About Monetary Policy
- Monetary policy is a set of tools used by a nation’s central bank to control the overall money supply and promote economic growth and employ strategies such as revising interest rates and changing bank reserve requirements.
- Under the Reserve Bank of India, Act,1934 (RBI Act,1934) (as amended in 2016), RBI is entrusted with the responsibility of conducting monetary policy in India with the primary objective of maintaining price stability while keeping in mind the objective of growth.
The Monetary Policy Framework
- In May 2016, the RBI Act, 1934 was amended to provide a statutory basis for the implementation of the flexible inflation targeting framework.
- Inflation Target: Under Section 45ZA, the Central Government, in consultation with the RBI, determines the inflation target in terms of the Consumer Price Index (CPI), once in five years and notifies it in the Official Gazette.
- Accordingly, the Central Government notified in the Official Gazette 4 per cent Consumer Price Index (CPI) inflation as the target for the period from August 5, 2016 to March 31, 2021 with the upper tolerance limit of 6 per cent and the lower tolerance limit of 2 per cent. On March 31, 2021, the Central Government retained the inflation target and the tolerance band for the next 5-year period – April 1, 2021 to March 31, 2026.
- Section 45ZB of the RBI Act provides for the constitution of a six-member Monetary Policy Committee (MPC) to determine the policy rate required to achieve the inflation target.
Failure to Maintain Inflation Target
- The Central Government has notified the following as the factors that constitute a failure to achieve the inflation target:
- The average inflation is more than the upper tolerance level of the inflation target for any three consecutive quarters; or
- The average inflation is less than the lower tolerance level for any three consecutive quarters.
- Where the Bank fails to meet the inflation target, it shall set out in a report to the Central Government:
- The reasons for the failure to achieve the inflation target;
- Remedial actions proposed to be taken by the Bank; and
- An estimate of the time period within which the inflation target shall be achieved pursuant to the timely implementation of proposed remedial actions.
- The operating framework of monetary policy aims at aligning the operating target – the weighted average call rate (WACR) – with the policy repo rate through proactive liquidity management to facilitate the transmission of repo rate changes through the entire financial system, which, in turn, influences aggregate demand – a key determinant of inflation and growth.
Monetary Policy Committee
- Section 45ZB of the amended RBI Act, 1934 provides for an empowered six-member monetary policy committee (MPC) to be constituted by the Central Government by notification in the Official Gazette. The first such MPC was constituted in September 2016. The present MPC members, as notified by the Central Government in the Official Gazette of October, 2020, are as under:
- Governor of the Reserve Bank of India—Chairperson, ex officio
- Deputy Governor of the Reserve Bank of India, in charge of Monetary Policy—Member, ex officio
- One officer of the Reserve Bank of India to be nominated by the Central Board—Member, ex officio
- Prof. Ashima Goyal, Professor, Indira Gandhi Institute of Development Research —Member
- Prof. Jayanth R. Varma, Professor, Indian Institute of Management, Ahmedabad—Member
- Dr. Shashanka Bhide, Senior Advisor, National Council of Applied Economic Research, Delhi—Member
- Last three persons are to be appointed by the central government. This category of appointments must be from “persons of ability, integrity and standing, having knowledge and experience in the field of economics or banking or finance or monetary policy”. (Section 45ZC)
- The MPC determines the policy repo rate required to achieve the inflation target.
- The MPC is required to meet at least four times in a year. The quorum for the meeting of the MPC is four members.
- Each member of the MPC has one vote, and in the event of an equality of votes, the Governor has a second or casting vote.
- Each Member of the Monetary Policy Committee writes a statement specifying the reasons for voting in favour of, or against the proposed resolution.
Instruments of Monetary Policy
There are several direct and indirect instruments that are used for implementing monetary policy.
- Repo Rate: The interest rate at which the Reserve Bank provides liquidity under the liquidity adjustment facility (LAF) to all LAF participants against the collateral of government and other approved securities.
- Standing Deposit Facility (SDF) Rate: The rate at which the Reserve Bank accepts non collateralized deposits, on an overnight basis, from all LAF participants. The SDF is also a financial stability tool in addition to its role in liquidity management. The SDF rate is placed at 25 basis points below the policy repo rate. With introduction of SDF in April 2022, the SDF rate replaced the fixed reverse repo rate as the floor of the LAF corridor.
- Marginal Standing Facility (MSF) Rate: The penal rate at which banks can borrow, on an overnight basis, from the Reserve Bank by dipping into their Statutory Liquidity Ratio (SLR) portfolio up to a predefined limit (2 percent). This provides a safety valve against unanticipated liquidity shocks to the banking system. The MSF rate is placed at 25 basis points above the policy repo rate.
- Liquidity Adjustment Facility (LAF): The LAF refers to the Reserve Bank’s operations through which it injects/absorbs liquidity into/from the banking system. It consists of overnight as well as term repo/reverse repos (fixed as well as variable rates), SDF and MSF. Apart from LAF, instruments of liquidity management include outright open market operations (OMOs), forex swaps and market stabilisation scheme (MSS).
- LAF Corridor: The LAF corridor has the marginal standing facility (MSF) rate as its upper bound (ceiling) and the standing deposit facility (SDF) rate as the lower bound (floor), with the policy repo rate in the middle of the corridor.
- Main Liquidity Management Tool: A 14-day term repo/reverse repo auction operation at a variable rate conducted to coincide with the cash reserve ratio (CRR) maintenance cycle is the main liquidity management tool for managing frictional liquidity requirements.
