Monetary Policy Instruments and Implementation

The Central Bank possesses a wide range of tools to be used as instruments of monetary policy. At present, the monetary policy places greater reliance on market based policy instruments. As a consequence, the main monetary policy instruments currently used are policy interest rates and Policy Rate Corridor (PRC), Open Market Operations (OMO) and the Statutory Reserve Requirement (SRR) on commercial bank deposit liabilities. A first step in the monetary policy implementation is the liquidity forecasting. (Click here for the details)

 

Policy Interest Rates and Open Market Operations (OMO)

At present, the Central Bank conducts its monetary policy under a system of active OMOs. The key elements of the system are (i) an interest rate corridor formed by the main policy rates of the Bank i.e. Standing Deposit Facility Rate (SDFR) and Standing Lending Facility Rate (SLFR), and (ii) Open Market Operations. 

1. The main instruments to achieve the intended inflation path are the standing deposit facility rate (formerly the repurchase rate) and the standing lending facility rate (formerly the reverse repurchase rate) of the Central Bank which form the lower and upper bounds for the overnight interest rates in money markets. These rates, which are the Bank's signaling mechanism on its monetary policy stance, are reviewed on a regular basis, usually eight times per year, and revised if necessary.

2. Standing facilities are available for those participating institutions which were unable to obtain their liquidity requirements at the daily auction. That is, even after an auction, if a participant has excess money he could deposit such funds under the standing deposit facility. Similarly, if a participant needs liquidity to cover a shortage, he could borrow funds on reverse repurchase basis under the standing lending facility. Accordingly, these facilities help containing wide fluctuations in interest rates.

3. OMOs are conducted either to absorb liquidity if there is excess liquidity, or to inject, if there is a shortage of liquidity and thereby to maintain the stability in the overnight interest rates. OMOs are conducted through auctions to buy /sell government securities on a permanent or a temporary basis (Click here for a detailed description of the process of conducting OMO). The auction is on a multiple bid, multiple price system. Participants in the money market could make up to three bids at each short term auction and up to six bids at each long term auction and the successful bidders would receive their requests at the rates quoted in the relevant bid.

The Bank Rate

There also exists another policy rate known as the Bank Rate (Section 87 of the MLA) which is the rate at which the Central Bank provides credit to commercial banks. These are collateralised any assets which are acceptable to the Monetary Board. The Bank rate is usually a penalty rate which, is higher than other market rates and is termed as Lender of Last Resort (LOLR) rate at which emergency loans are provided to banks.

 

Statutory Reserve Requirement (SRR)

The statutory reserve ratio (SRR) is the proportion of the deposit liabilities that commercial banks are required to keep as a cash deposit with the Central Bank. Under the Monetary Law Act (MLA), commercial banks are required to maintain reserves with the Central Bank at rates determined by the Bank. At present, demand, time and savings deposits of commercial banks denominated in rupee terms are subject to the SRR.

The SRR has been widely used to influence money supply in the past. However, the reliance on SRR as a regular monetary management measure has been gradually reduced with a view to enhancing market orientation of monetary policy and also reducing the implicit cost of funds which the SRR would entail on commercial banks. Therefore, at present, the Central Bank uses the SRR to address persistent liquidity issues in the market (Click here for details on how SRR is computed).

 

Other Policy Instruments

In addition, depending on the need and circumstances in the economy, the Central Bank can use foreign exchange operations, quantitative restrictions on credit, ceilings on interest rate, refinance facilities, moral suasion as well as certain macro-prudential measures such as imposing margin requirements and loan to value ratios for the purpose of monetary management.