Unconventional monetary policy: the global toolkit and India's use of it

Detail

1. Why central banks need it

• Conventional monetary policy means the central bank changes the short-term policy rate. In India this is the repo rate (the interest rate at which the RBI lends money to banks for a short time).
• Zero lower bound (ZLB): a policy rate cannot usually go much below 0%. If it did, people could simply hold cash, which earns 0%.
• Liquidity trap: interest rates are already very low and people prefer to hold cash. More money does not lead to more borrowing or spending.

• Rate cuts stop working → the central bank needs other tools.

• Frozen markets (2008 global financial crisis, 2020 COVID shock): banks and investors stop lending to each other.

• The policy rate changes → but loan and bond rates do not follow (transmission breaks) → credit does not reach firms.

• Unconventional monetary policy = any tool beyond changing the short-term policy rate. Usually the central bank uses its balance sheet (what it owns and owes) or its promises about the future.

2. The global toolkit

Quantitative easing (QE)

• Definition: a central bank buys bonds and other assets on a large scale. It pays with newly created money.
• How it works:
• The central bank buys bonds → bond prices rise → long-term yields (the interest a bond pays) fall.
• Banks get more reserves → there is more money to lend.

• Home loans and company borrowing become cheaper → spending and investment are supported.

• Examples: Bank of Japan (BoJ) 2001-06, the first major QE; US Federal Reserve QE1-QE3 (2008-14) and again in 2020; European Central Bank (ECB) 2015; Bank of England.

• Key feature: QE is meant to be temporary and reversible. The assets can later be sold or allowed to mature.

Quantitative tightening (QT)

• Definition: the reverse of QE. The central bank shrinks its balance sheet in one of two ways:
• it sells assets, or

• it lets bonds mature without reinvesting the money ("runoff").

• The effect is to take money out of the system and push long-term yields up.

• Fed QT rounds: 2017-19 and 2022-25 (NCERT: "verify end").
• Update: by 2026 the IMF recorded that the Fed had stopped its balance-sheet runoff and begun reserve management purchases (small bond purchases to keep enough reserves in the banking system) [7]. So the second round of QT ended in 2025.

Negative interest rate policy (NIRP)

• Definition: the policy rate is set below zero. Banks pay the central bank to keep extra reserves with it.
• Aim: holding spare cash becomes costly for banks, so they are pushed to lend it out.
• Worked example: the deposit rate is −0.5% and a bank keeps ₹100 crore of extra reserves. The bank pays ₹100 crore × 0.5% = ₹0.5 crore a year. Lending the money becomes more attractive.
• Users: ECB (2014), BoJ (2016-24), Switzerland, Sweden, Denmark.
• Risk: bank profits get squeezed. Banks may not pass negative rates on to ordinary depositors.

Yield curve control (YCC)

• Yield curve: a line showing the interest rates on bonds of different maturities, for example 1-year, 5-year and 10-year.
• Definition of YCC: the central bank announces a target for a specific long-term bond yield. It then buys as many bonds as needed to hold that yield.
• Difference from QE:
• QE fixes the quantity of bonds to buy.

• YCC fixes the price (the yield), and the quantity is whatever it takes.

• Examples: BoJ 2016-24 on the 10-year JGB (Japanese Government Bond); Reserve Bank of Australia 2020-21.

Operation Twist

• Definition: the central bank buys long-term securities and sells short-term securities at the same time.
• Effect: long-term yields fall (the curve is "twisted" flatter) without changing overall liquidity. The money paid out for the purchases comes back in through the sales.
• Worked example: the central bank buys ₹10,000 crore of 10-year bonds and sells ₹10,000 crore of 6-month bills. Net money added = ₹10,000 − ₹10,000 = ₹0. The long-term yield still falls.
• Fed examples: 1961 and 2011-12.

Helicopter money (idea from Milton Friedman, 1969)

• Definition: new central bank money is given directly to the public, or it permanently finances government spending.
• Key difference from QE: helicopter money is not reversed. QE assets are held temporarily and can be unwound. Helicopter money permanently adds to the money supply.
• Related idea, deficit monetisation: the central bank buys government bonds directly (in the primary market) to fund the fiscal deficit.

