Liquidity overhung

Liquidity overhung

Subject: Economy

Section: Monetary Policy

Context:

Dominance of ample system level surplus liquidity, resulting in a large liquidity increase in the net RBI

Cause:

• Credit to government -The increase in the net RBI credit to the government could be on account of large monetary accommodation to the government in terms of Ways and Means Advances (WMA).
• Increase in net foreign currency assets– RBI buys forex in return of domestic currency.

Impact:

• WACR>SDR-Weighted average call money rate (the operating target of the monetary policy) moving below the standing deposit facility rate (which is the floor in the LAF corridor to absorb liquidity).

Normally the rate for short-term lending remains above the long term lending rate.

Concept:

Operating Procedure of the Monetary Policy:

The operating procedure of monetary policy is guided by the objective of aligning the operating target of monetary policy – the WACR (weighted average call rate) – to the repo rate through active liquidity management, consistent with the stance of monetary policy.

The MPC sets the Flexible Inflation Targeting Framework in India. As enjoined by the RBI Act, the decision of the MPC on the policy rate has to be operationalised by the RBI so that it alters the spending behaviour of economic agents and, in turn, achieves the RBI’s mandate on inflation and growth.

Challenge for an efficient operating procedure:

• minimize the transmission lag from changes in the policy rate to the operating target – a variable that can be controlled by monetary policy actions – rapidly and efficiently;
• ensure that changes in the operating target are transmitted as fully as feasible across the interest rate term structure in the economy.

Procedure:

• The weighted average call rate (WACR) – which represents the unsecured segment of the overnight money market and is best reflective of systemic liquidity mismatches at the margin – is explicitly chosen as the operating target of monetary policy in India.
• An interest rate corridor – the liquidity adjustment facility (LAF) – has been defined since May 2011 by the interest rate on the marginal standing facility (MSF) as the upper bound (ceiling), the fixed overnight reverse repo rate as the lower bound (floor) and the policy repo rate in between.
• The framework aims at setting the policy repo rate based on an assessment of the current and evolving macroeconomic situation, and modulation of liquidity conditions to anchor money market rates at or around the repo rate.
• The LAF corridor effectively defines the operating procedure of monetary policy. Once the policy repo rate is announced, liquidity operations are conducted to keep the WACR closely aligned to the repo rate.