How does a central bank signal its monetary policy objectives?

Going by convention, a central bank has two sets of tools - quantitative and qualitative - to signal easing or tight money conditions, depending on its policy objective.

While quantitative tools would include imposing cash reserve requirements (CRR) for banks, fixing the repo or reverse-repo rates, the bank rate and prescribing the level of statutory liquidity ratio (SLR) to signal the level of growth in the financial markets, pursuant with its growth objective for the economy.

Popular qualitative measures would include imposing margins on certain loans and moral suasion. However, RBI often tweaks only the repo or reverse-repo rates and CRR.

CRR is the proportion of deposits banks need to keep with the RBI

What is Cash Reserve Ratio (CRR)?

Banks are required to maintain a part or portion of the deposits they mobilise as cash with the central bank as CRR. Banks are required to park these funds on the average daily deposit mobilised on a fortnightly basis.

This measure serves the policy objective instantly as liquidity is either infused or impounded almost immediately. However, this is not a very popular tool with central banks globally, though used by RBI often.

Back home, even though SLR (the portion of deposits raised by banks that needs to be parked in government bonds, effectively controlling the amount of lendable funds in the system) is a tool that is in vogue. However, it is not often that RBI revises the SLR.

RBI lends to banks at repo rate to manage their daily liquidity

What is repo rate?

It is essentially a short-term policy signal, the discount rate at which the central bank buys securities from commercial banks and infuses liquidity into the system.

In other words, it is the rate at which the central bank lends to commercial banks to manage their daily liquidity.

The intent is to signal the cost of funds in the system and indirectly influence the quantum of growth in funds while the bank rate is a signal for long-term rates and is a refinance rate for commercial banks. However, the bank rate has not been revised by RBI for over a decade now.

RBI sells securities to banks at reverse-repo rate to suck out excess liquidity from the system

What is the reverse-repo rate?

Conversely, reverse-repo is the rate at which the central bank sells securities to banks in order to suck out excess liquidity from the system.

If RBI wants to discourage banks from piling up idle cash, it reduces such rates. This will then force banks to look at other options to deploy their funds and earn better returns.

Under its current liquidity management strategy, the repo and reverse-repo rates serve as a corridor for the movement of the overnight call money rates for banks.

RBI initiated measures to keep the country at bay from the global financial crisis

What are the other tools that a central bank has to signal its policy intent?

Under exceptional circumstances, like during the crisis in the global financial markets after the collapse of investment bank Lehman Brothers, RBI not only took recourse to conventional tools, but also used other measures such as extending credit lines to sectors hit by the crisis and by easing certain provisioning norms for banks for lending to a few sectors.

It imposes margins on lending to sensitive sectors such as commodities and stocks to restrict disbursal of loans by banks. The central bank issues special bonds with a specific intent in mind. For example, bonds under the Market Stabilisation Scheme (MSS) were issued only to suck out excess liquidity generated due to the surge in capital inflows.