## transitioningoperationaltargets

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---

### Executive summary and key recommendation
- Countries that still formally use reserve money as the operating target should transition to an interest rate-focused framework as soon as possible.
- Reserve money targeting (RMT) is in almost all circumstances suboptimal and associated with:
  - unclear and multiple policy objectives,
  - volatile inflation,
  - high interest-rate volatility and high liquidity risk,
  - weak policy transmission,
  - underdeveloped financial markets,
  - underdeveloped central bank analytical capacity.
- Transition is preferably done as part of modernization to a full monetary policy framework based on the principles of effective monetary policy frameworks in IMF (2015), with the most important principle being that the primary objective of monetary policy is price stability.
- There are no preconditions for adopting an interest rate-focused operating framework, except that the central bank should have the operational independence to set interest rates.
- Most countries can move quickly to a full-fledged interest rate-focused framework, which involves:
  - choosing an operational framework that allows the central bank to control the short-term interest rates that banks transact at when placing excess reserves or obtaining short-term funding, either from each other or the central bank;
  - establishing rules and procedures for: (i) setting the level of the central bank’s interest rate target; and (ii) adjusting the target (when, in what direction, and by how much) to achieve the policy objective. The policy objective must first be clarified internally;
  - shifting the focus of the central bank’s high-frequency liquidity management operations from money aggregates to market interest rates.
- Clear communication is essential; it strengthens market understanding and policy transmission. Announcing reforms and then not following through can be very damaging to central bank reputation. In some instances, it may be better to de facto implement reforms before publicly communicating them.

### I. Context and issues
- Definition:
  - The operating target is a variable that can be sufficiently controlled by the central bank to serve as a guide for day-to-day liquidity management operations; it should facilitate communication of the policy stance and be clearly linked to the policy objective.
- RMT is appropriate only under limited circumstances, for example:
  - absence of central bank independence to set and adjust short-term interest rates,
  - high risk of severe fiscal dominance,
  - opaque monetary policy objectives,
  - immediate aftermath of very high inflation.
- RMT weaknesses:
  - monetary relationships underpinning RMT are much weaker at lower levels of inflation,
  - rigid RMT implementation results in volatile interest rates, undermining transmission and market development.
- Migration to an interest rate operating target should preferably be part of broader reforms, typically including:
  - moving to greater exchange rate flexibility,
  - reforms to ensure operational independence and clear accountability,
  - developing analytical tools for policymaking,
  - enhancing monetary policy communication,
  - developing and deepening domestic financial markets,
  - enhancing policy transmission.
- No preconditions other than de facto operational independence to set an appropriate interest rate target; monetary aggregates can be reclassified as information variables or intermediate targets.

### II. Conceptual background and transmission
- Transmission under MT and other frameworks (including inflation targeting) operates via the same channels; key influences include:
  - banks’ perceived risk of ending the reserve maintenance period long or short of excess reserves,
  - interest rates on central bank standing lending and deposit facilities.
- These factors determine liquidity risk, overnight interbank rates, bid rates for OMOs and government securities, and other short-term market rates, thereby influencing credit expansion, deposit creation, broad and reserve money growth, output, and inflation.
- Reserve requirements create an automatic feedback loop from deposit/broad money growth to excess reserves and short-term interest rates:
  - With required reserves set as a ratio to reservable liabilities, increased bank lending increases required reserves (L2) and decreases excess reserves (L3), increasing liquidity risk and short-term interbank rates.
- Central bank choices when facing reserve-driven rate changes:
  - Rely on automatic feedback loop to indirectly steer short-term rates (textbook RMT).
  - Use OMOs to offset changes in excess reserves and keep them broadly constant at the targeted level, and directly steer short-term interest rates by changing rates on standing facilities.
- Benefits of stable short-term rates:
  - discrete changes in the policy rate have greater impact on banks’ pricing,
  - improved reflection of policy rate changes in deposit/lending rates,
  - facilitates development of longer-term securities markets and strengthens transmission along the yield curve.
- Simplified central bank balance sheet notation (Table 1):
  - Assets: A1. Net international reserves; A2. Net lending to government; A3. Lending to banks (OMO); A4. Lending to banks (standing facilities).
  - Liabilities: L1. Currency in circulation; L2. Required reserves = f(retail deposits); L3. Excess reserves (includes overnight deposit facilities); L4. Central bank bills and substitutes (OMO); L5. Capital and reserves.
  - Reserve money: (L1 + L2 + L3) = (A1 + A2 + (A3 + A4 - L4) - L5)
  - Total reserves: (L2 + L3)
  - Endogenous components (autonomous factors): L1, L2, L5; A1, A2, A4
  - Exogenous components (central bank instruments): A3, L4
  - Directly controlled by central bank through use of its instruments: L3

