MONETARY POLICY

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.

OVERVIEW

·         Monetary policy refers to the policy of the central bank with regard to the use of instruments under its control to achieve the goals specified in the Act.

·         The Reserve Bank of India (RBI) is vested with the responsibility of conducting monetary policy with the primary objective of maintaining price stability while keeping in mind the objective of growth. This responsibility is explicitly mandated under the Reserve Bank of India Act, as amended in 2016 and notified in the official Gazette on May 14, 2016.

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 formally announced on January 28, 2014 a “glide path” for disinflation that explicitly stated the objective of keeping CPI inflation below 8 per cent by January 2015 and below 6 per cent 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.

·         The amended RBI Act, has replaced the Agreement on Monetary Policy Framework, which provides for inflation target to be set by the Government, in consultation with the Reserve Bank, once in every five years. The Government shall notify the inflation target in the official Gazette.

·         Price stability is a necessary precondition to sustainable growth. 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.

Policy Framework

·         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 envisages liquidity management on a day-to-day basis through appropriate actions, which aim at anchoring the operating target – the weighted average call rate (WACR) – around the repo rate.

·         The operating framework is fine-tuned and revised depending on the evolving financial market and monetary conditions, while ensuring consistency with the monetary policy stance. The liquidity management framework accordingly was revised significantly in September 2014 and again in April 2016.

The Monetary Policy Process

·         The Reserve Bank’s Monetary Policy Department (MPD) assists the Governor in formulating the monetary policy. Views of 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 decision on policy repo rate. The Financial Markets Operations Department (FMOD) 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.

·         The amended RBI Act, 2016 provides a statutory basis for constitution of an empowered monetary policy committee (MPC). The Central Government shall notify the constitution of the Monetary Policy Committee. The Governor, one Deputy Governor and one officer of the Bank would be the ex-officio members of the Committee. The other three members shall be appointed by the Central Government as per the procedure laid down in the amended RBI Act. The Committee will determine the policy interest rate required to achieve the inflation target.

Instruments of Monetary Policy

There are several direct and indirect instruments that are used in the implementation of monetary policy.

 Repo Rate: The (fixed) interest rate at which the Reserve Bank provides short-term (overnight) liquidity to banks against the collateral of government and other approved securities under the liquidity adjustment facility (LAF). The LAF consists of overnight and term repo auctions. Progressively, the Reserve Bank has increased the proportion of liquidity injected in the LAF through term-repos (of up to 56 days) at variable rates. The aim of term repo is to help develop inter-bank term money market, which in turn can set market based benchmarks for pricing of loans and deposits, and through that improve transmission of monetary policy.

§  Reverse Repo Rate: The (fixed) interest rate (currently 50 bps below the repo rate) at which the Reserve Bank absorbs short-term liquidity, generally on an overnight basis, from banks against the collateral of government and other approved securities under the LAF. The Reserve Bank also conducts variable interest rate reverse repo auctions, as necessary.

§  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 Statutory Liquidity Ratio (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 50 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 the weighted average call money rate.

§  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.

§  Cash Reserve Ratio (CRR): The share of net demand and time liabilities that banks must maintain as cash balance with the Reserve Bank.

§  Statutory Liquidity Ratio (SLR): The share of net demand and time liabilities that banks must maintain in safe and liquid assets, such as, unencumbered government securities, cash and gold. Changes in SLR often influence the availability of resources in the banking system for lending to the private sector.

§  Open Market Operations (OMOs): These include both outright purchase/sale of government securities for injection/absorption of durable liquidity, respectively.

§  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.

§  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.

Open and Transparent Monetary Policy-Making

·         The MPC will determine the policy rate required to achieve the inflation target.

·         The MPC will meet at least four times in a year.

·         The questions which come up before the MPC will be decided by majority of votes by the members present in voting.

·         The resolution adopted by the MPC will be published after conclusion of every meeting of the MPC.

·         On the 14th day, the minutes of the proceedings of the MPC will be published which include:

                             the resolution adopted by the MPC; 

                   the vote of each member on the resolution, ascribed to such member; and

                          the statement of each member on the resolution adopted.

Once in every six months, the bank will publish a document called the Monetary Policy Report which will explain:

§  the source of inflation; and

§  the forecast of inflation for 6-18 months ahead.