Deepak Mohanty: How does the Reserve Bank of India conduct its
monetary policy?
Speech by Mr Deepak Mohanty, Executive Director of the Reserve Bank of India, at the
Indian Institute of Management (IIM), Lucknow, 12 August 2011.
* * *
The assistance provided by Shri Jeevan Khundrakpam is acknowledged.
I thank the Indian Institute of Management (IIM), Lucknow for inviting me to address this
distinguished gathering. I do see many bright young prospective managers in the audience.
As you step out of the portals of the Institute, you will be faced with the challenge of
managing some or the other key aspect of our economy, be it agriculture, industry or
services. This evening, let me give you a flavour of how do we manage monetary policy in
the Reserve Bank of India? In central banking parlance this is known as the operating
procedure or the implementation of monetary policy. Essentially, it is the day-to-day
management of monetary policy in pursuit of ultimate objectives of price stability and growth.
In my presentation, I will address the following questions: Why is monetary policy operating
procedure important? How do major central banks operate their monetary policy? What is the
Reserve Bank's monetary policy operating framework? How effective is the Reserve Bank's
monetary operating framework? I will conclude by highlighting some challenges in the
operations of monetary policy on the way forward.
Why is monetary policy operating procedure important?
Monetary policy as an arm of public policy has set objectives and priorities. These objectives
are derived from the respective mandates of central banks. It ranges from a single objective
of price stability, considered to be the dominant objective of monetary policy, to multiple
objectives that include growth and financial stability as well.
Central banks strive to achieve these objectives indirectly through instruments under their
direct control and on the basis of the empirical relationship these instruments have with the
final objectives. This requires articulation of a consistent monetary policy framework that
enables transmission of policy signals in such a way that monetary and financial conditions
are influenced to the desired extent to attain the objectives. Monetary policy framework,
however, is a continuously evolving process contingent upon the level of development of
financial markets and institutions, and the degree of global integration.
As long as the value of money was linked to gold or silver, monetary policy had a secondary
role. With the breakdown of the Bretton Woods system of fixed exchange rate, monetary
policy framework evolved from that of setting an intermediate target. Under this framework,
central banks, through the instruments under their direct control, were trying to influence an
intermediate target such as money supply which had a stable relationship with the final
objectives of price and output. This framework was abandoned by advanced central banks
towards the late 1980s because of the unstable relationship of money with the final
objectives attributed to financial innovations. As an alternative, since the late 1980s, many
central banks began to adopt inflation targeting framework in which inflation was directly
targeted as the sole final objective. The recent global financial crisis has, however,
questioned the virtue of this framework, as sole focus on price stability failed to ensure
financial stability (Subbarao, 2010).1
Among advanced central banks, while the Bank of England is an inflation targeting central
bank, there are many others which follow an eclectic approach. For instance, the US Federal
Reserve follows a framework termed as risk management approach wherein a view on
interest rate is taken on consideration of balance between risks to inflation and growth.
Similarly, the European Central Bank takes policy decisions based on a twin strategy
comprising economic and monetary analysis. It is, however, important to note that
irrespective of differences in frameworks, price stability, interpreted as low and stable
inflation, remains the dominant objective of monetary policy for all these central banks.
Once a monetary policy framework is in place, it needs to have a supporting operating
procedure through which monetary policy is implemented. An operating procedure is defined
as day-to-day management of monetary conditions consistent with the overall stance of
monetary policy. Generally, it involves: (i) defining an operational target, generally an interest
rate; (ii) setting a policy rate which could influence the operational target; (iii) setting the width
of corridor for short-term market interest rates; (iv) conducting liquidity operations to keep the
operational target interest rate stable within the corridor; and (v) signalling of policy
intentions.
In addition, most central banks require commercial banks to keep minimum cash reserves
with them. Commercial banks also require cash to meet the currency demand of their clients.
The inter-bank transactions are also ultimately settled in their accounts with the central bank.
The demand for and supply of cash reserves provide the lever to central banks not only to
modulate liquidity in the system but also to set interest rate in the money market.
Through the calibration of monetary conditions by using instruments under its direct control,
a central bank guides the operating target to the desired level. Under a monetary targeting
framework, bank reserves used to be the operating target. Central banks used to influence
money supply through varying required reserves. Though cash reserve requirements remain
in the toolkit of central banks, they are not actively used by advanced economies as an
operating target in normal times. Consequently, most of the central banks now signal their
monetary policy stance by setting interest rates in the money market. The operating target,
therefore, is one of the short-term market interest rate.
