The Reserve Bank of India (RBI) is proposing to set up a working group to review the current operating procedure of the monetary policy including the liquidity adjustment facility (LAF).

In his first quarter review of the Monetary Policy for 2010-11, RBI Governor D Subbarao said ‘in the context of changing liquidity dynamics the epration of LAF need to be studied’. As the systemic liquidity transits from an uni-directional surplus mode to a bi-directional mode, it would have implications for the effectiveness of monetary policy transmission, he added.

He said current market conditions indicate that while liquidity pressures will ease, the system is likely to remain in deficit mode for now. This implies a significant change in the monetary policy operation which has a direct bearing on our actions. In a deficit liquidity mode, LAF has emerged as the eprating policy rate.

The LAF operates in such a manner that as systemic liquidity alternates from surplus to deficit, event at the margin, the overnight call money rates alternate between the reverse repo rate and the repo rate. This imparts volatility to call rates to the extent of the width of the LAF corridor.

He said there was no unique way to determine the appropriate width of the policy interest rate corridor. But the guiding principles were it should be brought enough not to unduly incentivise market players to place their surplus funds with the central bank and it should not be so broad that it gave scope for greater interest rate volatility to distort policy signal. The challenge therefore is to strike the right balance.

UNI