The Monetary Policy Committee is responsible for fixing the benchmark interest rate in India. The meetings of the Monetary Policy Committee are held at least four times a year (specifically, at least once a quarter) and it publishes its decisions after each such meeting.
The committee comprises six members – three officials of the Reserve Bank of India and three external members nominated by the government of India. They need to observe a “silent period” seven days before and after the rate decision for “utmost confidentiality”. The governor of the Reserve Bank of India is the chairperson ex officio of the committee. Decisions are taken by majority with the governor having the casting vote in case of a tie. The current mandate of the committee is to maintain 4% annual inflation until 31 March 2026 with an upper tolerance of 6% and a lower tolerance of 2%.
The Reserve Bank of India Act, 1934, was amended by Finance Act (India), 2016, to constitute MPC which will bring more transparency and accountability in fixing India’s monetary policy. The monetary policy is published after every meeting with each member explaining his opinions. The committee is answerable to the government of India if the inflation exceeds the range prescribed for three consecutive quarters.
Key decisions pertaining to benchmark interest rates used to be taken by the governor of the Reserve Bank of India alone prior to the establishment of the committee. The governor of RBI is appointed and can be disqualified by the government anytime. This led to uncertainty and resulted in friction between the government and the RBI, especially during the times of low growth and high inflation. Before the constitution of the MPC, a Technical Advisory Committee (TAC) on monetary policy with experts from monetary economics, central banking, financial markets and public finance advised the Reserve Bank on the stance of monetary policy. However, its role was only advisory in nature.
The setting up of a committee to decide on monetary policy was first proposed by the Urjit Patel Committee. The committee suggested a five-member MPC; three members from the RBI and two nominated by the government. The government initially proposed a seven-member committee three from the RBI and four nominated by it. Subsequent negotiations led to the current composition of the committee, with the external members having a four-year term.
The Reserve Bank’s Monetary Policy Department (MPD) assists the MPC in formulating the monetary policy. Views of key stakeholders in the economy, and analytical work of the Reserve Bank contribute to the process for arriving at the decision on the 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 liquidity conditions so as to ensure that the operating target of monetary policy (weighted average lending rate) is kept close to the policy repo rate. Monetary Policy Committee came into force on 27 June 2016.
Suggestions for setting up a monetary policy committee is not new and goes back to 2002 when YV Reddy committee proposed to establish a MPC, then Tarapore committee in 2006, Percy Mistry committee in 2007, Raghuram Rajan committee in 2009 and then Urjit Patel Committee in 2013.
The composition of the current monetary policy committee is as follows:
- 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; and
- Dr. Shashanka Bhide, Senior Advisor, National Council of Applied Economic Research, Delhi—Member.
Members referred from 4 to 6 above, will hold office for a period of four years from the date of appointment while the other three members are official. None of the central government nominees are eligible to be re-appointed.
Functions of the MPC:
- Under Section 45ZA(1) of the RBI Act, 1934, the Central Government determines the inflation target in terms of the Consumer Price Index, once in every five years in consultation with the RBI.
- Under the Monetary Policy Framework Agreement, the RBI will be responsible for containing inflation targets at 4% (with a standard deviation of 2%) in the medium term.
- This target would be notified in the Official Gazette.
- Though the central bank already had a monetary framework and was implementing the monetary policy, the newly designed statutory framework would mean that the RBI would have to give an explanation in the form of a report to the Central Government, if it failed to reach the specified inflation targets.
- It shall, in the report, give reasons for failure, remedial actions as well as estimated time within which the inflation target shall be achieved. (The factors that constitute failure shall be such as may be notified by the Central Government in the Official Gazette.)
- Further, RBI is mandated to publish a Monetary Policy Report every six months, explaining the sources of inflation and the forecasts of inflation for the coming period of six to eighteen months.
- Given this backdrop, MPC decides the changes to be made to the policy rate (repo rate) so as to contain the inflation within the target level specified to it by the Central Government.
- Each Member of the Monetary Policy Committee has to write a statement specifying the reasons for voting in favour of, or against the proposed resolution, and the same alongwith the resolution adopted by the MPC is published as minutes of the meeting by RBI after 14 days of the said meeting.
- In addition, subsequent to the MPC meeting, RBI has to publish a document explaining the steps to be taken by it to implement the decisions of the Monetary Policy Committee, including any changes thereto.
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 uncollateralised 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 per cent). 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 per cent 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.