The operating target, however, is only an intermediate objective of monetary policy. The
ultimate objectives are price stability, growth and financial stability. The effect of interest rate
on these ultimate objectives would depend upon how the signals are transmitted through the
financial system and how businesses and households respond to these changes. These
transmission channels could be commercial interest rates, asset prices, exchange rate and
expectations. The main transmission channel, however, is the commercial interest rate
channel whereby change in the policy interest rate impacts deposits and lending rates of
financial institutions, and alters the spending and investment decisions of households and
businesses. The relative importance and effectiveness of each of these four channels of
transmission, however, are conditioned by development of financial markets and institutions,
and the degree of global integration.
How do major central banks operate their monetary policy?
I propose to briefly highlight the operating procedures of the US Federal Reserve (Fed), the
Bank of England (BoE) and the European Central Bank (ECB). This will facilitate a
comparison of the RBI's operating procedure vis-á-vis the international best practice.
Federal Reserve Bank
Depository institutions or commercial banks in the US are required to maintain a prescribed
minimum reserve at the Fed. The actual reserve balance for a bank, however, keeps
fluctuating during a day with continuous receipts and payments taking place. While some
banks expect the end-of-day reserve balance to fall short of the minimum required, other
banks anticipate a surplus balance. Thus, banks expecting surplus reserve balance at the
Fed lend to banks expecting to end with deficit reserve balance. The market in which the
lending of Federal Reserve balances takes place is known as the federal funds market. The
overnight interest rate at which the loan is made is called federal funds rate. The federal
funds rate eventually gets transmitted to other interest rates and impact the economy. Thus,
the operating procedure of the Fed is focussed on keeping the federal funds rate at a
preannounced target level.
First, based on the outlook of inflation and growth, the target for the federal funds rate is
announced by the Federal Open Market Committee (FOMC). Second, the Fed attempts to
adjust the total supply of reserve balances so that it exactly equals demand at the target
federal funds rate. This adjustment of total supply of reserve balances available to
commercial banks is carried out primarily through open market operations (OMO) where
government bonds or other securities are exchanged for reserves. The OMO is largely
conducted by arranging overnight repurchase (repo) auctions with primary dealers.
Besides OMO, credits provided by the Fed to banks at a rate higher than the federal funds
rate - called discount rate - play an important role in the implementation of monetary policy.
Credits are provided under two programmes, viz., primary credit and secondary credit. Under
primary credit, the Fed extends short-term credit to eligible banks at a rate above the target
federal funds rate. Since the Fed operates in a systemic liquidity deficit mode, the interest
rate on primary credit acts as the upper ceiling for the federal funds rate. Secondary credit is
provided only under abnormal circumstances when depository institutions do not qualify for
primary credit or for resolution of financial difficulties. Understandably, the interest rate
charged for this credit is higher than that for primary credit.
As such, there was no lower bound for federal funds rate. However, since December 2008,
the Fed has been providing remuneration to all reserves at the rate of 25 basis points. This
rate on reserves is expected to act as the lower bound to the federal funds rate.
Bank of England
Let me first illustrate the normal monetary operating procedure of the BoE which has been
suspended since March 2009 following the global financial crisis. Each of the UK banks and
building societies, eligible and participating in the reserves-averaging scheme, is required to
set its own target of average sterling reserve balances it will hold during a reserve
maintenance period.2 The BoE remunerates these reserves holding at the Bank Rate so long
as they are, on an average, over the maintenance period, within a small range around the
target. Thus, to keep the reserve balances within the target range, banks lend and borrow
among themselves in the sterling interbank market. The aim of the BoE is to ensure that the
sterling interbank market rates are in line with the Bank Rate by operating at the margin as
supplier or taker of funds.
The policy rate, i.e., the Bank Rate is set by the Monetary Policy Committee (MPC) based on
macroeconomic conditions. Changes in the Bank Rate affect the whole range of interest
rates set by commercial banks, building societies and other institutions. Thus, the level of the
Bank Rate denotes the stance of monetary policy. To keep the aggregate supply of reserves
at the desired level, the BoE undertakes OMO of varying maturities. The short-term repos
are conducted at the Bank Rate.3 The BoE also conducts outright OMO to influence liquidity
conditions which are unlikely to be reversed quickly.
Modulation of reserve supply by the BoE at the aggregate level, however, does not always
ensure that the average reserves holding of an individual bank is within the target range.