Targeted lending schemes

• Definition: the central bank gives cheap, long-term funds to banks. In return, the banks must lend the money to specified sectors.
• Aim: send credit to the parts of the economy where it is stuck, instead of spreading liquidity everywhere.

3. India's use of the toolkit

India never went to a zero or negative rate. The RBI used softer, India-sized versions of these tools, mainly during 2019-21.

Special OMOs, India's "Operation Twist" (December 2019 - 2020)

• OMO (open market operation): the RBI buys or sells government securities (G-secs) in the market to add or remove money.
• Special OMO: the RBI buys long-dated G-secs and sells short-dated securities at the same time.

• Aim: bring down long-term yields, and so long-term borrowing costs, without adding extra liquidity.

• Example tranche (auction on 3 September 2020): ₹20,000 crore in total, in two tranches of ₹10,000 crore each [2].

• Bought: 7.72% GS 2025, 6.79% GS 2027 and 5.79% GS 2030.
• Sold: 182-day Treasury Bills maturing in October-November 2020 [2].

G-SAP 1.0 and 2.0 (2021), India's "QE-lite"

• G-SAP (G-sec Acquisition Programme): the RBI promised in advance to buy a fixed amount of G-secs.

• The early promise calmed the bond market, because investors knew a big buyer was coming.

• G-SAP 1.0: ₹1 lakh crore in Q1 2021-22. It was announced on 7 April 2021 "to enable a stable and orderly evolution of the yield curve". The first auction was on 15 April 2021 for ₹25,000 crore [3].

• G-SAP 2.0: ₹1.2 lakh crore in Q2 2021-22. The first auction was on 8 July 2021 for ₹20,000 crore, in five G-secs maturing between 2027 and 2033 [4].
• Total: ₹1 lakh crore + ₹1.2 lakh crore = ₹2.2 lakh crore of pre-committed purchases.
• Why "QE-lite" and not full QE:
• It had a fixed size and lasted for a limited time.
• It was done through the secondary market (buying from existing bondholders, not directly from the government).
• Its stated aim was a smooth yield curve, not large money creation.

TLTROs (2020), India's targeted lending scheme

• TLTRO (Targeted Long-Term Repo Operation): the RBI lends to banks for up to 3 years at a rate linked to the repo rate. Banks must use the money in specified debt instruments.
• Size: up to ₹1,00,000 crore. It was announced on 27 March 2020, and the first ₹25,000 crore tranche was held on 27 March 2020 [5].
• Where the money had to go (TLTRO 1.0): investment-grade corporate bonds, commercial paper (CP) and non-convertible debentures (NCDs). Half had to go to the primary market (new issues) and half to the secondary market (already-issued debt) [6].
• TLTRO 2.0 (April 2020): at least 50% had to go to small and mid-sized NBFCs and microfinance institutions (MFIs). Small NBFCs here means those with assets of ₹500 crore or less [6].
• Rules to make sure the money was used:
• Bought securities had to be kept in the HTM (Held to Maturity) category.
• Funds not deployed attracted a penalty of repo rate + 200 basis points [6].
• Banks had to deploy the money within 30 working days [5].

The 2020 debate on deficit monetisation

• The issue: during COVID-19, government revenue fell and spending needs rose. Some argued that the RBI should directly fund the deficit, which is a form of helicopter money.
• For: it is quick and cheap funding at a time of crisis.
• Against:
• It creates inflation risk.
• It damages the RBI's credibility on its inflation target.

• It brings back the pre-1997 problem of ad hoc Treasury Bills, when the RBI automatically financed the government.

• What happened: India mostly relied on indirect support through OMOs and G-SAP in the secondary market.

4. Taper tantrum and spillovers (2013)

• Taper tantrum: a sudden jump in bond yields and a rush of capital outflows from emerging markets in 2013.
• Trigger: in May 2013, Fed Chair Ben Bernanke hinted that the Fed would slow down ("taper") its QE bond purchases.

