Monetary Policy Instruments and Implementation

The Central Bank possesses a wide range of tools to be used as instruments of monetary policy. The main monetary policy instruments used currently are policy interest rates, Open Market Operations (OMO) and the Statutory Reserve Requirement (SRR) on commercial banks’ rupee deposit liabilities. 

Policy Interest Rates and Open Market Operations (OMO)

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 interest 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 SDFR and the SLFR 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 main signalling mechanism on its monetary policy stance, are reviewed on a regular basis, and revised if necessary.
2. Standing facilities are available for those participating financial institutions that were unable to obtain their liquidity requirements at the daily auction. For example, if a participant has excess money even after an OMO auction, the participant could deposit such funds under the standing deposit facility. Similarly, if a participant needs liquidity to cover a shortage, the participant could borrow funds on a reverse repurchase basis under the standing lending facility. Accordingly, these facilities help contain wide fluctuations in overnight interest rates.
3. OMOs are conducted either to absorb liquidity if there is excess liquidity, or to inject liquidity if there is a shortage of liquidity, thereby maintaining stability in 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 first step in the monetary policy implementation is liquidity forecasting. (Click here for the details)

The Statutory Reserve Requirement (SRR) is the proportion of deposit liabilities that the Licensed Commercial Banks (LCBs) are required to keep as a cash deposit with the Central Bank. Under the  CBA, LCBs are required to maintain reserves with the Central Bank at rates determined by the Bank. Demand, time and savings deposits of LCBs denominated in rupee terms are subject to SRR.

SRR has been widely used to influence the 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 the market orientation of monetary policy and also reducing the implicit cost of funds that the SRR would entail on LCBs. Therefore, at present, the Central Bank uses SRR to address persistent liquidity issues in the market (Click here for details on how SRR is computed).

In addition, depending on the need and circumstances in the economy, the Central Bank can use quantitative restrictions on credit, ceilings on interest rates, moral suasion as well as communication and forward guidance for the purpose of monetary management.