Average reserves outside the target range attract a charge. However, to avoid the charge,
two overnight operational standing facilities are made available to banks. One is an overnight
collateralised lending facility from which banks, in the event of reserve shortfall, can borrow
from the BoE against high quality collateral at a rate higher than the Bank Rate. The other
facility is an uncollateralised deposit facility for surplus reserves at a rate below the Bank
Rate. Typically, a commercial bank will be unwilling to deal in the inter-bank market on a
term worse than the above two facilities. Thus, the two rates act as the ceiling and floor of an
interest rate corridor around the rate at which inter-bank dealings take place.
Since March 2009, the BoE has been undertaking asset purchases financed through creation
of central bank reserves, known as quantitative easing. As a result, supply of reserves is
largely determined by asset purchases decision of the BoE, rather than the demand for
reserves by banks. Under this potential imbalance in the demand and supply of reserves,
continuation with reserve requirement could have resulted in loss of control over market
interest rates. Thus, the BoE suspended reserve averaging regime in March 2009. Instead,
the BoE currently operates a "floor system" whereby all reserves balances are remunerated
at the Bank Rate. Thus, there is no need for the deposit facility for reserve account holders.
But, some operating standing facilities participants do not have reserve account with the
BoE, meaning the deposit rate still acts as the floor for them. Since March 2009, the deposit
rate has been set a zero. The short-term OMOs have also been suspended, as there are no
reserve targets currently.4
European Central Bank
The key monetary policy instrument of the ECB is a liquidity injection OMO called the Main
Refinancing Operation (MRO). The Governing Council of ECB decides the minimum bid rate
in the MRO repo auction which is the policy rate. Through the MRO, the ECB guides the
overnight inter-bank market rate, viz., euro overnight index average (EONIA) around the
minimum bid rate.
Further, for the purpose of controlling EONIA, and reducing its volatility, a marginal lending
facility and a deposit facility are provided. The two rates in the standing facilities form the
upper and the lower bound of the interest rate corridor within which overnight inter-bank rates
fluctuate. Besides the above main operation, the ECB conducts OMO for longer term
refinancing operations, fine-tuning operations and structural operations. The credit
institutions or banks in the euro area are also subject to minimum reserve requirement with
the respective national central banks (NCBs).
A snapshot of the practice in the Fed, the BoE and the ECB is given in Table below (Table).
Table:
Key features of major Central Banks operating procedures
MSF= Marginal Standing Facility; and ECR = Export Credit Refinance (available at repo rate up to 15 per cent of
outstanding export credit); LAF= Liquidity Adjustment Facility.
* Since March 2009, BOE has suspended the reserve averaging regime and short-term open market operations
on account of its asset purchases through creation of central bank reserves (known as quantitative easing).
Source: Adapted for advanced countries from Friedman B.M. and Kenneth N. Kuttner, Handbook of Monetary
Economics, Vol.3B, North Holland, 2011.
From this survey of advanced economies, five key features of monetary operations stand
out. First, there is a minimum reserve requirement. Second, there is a single policy rate.
Third, the objective of the policy rate is to target a short-term money market rate. Fourth,
there is a corridor around the policy rate charted by interest rates for standing facilities which
aim to contain the volatility in the target interest rate. Fifth, the interest rates on standing
facilities are determined with reference to the policy rate.
What is the Reserve Bank of India's operating framework?
The monetary policy framework and the associated operating procedure of monetary policy
in India have also evolved over time. On 3rd May 2011, the Reserve Bank in its Annual
Monetary Policy Statement announced a revised monetary policy operating procedure based
on the recommendations of a Committee constituted for the purpose.5 Before I delve into the
current operating procedure, let me give you a snapshot of the evolution of our monetary
policy operations since the inception of the Reserve Bank of India in 1935.
First, in the formative years during 1935-1950, the focus of monetary policy was to regulate
the supply of and demand for credit in the economy through the Bank Rate, reserve
requirements and OMO.
Second, during the development phase during 1951-1970, the need to support plan
financing through accommodation of government deficit financing by the RBI began to
significantly influence the conduct of monetary policy. This led to introduction of several
quantitative control measures to contain the consequent inflationary pressures while
ensuring credit to preferred sectors. These measures included selective credit control, credit
authorisation scheme (CAS) and "social control" measures to enhance the flow of credit to
priority sectors. The Bank Rate was raised more frequently during this period.
Third, during 1971-90, the focus of monetary policy was on credit planning. However, the
dominance of fiscal policy over monetary policy accentuated and continued through the
1980s. To raise resources for the government from banks, the statutory liquidity ratio (SLR)
was progressively increased from the statutory minimum of 25 per cent of banks' net demand
and time liabilities (NDTL) in 1970 to 38.5 per cent by 1990. And to neutralise the inflationary
impact of deficit financing, the cash reserve ratio (CRR) was gradually raised from its
statutory minimum of 3 per cent to 15 per cent of NDTL during the period.
