Central banks typically set the policy rate at an appropriate level, best known to themselves. They also revisit the same, generally at regular intervals, depending on the evolving macroeconomic situation in the domestic economy and abroad. The implementation of monetary policy is mostly done through day-to-day liquidity management so that the overnight rate converges to the policy rate. The short, medium and long-term interest rates, which are expected to move in the desired direction through a process called monetary policy transmission, obviously contain elements of term and risk premiums for each instrument as dictated by market dynamics.
Liquidity management has evolved over time and assumed a considerable degree of sophistication depending on the operating procedure of monetary policy followed by each central bank, development of financial markets/ products, and institutional arrangement made to conduct liquidity operation regularly.
Central banks generally distinguish between structural and frictional factors responsible for liquidity shortage/ surplus and accordingly deploy suitable instruments at their disposal to achieve equilibrium in the money market. For example, there could be a wide gap between deposit and credit growth leading to large liquidity surplus/ deficit, which is obviously structural in nature unless a temporary surge in either credit or deposit is observed for a very short period due to unforeseen/specific reasons. Similarly, there could be a large inflow of foreign capital, disproportionate to current account deficit, in response to domestic policy initiatives and central banks are required to intervene in the forex markets to stabilize the exchange rate.
It is often difficult to distinguish between structural and frictional factors, which might have contributed to a mismatch between demand for and supply of liquidity in the market. Capital inflows/ outflows may also be due to unknown/ transient global developments like geopolitical tension, taper tantrum by the US Fed, Brexit, etc., leading to risk-on/ risk-off behaviour by overseas investors.
Many frictional factors that are domestic are known unknown to the central bankers such as sudden drawdown of government balances due to emergency spending, the surge in government balances due to advance tax payments, festival demand for currency resulting in leakage of bank deposit, large election spending mostly in currency, etc.
Strategies adopted by central banks to deal with liquidity problems arising out of structural and frictional factors are different, non-standard, and situation-specific. In order to be efficient, central banks use to have a rough and ready estimate/ forecast of liquidity based on available information. These forecasts are revisited as frequently as possible by professional staff, which helps the top management to make an informed decision about the magnitude and appropriate instrument to manage liquidity consistent with the stance of monetary policy.
Although the modus operandi of liquidity management is non-standard, market participants can visualize the direction and instruments a central bank can deploy to manage liquidity in a given situation. The options to manage structural surplus/ shortage of liquidity are: a) hike/ cut in the cash reserve ratio (CRR), b) conduct open market sale/ purchase of government securities, c) provide standing deposit/lending facility for absorption/ injection of liquidity at a penal rate i.e. below/ above the policy rate.
The CRR as an instrument of monetary policy is most powerful but less efficient to the extent it interferes with the efficient allocation of resources. Moreover, it is considered as a tax on banks as most of the central banks do not pay interest on such resources impounded from banks. Central banks generally avoid using this instrument or use it sparingly as a last resort for liquidity management.
Outright sale and purchase of government securities, typically called open market operation (OMO), is a versatile instrument that can influence both magnitude of liquidity and interest rate. The central bank has to lose/ acquire G-sec on a long-term basis in the case of OMO. The size of such operation is constrained by the availability of G-sec and market appetite at any point in time.
Standing deposit and lending facilities could be used on a daily basis with an option to roll it over at a fixed rate. Usually, residual excess liquidity is absorbed at a lower rate while residual demand for liquidity is provided at a higher rate over the policy rate subject to restriction, if any, imposed by the central bank from time to time. Standing facilities do not distinguish between structural or frictional liquidity but provide a corridor within which overnight rates fluctuate. The corridor may be a formal one or informally evolved. The width of the corridor varies from country to country.
For handling frictional liquidity problem, central banks generally rely on collateralized lending (repo) and borrowing (reverse repo) operations on an overnight/ short-term basis at preset/ variable rates. Central banks also undertake multiple fine-tuning operations in a single day as and when required. There is a second lag of transaction in case of repo/ reverse repo when reversal takes place after the expiry of the contract period. The magnitude and duration of these operations are discretionary based on evolving liquidity conditions.
Liquidity management becomes complex when central banks have to balance between exchange rate stability and interest rate stability. Balancing is done by offsetting operations in forex and money markets so that liquidity condition is evenly balanced. For example, the purchase of foreign exchange, which results in excess liquidity, is offset by sterilized operation through OMO sales and vice versa. Sterilised operations are often constrained by the availability of government securities.
When monetary policy is constrained by zero lower bound, the behavioural relationship between the quantity of money and interest rate breaks down. In such a situation, central banks of developed countries typically pursue an unconventional monetary policy like quantitative easing, including long-term liquidity operation, switch operation/operation twist, sector-specific operation, etc. In the process, they often breach zero lower bound and enter into the territory of a negative interest rate. Liquidity management is an art and central bankers are unbeatable, at least in managing liquidity, a la the lender of last resort. Monetary/liquidity management has obvious limitations even as helicopter money could not solve the real sector problem in extreme cases.
About the Author:
*The author is currently a Visiting fellow, IGIDR, & former head of RBI’s Monetary Policy Department. Views are personal.