monetary policy.
- Cash Reserve Ratio (CRR): The share of net demand and time liabilities (deposits) that banks must maintain as cash balance with the Reserve Bank.
- Statutory Liquidity Ratio (SLR): The share of net demand and time liabilities (deposits) that banks must maintain in safe and liquid assets, such as, government securities, cash and gold. Changes in SLR often influence the availability of resources in the banking system for lending to the private sector.
- Refinance facilities: Sector-specific refinance facilities aim at achieving sector specific objectives through provision of liquidity at a cost linked to the policy repo rate. The Reserve Bank has, however, been progressively de-emphasising sector specific policies as they interfere with the transmission mechanism.
- Liquidity Adjustment Facility (LAF): Consists of overnight and term repo/reverse repo auctions. Progressively, the Reserve Bank has increased the proportion of liquidity injected in the LAF through term-repos.
- Term Repos: Since October 2013, the Reserve Bank has introduced term repos (of different tenors, such as, 7/14/28 days), to inject liquidity over a period that is longer than overnight. The aim of term repo is to help develop inter-bank money market, which in turn can set market based benchmarks for pricing of loans and deposits, and through that improve transmission of monetary policy.
- Marginal Standing Facility (MSF): A facility under which scheduled commercial banks can borrow additional amount of overnight money from the Reserve Bank by dipping into their SLR portfolio up to a limit (currently two per cent of their net demand and time liabilities deposits) at a penal rate of interest (currently 100 basis points above the repo rate). This provides a safety valve against unanticipated liquidity shocks to the banking system. MSF rate and reverse repo rate determine the corridor for the daily movement in short term money market interest rates.
- Open Market Operations (OMOs): These include both, outright purchase/sale of government securities (for injection/absorption of liquidity)
- Bank Rate: It is the rate at which the Reserve Bank is ready to buy or rediscount bills of exchange or other commercial papers. This rate has been aligned to the MSF rate and, therefore, changes automatically as and when the MSF rate changes alongside policy repo rate changes.
- Market Stabilisation Scheme (MSS): This instrument for monetary management was introduced in 2004. Surplus liquidity of a more enduring nature arising from large capital inflows is absorbed through sale of short-dated government securities and treasury bills. The mobilised cash is held in a separate government account with the Reserve Bank. The instrument thus has features of both, SLR and CRR.
- With the agreement on Monetary Policy Framework between the Government and the Reserve Bank of India dated February 20, 2015, the Reserve Bank has formally adopted a flexible inflation targeting (FIT) framework. As announced in the Union Budget for 2015-16, decision making by an empowered monetary policy committee (MPC) would require amendment of the Reserve Bank of India Act, which the Government intends to do in 2015-16. The recommendations of the Dr. Urjit Patel Committee Report on all related aspects of monetary policy are being examined and progressively implemented. In implementing the framework, strengthening the transmission of policy changes to the ultimate objectives while dealing with uncertainties in terms of unanticipated global and domestic shocks will remain a major challenge.
Open and Transparent Monetary Policy-Making
- Transparency in monetary policy that makes it more predictable and effective requires communication to avoid undue apprehensions about monetary policy.
- The Reserve Bank explains the rationale of its monetary policy stance in a transparent manner, provides forward guidance on the near-term likely stance of monetary policy to contain uncertainty arising from possible noisy market expectations, emphasises a consultative approach in policy formulation, enjoys autonomy in policy operations and harmonies goals with other elements of macroeconomic policies. The monetary policy formulation is aided by advice and input from:
- Technical Advisory Committee on Monetary Policy
- Pre-policy consultations with bankers, economists, market participants, chambers of commerce and industry and other stakeholders
- Regular discussions with credit heads of banks
- Feedback from banks and financial institutions
- Internal analysis
- Starting with the first bi-monthly statement of monetary policy in April 2014, the Reserve Bank has changed the normal frequency of monetary policy announcements from eight times in a year (i.e., four quarterly and four mid- quarter) to six times in a year (i.e., bi-monthly).