Fourth, the 1980s saw the adoption of monetary targeting framework based on the
recommendations of Chakravarty Committee (1985). Under this framework, reserve money
was used as operating target and broad money (M3) as an intermediate target. A number of
money market instruments such as inter-bank participation certificates (IBPCs), certificates of
deposit (CDs) and Commercial Paper (CP) were introduced based on the recommendations
of Vaghul Committee (1987).
Fifth, structural reforms and financial liberalisation in the 1990s led to a shift in the financing
paradigm for the government and commercial sectors with increasingly market-determined
interest rates and exchange rate. By the second half of the 1990s, in its liquidity
management operations, the RBI was able to move away from direct instruments to indirect
market-based instruments. The CRR and SLR were brought down to 9.5 per cent and
25 per cent of NDTL of banks by 1997.
Sixth, the monetary policy operating procedure also underwent a change following the
recommendation of Narasimham Committee II (1998). The RBI introduced the Interim
Liquidity Adjustment Facility (ILAF) in April 1999, under which liquidity injection was done at
the Bank Rate and liquidity absorption was through fixed reverse repo rate. The ILAF
gradually transited into a full-fledged liquidity adjustment facility (LAF) with periodic
modifications based on experience and development of financial markets and the payment
system. The LAF was operated through overnight fixed rate repo and reverse repo from
November 2004.
The LAF helped to develop interest rate as an instrument of monetary transmission. In the
process, two major weaknesses came to the fore. First was the lack of a single policy rate.
The operating policy rate alternated between repo and reverse repo rates depending upon
the prevailing liquidity condition. In a surplus liquidity condition, the operating policy rate was
the reverse repo rate, while in a deficit liquidity situation it was the repo rate. Second was the
lack of a firm corridor. The effective overnight interest rates dipped below the reverse repo
rate in surplus conditions and rose above the repo rate in deficit conditions. Moreover,
overnight call rates became unbounded under occasional liquidity stress. Thus, more often
the overnight interest rate remained outside the corridor.
New operating procedure
Against this background, the new operating procedure retained the essential features of the
LAF framework with the following key modifications.
First, the weighted average overnight call money rate was explicitly recognised as the
operating target of monetary policy.
Second, the repo rate was made the only one independently varying policy rate.
Third, a new Marginal Standing Facility (MSF) was instituted under which scheduled
commercial banks (SCBs) could borrow overnight at their discretion up to one per cent of
their respective NDTL at 100 basis points above the repo rate.
Fourth, the revised corridor was defined with a fixed width of 200 basis points. The repo rate was
placed in the middle of the corridor, with the reverse repo rate 100 basis points below it and the
MSF rate 100 basis points above it. The current operating framework is illustrated in Chart 1.
The new operating procedure improves upon the earlier LAF framework by removing some
of the major drawbacks. It is also a move towards international best practices. It is expected
that the new procedure will improve the implementation and transmission of monetary policy.
First, explicit announcement of an operating target makes it clear to the market participants
about the desired policy impact. Second, a single policy rate removes the confusion arising
out of policy rate alternating between the repo and the reverse repo rates. It also improves
the accuracy of signalling monetary policy stance. Third, the institution of MSF provides a
safety valve against unanticipated liquidity shocks. It will help stabilise the overnight interest
rate around the repo rate, particularly during deficit liquidity situation. Fourth, a fixed interest
rate corridor set by MSF rate and reverse repo rate, by reducing uncertainty and avoiding
communication difficulties associated with a variable corridor, will help keep the overnight
average call money rate close to the repo rate.
How effective is the new operating framework?
While it is too early to judge the efficacy of the new operating procedure, experience of over
3 months suggests that overnight interest rate was more stable following the implementation
of the new procedure (Chart 2).
The new operating framework with the modified LAF presupposes the dominance of the
interest rate channel of monetary transmission. This means that once the RBI changes policy
repo rate, it should immediately impact the overnight interest rate which is the operational
rate and then transmit through the term structure of interest rates as well as bank lending
rates. However, there are challenges. The strength of transmission through the interest rate
channel depends on several factors, particularly on liquidity conditions. Recent experience
suggests that as long as systemic liquidity was in surplus, the transmission of policy signal
was weak. But once systemic liquidity turned into deficit, the response of the overnight call
rate to policy rate was stronger (Chart 3).