- Fine Tuning Operations: The main liquidity operation is supported by fine-tuning operations, overnight and/or longer tenor, to tide over any unanticipated liquidity changes during the reserve maintenance period. In addition, the Reserve Bank conducts, if needed, longer-term variable rate repo/reverse repo auctions of more than 14 days.
- Reverse Repo Rate: The interest rate at which the Reserve Bank absorbs liquidity from banks against the collateral of eligible government securities under the LAF. Following the introduction of SDF, the fixed rate reverse repo operations will be at the discretion of the RBI for purposes specified from time to time.
- Bank Rate: The rate at which the Reserve Bank is ready to buy or rediscount bills of exchange or other commercial papers. The Bank Rate acts as the penal rate charged on banks for shortfalls in meeting their reserve requirements (cash reserve ratio and statutory liquidity ratio). The Bank Rate is published under Section 49 of the RBI Act, 1934. This rate has been aligned with the MSF rate and changes automatically as and when the MSF rate changes alongside policy repo rate changes.
- Cash Reserve Ratio (CRR): The average daily balance that a bank is required to maintain with the Reserve Bank as a percent of its net demand and time liabilities (NDTL) as on the last Friday of the second preceding fortnight that the Reserve Bank may notify from time to time in the Official Gazette.
- Statutory Liquidity Ratio (SLR): Every bank shall maintain in India assets, the value of which shall not be less than such percentage of the total of its demand and time liabilities in India as on the last Friday of the second preceding fortnight, as the Reserve Bank may, by notification in the Official Gazette, specify from time to time and such assets shall be maintained as may be specified in such notification (typically in unencumbered government securities, cash and gold).
- Open Market Operations (OMOs): These include outright purchase/sale of government securities by the Reserve Bank for injection/absorption of durable liquidity in the banking system.
Monetary Policy Process
The Reserve Bank has notified the Reserve Bank of India Monetary Policy Committee and Monetary Policy Process Regulations, 2016 which consists of the following:
- Meeting schedule: The schedule of monetary policy voting/decision meetings for the entire fiscal year is announced in advance.
- Meeting notice: Ordinarily, not less than fifteen days’ notice is given to members for meetings of the Committee. Should it be found necessary to convene an emergency meeting, 24 hours’ notice is given to every member to enable him/her to attend, with technology enabled arrangements for even shorter notice period for meetings.
- Meeting duration: The duration of monetary policy meetings is as decided by the Committee. The policy resolution is publicly released after the conclusion of the MPC meeting keeping in view the functioning and timing of financial markets.
- The MPC in its meetings reviews the surveys conducted by the Reserve Bank to gauge consumer confidence, households’ inflation expectations, corporate sector performance, credit conditions, the outlook for the industrial, services and infrastructure sectors, and the projections of professional forecasters.
- The MPC also reviews in detail the staff’s macroeconomic projections, and alternative scenarios around various risks to the outlook. Drawing on the above and after extensive discussions on the stance of monetary policy, the MPC adopts a resolution.
- The MPC Resolution: The Bank publishes, after the conclusion of every meeting of the MPC, the resolution adopted by the said Committee. The resolution includes the MPC’s decision on the policy repo rate.
- Minutes of the MPC meeting: On the 14th day after every meeting of the MPC, the minutes of the proceedings of the MPC are published which include: (a) the resolution adopted by the MPC; (b) the voting of each member on the resolution; and (c) short written statements of individual members justifying the vote, consistent with the provisions of Section 45ZL of the RBI Act. Minutes shall be released at 5 pm on the 14th day from the date of the policy day (or next earliest working day, if a holiday in Mumbai).
- The Monetary Policy Report: Once in every six months, the Reserve Bank publishes the Monetary Policy Report containing the following elements:
- Explanation of inflation dynamics in the last six months and the near term inflation outlook.
- Projections of inflation and growth and the balance of risks.
- An assessment of the state of the economy, covering the real economy, financial markets and stability, fiscal situation, and the external sector, which may entail a bearing on monetary policy decisions.
- An updated review of the operating procedure of monetary policy.
- An assessment of projection performance.
Monetary Policy Stance
The MPC indicates its broader policy approach by guiding the markets with policy stances.
- Accommodative: means the central bank is prepared to expand the money supply to boost economic growth. The central bank, during an accommodative policy period, is willing to cut the interest rates. A rate hike is ruled out. The central bank typically adopts an accommodative policy when growth needs policy support and inflation is not the immediate concern.
- Neutral: suggests that the central bank can either cut rate or increase rate. This stance is typically adopted when the policy priority is equal to both inflation and growth. During neutral policy, the central bank doesn’t commit to hiking rates or cuts. The interest rate can move to either side depending on incoming data. The guidance indicates that the market can expect a rate action on either way at any point.
- Hawkish: indicates that the central bank’s top priority is to keep the inflation low. During such a phase, the central bank is willing to hike interest rates to curb money supply and thus reduce the demand. A hawkish policy also indicates tight monetary policy. A rate cut is nearly certain during such a period. When the central bank increases rates or ‘tightens’ the monetary policy, banks too increase their rate of interest on loans to end borrowers which, in turn, curbs demand in the financial system.
- Calibrated tightening: means during the current rate cycle, a cut in the repo rate is off the table. But, the rate hike will happen in a calibrated manner. This means the central bank may not go for a rate increase in every policy meeting but the overall policy stance is tilted towards a rate hike. This can happen outside the policy meetings as well if the situation warrants it.