Monetary policy refers to the policy of the central bank regarding the use of monetary instruments under its control to achieve the objectives specified in the law. The Reserve Bank of India (RBI) is responsible for implementing the monetary policy. This responsibility is explicitly set out in the Reserve Bank of India Act – 1934. The main objective of monetary policy is to maintain price stability taking into account the objective of growth. Price stability is a prerequisite for sustainable growth.
In May 2016, the Reserve Bank of India (RBI) Act of 1934 was amended to provide a legal basis for the implementation of the flexible inflation targeting framework. The RBI amendment also sets the inflation target to be set by the Indian government, in consultation with the Reserve Bank, once in every five years. Consequently, the central government notified 4% inflation of the consumer price index (CPI) as a target for the period between August 5, 2016 to March 31, 2021 with an upper tolerance limit 6% and lower tolerance limit of 2%.
The central government has notified the following factors as constituting non-compliance with the inflation target
- Average inflation has been above the upper tolerance level of the inflation target for three consecutive quarters; or
- Average inflation has been below the lowest tolerance level for three consecutive quarters.
Before the amendment of the RBI law in May 2016, the flexible inflation targeting framework was governed by a monetary policy framework agreement between the government and the Reserve Bank of India of February 20, 2015.
The amended RBI law explicitly grants the legislative mandate to the Reserve Bank to administer the country’s monetary policy framework. The framework aims to set the repurchase rate (Repo) based on an assessment of the current and evolving macroeconomic situation; and modulating liquidity conditions to anchor money market rates at or around the repurchase rate. Changes in repurchase rates pass through the money market to the entire financial system, which, in turn, influences aggregate demand, a key determinant of inflation and growth. Once the repurchase rate has been announced, the operational framework designed by the Reserve Bank will contemplate managing daily liquidity through appropriate actions, which aim to anchor the operational objective – the weighted average call rate (WACR) – around the repo rate.
The operating framework is refined and revised in accordance with the evolution of financial markets and monetary conditions, while ensuring consistency with the monetary policy stance. The liquidity management framework was last revised significantly in April 2016.
Section 45ZB of the amended RBI Act of 1934 also provides for the establishment of a six-member monetary policy committee (MPC) empowered by the central government by notification in the Official Gazette. Consequently, in September 2016, the central government established the MPC.
The MPC determines the key interest rate necessary to reach the inflation target. The first MPC meeting was held on October 3 and 4, 2016 on the eve of the fourth bi-monthly monetary policy statement 2016-2017. The RBI Monetary Policy Department (MPD) assists the MPC in formulating its monetary policy. The opinions of the main economic players and the analytical work of the Reserve Bank contribute to the decision-making process on the key rate.
The Financial Markets Operations Department (FMOD) operationalizes monetary policy, mainly through daily liquidity management operations. The Financial Markets Committee (FMC) meets daily to review the liquidity conditions to ensure that the operational objective of the weighted average call rate (WACR) is reached.
Before the establishment of the MPC, a technical advisory committee (TAC) on monetary policy, composed of experts in the monetary economy, central banks, financial markets and public finance, advised the Reserve Bank on the direction of monetary policy. However, its role was only of an advisory nature. With the formation of the MPC, the TAC on monetary policy ceased to exist. 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 overnight liquidity to banks against the collateral of government and other approved securities under the liquidity adjustment facility (LAF).
- Reverse Repo Rate: The interest rate at which the Reserve Bank absorbs liquidity, on an overnight basis, from banks against the collateral of eligible government securities under the LAF.
- Liquidity Adjustment Facility (LAF): The LAF consists of overnight as well as term repo auctions. Progressively, the Reserve Bank has increased the proportion of liquidity injected under fine-tuning variable rate repo auctions of range of tenors. The aim of term repo is to help develop the inter-bank term money market, which in turn can set market based benchmarks for pricing of loans and deposits, and hence improve transmission of monetary policy. The Reserve Bank also conducts variable interest rate reverse repo auctions, as necessitated under the market conditions.
- 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 at a penal rate of interest. This provides a safety valve against unanticipated liquidity shocks to the banking system.
- Corridor: The 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. The Bank Rate is published under Section 49 of the Reserve Bank of India Act, 1934. 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 average daily balance that a bank is required to maintain with the Reserve Bank as a share of such per cent of its Net demand and time liabilities (NDTL) that the Reserve Bank may notify from time to time in the Gazette of India.
- Statutory Liquidity Ratio (SLR): The share of NDTL that a bank is required to 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 and sale of government securities, for injection and absorption of durable liquidity, respectively.
- Market Stabilizations 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 cash so mobilized is held in a separate government account with the Reserve Bank.
Under the amended RBI Act, the monetary policy making is as under
- 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.
- The resolution adopted by the MPC is published after conclusion of every meeting of the MPC in accordance with the provisions of Chapter III F of the Reserve Bank of India Act, 1934.
- On the 14th day, the minutes of the proceedings of the MPC are 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 Reserve Bank is required to publish a document called the Monetary Policy Report to explain
- the sources of inflation; and
- The forecast of inflation for 6-18 months ahead.
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