The next in the sequence of policy transmission is the general money market. Empirical
evidence suggests a strong correlation between the weighted average call rate and other
money market interest rates. In other words, they move in tandem (Chart 4).
The direction of transmission from the money market interest rate to debt market is the
same, but the magnitude depends on several factors including supply and demand of
securities, inflation expectations and economic activity. Debt-market interest rates moved in
response to changes in the money market interest rates once call money rates rose from low
levels (Chart 5).
The transmission to the credit market is much more complex and occurs through the cost
channel. Policy rate changes get translated to deposit rates depending on liquidity conditions
and credit demand. As the cost of deposits rises alongside money market rates, lending
rates respond to policy rate changes with a lag (Chart 6).
It can thus be seen that the strength of transmission of monetary policy depends on the
ability of the central bank to keep liquidity in deficit mode. This raises the question: can the
Reserve Bank keep the liquidity in the system in a deficit mode at all times? In this regard,
monetary developments over the last few years have been instructive. Liquidity is created in
the central bank balance sheet by expansion of either net foreign assets (NFA) or net
domestic assets (NDA) or both. For emerging market economies (EMEs) like ours, if capital
inflows are far in excess of the absorptive capacity of the economy, it creates domestic
liquidity beyond the desired level as excess foreign exchange is absorbed by the central
bank. It normally takes offsetting action, by reducing NDA in its book, to neutralise the
expansionary effect of foreign currency assets. This operation is known as sterilisation.
It can be seen from Chart 7 that during 2006-07 and 2007-08, NFA of the RBI increased
sharply following strong capital inflows. Hence, the RBI had to resort to sterilisation by
reducing NDA to contain liquidity, i.e., reserve money. In contrast, in 2009-10 when there
was foreign exchange outflow following the global financial crisis, the RBI had to expand
NDA to maintain an adequate level of rupee liquidity. The year 2010-11 provides a more
balanced picture with a mix of NFA and NDA contributing to desired liquidity expansion.
Hence, in a normal situation it may not be very difficult to keep liquidity in a deficit mode.
In the case of excessive capital inflows it could still be feasible to keep the system in liquidity
deficit mode. If surplus capital inflows are taken into balance sheet of the RBI, other
instruments such as market stabilisation scheme (MSS)6 bonds and cash reserve ratio
(CRR) could be utilised to bring the system into deficit mode. However, occasionally it may
not be possible to bring the system into deficit mode despite deployment of all instruments as
was seen during 2006-08. In recognition of the fact that monetary transmission will be better
if the liquidity in the system is in deficit, the Reserve Bank's position on liquidity as articulated
in the recent monetary policy statements aims to ".... manage liquidity to ensure that
monetary transmission remains effective, without exerting undue stress on the financial
system".7
Challenges on the way forward!
The new operating procedure of monetary policy has been drawn up in order to remove the
drawbacks experienced in the earlier LAF framework and it is consistent with the
international best practices. The announcement of an explicit operating target, institution of
an independently varying single policy rate and an interest rate corridor set by MSF and
reverse repo will all improve the implementation of monetary policy in India. At the same
time, there are three main challenges going forward, which need to be recognised.
One, international best practices and our own empirical evidence suggest that the
transmission of policy signals to the operating target and other short-term market interest
rates is most effective under deficit liquidity conditions. The challenge is to keep the systemic
liquidity in a deficit mode consistently. This needs an accurate forecasting of liquidity. But
several autonomous factors limit the ability of the RBI and market participants to forecast
liquidity. Foremost among these factors is the uncertainty arising out of government cash
balances and unanticipated swings in capital flow. We need to put in place a system which
can reasonably forecast the changes in these autonomous determinants of liquidity, so that
commensurate action can be taken.
Two, even if uncertainties of sudden swings in liquidity are not there, there could be
prolonged phases of autonomous liquidity infusion due to sustained capital inflows or liquidity
drain due to persistent surplus of government cash balances. The challenge in this case,
however, is in having the capacity to conduct longer term liquidity management operation
through instruments such as long-term and outright OMO, MSS and CRR. It is a challenge
because the success of these instruments is circumscribed by market appetite. These
instruments also need to be augmented by a scheme of auction of government cash
balances.
Three, effective transmission of policy signals to the operating target, while necessary, is not
a sufficient condition for the success of monetary policy. Needless to say, the success lies in
the achievement of the ultimate objective of sustained growth with price and financial
stability. This entails improved transmission of short-term interest rates to other long-term
commercial interest rates. This will require further deepening of financial markets and
removal of structural rigidities coming in the way of market determination of interest rates.