Monetary Policy Framework in India: MPC, Tools, and Transmission Channels

Monetary Policy Framework in India

Under the Monetary Policy Framework Agreement signed in 2015 and codified via amendments to the RBI Act, 1934 in 2016, India transitioned to a formal Flexible Inflation Targeting (FIT) regime.

Statutory Mandate and Target

• Primary Objective: Maintain price stability while keeping in mind the objective of growth (Section 45ZA).
• Inflation Target: 4% headline CPI inflation with a tolerance band of +/- 2% (i.e., 2% to 6%).
• Failure Condition: Inflation remaining above 6% or below 2% for three consecutive quarters. The RBI must report to the Central Government explaining causes, remedial actions, and estimated time to target attainment.

Composition of the Monetary Policy Committee (MPC)

Under Section 45ZB of the RBI Act:

• 6 Members:

- Governor of RBI (Ex-officio Chairperson).

- Deputy Governor in charge of monetary policy.

- One officer of RBI nominated by the Central Board.

- Three external members appointed by Central Government for a 4-year term (not eligible for reappointment).

• Decision Rule: Majority voting. Each member has one vote; the Governor has a casting vote in case of a tie.
• Transparency: Minutes containing individual voting records and statements published on the 14th day after every meeting.

Key Monetary Policy Instruments

1. Policy Rates & Liquidity Adjustment Facility (LAF)

• Policy Repo Rate: Interest rate at which RBI lends short-term funds to scheduled commercial banks against eligible government securities.
• Standing Deposit Facility (SDF): Introduced in 2022 to absorb excess liquidity without collateral requirement. Sits 25 bps below the Repo rate (replaces fixed-rate reverse repo as floor of the LAF corridor).
• Marginal Standing Facility (MSF): Overnight emergency borrowing window for banks dipping into SLR quota. Sits 25 bps above the Repo rate (ceiling of LAF corridor).
• LAF Corridor: MSF (Ceiling) ↔ Repo Rate (Center) ↔ SDF (Floor), spanning 50 bps.

2. Reserve Ratios

• Cash Reserve Ratio (CRR): Share of Net Demand and Time Liabilities (NDTL) banks must park as cash with RBI. No interest is paid by RBI on CRR.
• Statutory Liquidity Ratio (SLR): Percentage of NDTL that banks must maintain in liquid assets (cash, gold, approved government securities).

3. Open Market Operations (OMOs)

• Buying and selling of Government securities (G-Secs) by RBI to inject or absorb permanent liquidity.
• Operation Twist: Simultaneous purchase of long-term G-Secs and sale of short-term G-Secs to flatten the sovereign yield curve.

Channels of Monetary Transmission

1. Interest Rate Channel: Changes in repo rate pass on to bank lending and deposit rates (accelerated by the External Benchmark Lending Rate - EBLR mechanism since 2019).
2. Credit Channel: Influencing volume of credit extended to businesses and households.
3. Asset Price Channel: Impact on equity and real estate valuations affecting wealth sentiment.
4. Exchange Rate Channel: Differential interest rates affecting capital flows and currency valuation.