• The chain: US yields expected to rise → foreign investors pull money out of India → they sell rupees for dollars → the rupee falls.

• Impact on India:

• The rupee fell to about ₹68.8/$ in August 2013.

• India was named among the "Fragile Five": economies with high current account deficits and a heavy need for foreign money. The others were Brazil, Indonesia, Turkey and South Africa.

• Worked example (illustrative): if the rupee moves from ₹55/$ to ₹68.8/$:

• Depreciation = (68.8 − 55) ÷ 55 × 100 ≈ 25%.

• An import costing $100 now costs ₹6,880 instead of ₹5,500.

• RBI's response:

• MSF raised to 10.25% (July 2013). MSF (Marginal Standing Facility) is the emergency overnight window where banks borrow from the RBI at a penalty rate. A higher MSF made rupee funds costly, which made it harder to borrow rupees to buy dollars.

• FCNR(B) swap window (September 2013). FCNR(B) deposits are foreign-currency deposits of NRIs in Indian banks. The RBI swapped these dollars at a concessional rate, which drew in large dollar inflows.

• Lesson:

• Fed policy spills over to India.
• India needs large forex reserve buffers and the capacity to sterilise. Sterilisation means the RBI offsets the effect of forex operations on domestic money supply, usually through OMOs.
• India also needs a manageable current account deficit.

Prelims Hooks

• QE vs helicopter money: QE is a temporary, reversible purchase of assets. Helicopter money is a permanent, unreversed injection given directly to the public or the government.
• Operation Twist: buy long-term and sell short-term securities at the same time → long yields fall and net liquidity is unchanged. The Fed did this in 1961 and 2011-12. RBI's version is the special OMO (Dec 2019 - 2020).
• Yield curve control targets a price (the yield). QE targets a quantity of bonds. BoJ applied YCC to the 10-year JGB (2016-24).
• QT can happen without selling anything: the central bank simply lets bonds mature without reinvesting.
• G-SAP 1.0 = ₹1 lakh crore (Q1 2021-22). G-SAP 2.0 = ₹1.2 lakh crore (Q2 2021-22). The total ₹2.2 lakh crore was bought through the secondary market [3][4].
• TLTRO (March 2020): up to ₹1 lakh crore, up to 3-year tenor, deployed in corporate bonds, CPs and NCDs. TLTRO 2.0 required at least 50% to go to small and mid NBFCs and MFIs [5][6].
• Taper tantrum 2013: triggered by Bernanke (May 2013). The rupee fell to about ₹68.8/$ (Aug 2013). India was among the "Fragile Five".
• RBI's 2013 response: MSF raised to 10.25% (July 2013) and the FCNR(B) swap window (Sept 2013).
• Trap: the ECB (2014) and BoJ (2016) had negative rates. The RBI has never used a negative policy rate.

Mains Points

• Limits of conventional policy: at the ZLB, or when markets freeze, cutting the repo rate does not reach borrowers. Balance-sheet tools (QE, YCC, Operation Twist) and targeted lending (TLTRO) repair transmission. The costs are asset-price bubbles, wider inequality (asset holders gain most) and difficulty in exiting.
• India's calibrated approach: special OMOs, G-SAP and TLTROs avoided open-ended QE and direct deficit monetisation. This protected the inflation-targeting framework and RBI's credibility while still lowering long-term yields during COVID-19. It is a useful model of "unconventional but bounded" policy.
• Global spillovers: QE and QT in advanced economies drive capital flows into and out of emerging markets. The 2013 taper tantrum showed this. The 2022-25 Fed QT tested it again. The case for forex reserves, sterilisation capacity, a lower current account deficit and macroprudential tools (GS-III: external sector) rests on these episodes.
• Monetary-fiscal boundary: the 2020 monetisation debate shows the tension between the need for quick crisis funding and central bank independence. It links to the FRBM framework and the end of ad hoc Treasury Bills in 1997 (GS-III: fiscal policy; GS-II: independence of statutory bodies).