Why is monetary policy operating procedure important?

Monetary policy as an arm of public policy has set objectives and priorities. These objectives are derived from the respective mandates of central banks. It ranges from a single objective of price stability, considered to be the dominant objective of monetary policy, to multiple objectives that include growth and financial stability as well. Central banks strive to achieve these objectives indirectly through instruments under their direct control and on the basis of the empirical relationship these instruments have with the final objectives. This requires articulation of a consistent monetary policy framework that enables transmission of policy signals in such a way that monetary and financial conditions are influenced to the desired extent to attain the objectives. Monetary policy framework, however, is a continuously evolving process contingent upon the level of development of financial markets and institutions, and the degree of global integration. As long as the value of money was linked to gold or silver, monetary policy had a secondary role. With the breakdown of the Bretton Woods system of fixed exchange rate, monetary policy framework evolved from that of setting an intermediate target. Under this framework, central banks, through the instruments under their direct control, were trying to influence an intermediate target such as money supply which had a stable relationship with the final objectives of price and output. This framework was abandoned by advanced central banks towards the late 1980s because of the unstable relationship of money with the final objectives attributed to financial innovations. As an alternative, since the late 1980s, many central banks began to adopt inflation targeting framework in which inflation was directly targeted as the sole final objective. The recent global financial crisis has, however, 2 BIS central bankers’ speeches questioned the virtue of this framework, as sole focus on price stability failed to ensure financial stability (Subbarao, 2010).1 Among advanced central banks, while the Bank of England is an inflation targeting central bank, there are many others which follow an eclectic approach. For instance, the US Federal Reserve follows a framework termed as risk management approach wherein a view on interest rate is taken on consideration of balance between risks to inflation and growth. Similarly, the European Central Bank takes policy decisions based on a twin strategy comprising economic and monetary analysis. It is, however, important to note that irrespective of differences in frameworks, price stability, interpreted as low and stable inflation, remains the dominant objective of monetary policy for all these central banks. Once a monetary policy framework is in place, it needs to have a supporting operating procedure through which monetary policy is implemented. An operating procedure is defined as day-to-day management of monetary conditions consistent with the overall stance of monetary policy. Generally, it involves: (i) defining an operational target, generally an interest rate; (ii) setting a policy rate which could influence the operational target; (iii) setting the width of corridor for short-term market interest rates; (iv) conducting liquidity operations to keep the operational target interest rate stable within the corridor; and (v) signalling of policy intentions. In addition, most central banks require commercial banks to keep minimum cash reserves with them. Commercial banks also require cash to meet the currency demand of their clients. The inter-bank transactions are also ultimately settled in their accounts with the central bank. The demand for and supply of cash reserves provide the lever to central banks not only to modulate liquidity in the system but also to set interest rate in the money market. Through the calibration of monetary conditions by using instruments under its direct control, a central bank guides the operating target to the desired level. Under a monetary targeting framework, bank reserves used to be the operating target. Central banks used to influence money supply through varying required reserves. Though cash reserve requirements remain in the toolkit of central banks, they are not actively used by advanced economies as an operating target in normal times. Consequently, most of the central banks now signal their monetary policy stance by setting interest rates in the money market. The operating target, therefore, is one of the short-term market interest rate. The operating target, however, is only an intermediate objective of monetary policy. The ultimate objectives are price stability, growth and financial stability. The effect of interest rate on these ultimate objectives would depend upon how the signals are transmitted through the financial system and how businesses and households respond to these changes. These transmission channels could be commercial interest rates, asset prices, exchange rate and expectations. The main transmission channel, however, is the commercial interest rate channel whereby change in the policy interest rate impacts deposits and lending rates of financial institutions, and alters the spending and investment decisions of households and businesses. The relative importance and effectiveness of each of these four channels of transmission, however, are conditioned by development of financial markets and institutions, and the degree of global integration