### III. Steps in the transition
- Background considerations:
  - Major steps in the transition: (i) setting the initial level of the interest rate target; (ii) developing procedures for determining when, and by how much, the interest rate target should be adjusted; (iii) choosing a particular configuration of the operating framework, including structure and calibration of OMOs.
  - A quick transition brings benefits even in difficult circumstances, but risks include market rates deviating from targets, need to recalibrate OMOs, and risk of setting the initial interest rate too high or too low.
  - The main reputational risk is overselling initial benefits rather than not getting everything perfectly right.
  - Circumstances warranting a gradual approach include need to build capacity and/or acquire necessary operational independence.
  - Central banks should carefully consider timing and modality of public communication; do not announce changes until ready to shift operational focus from monetary quantities to market interest rates. A less risky strategy can be to de facto adopt an interest rate-focused framework before public announcement.
- Three steps in a gradual transition (pace should be carefully considered):
  - Step 1: Reduce undue interest rate volatility by moving away from period-end reserve money targets and by calibrating OMOs so that excess reserves and total reserves are kept stable and on the path implied by the reserve money target.
  - Step 2: Set up a corridor without specifying a point target for interest rates while retaining reserve money as the operating target. Use a standing lending facility to cap rates and a standing deposit facility to set a floor; set corridor width guided by the level and observed volatility of nominal interest rates.
  - Step 3: Announce a point policy rate as the operating target once operational capacity has improved, the capacity to set interest rates has been gained, and short-term interest rate volatility has subsided.

### IV. Configuring an interest rate-based operating framework
- Ways to implement an interest rate-based operational framework:
  - Announcing a target for a market rate (the “policy rate”):
    - Usually entails fixed-quantity variable-rate OMOs to align a market rate (generally secured or unsecured overnight interbank rate) with the policy rate.
    - The policy rate is typically positioned in the middle of the corridor formed by standing lending and deposit facilities; facility rates are moved in tandem with the policy rate.
    - Requires a robust short-term liquidity forecasting framework and understanding of banks’ demand for excess reserves; requires a well-functioning interbank market.
  - Attaching the “policy rate” to a central bank instrument:
    - Floor system: central bank’s standing deposit facility rate serves as the policy rate.
      - Simple to operate and robust to market imperfections and liquidity forecasting weaknesses common in low- and lower-middle-income countries.
      - Requires maintaining a structural liquidity surplus; anchors the short end of the yield curve and helps develop longer-term securities markets.
      - A parsimonious floor system targets the minimum structural liquidity surplus necessary to keep rates at the floor so the central bank balance sheet is no larger than required.
    - Fixed-rate, full-allotment, mid-corridor system: OMOs conducted at the policy rate set in the middle of the corridor; central bank supplies the full amount demanded by banks.
- Role of OMOs under an interest rate-focused framework:
  - OMOs are aimed at offsetting changes in liquidity conditions caused by autonomous factors so that excess reserves are kept constant at the targeted level.
  - OMO instruments can be the same as under RMT but may be structured differently.
- Maturity and frequency of OMOs depend on operating framework and interaction with other instruments (including reserve requirement):
  - Floor systems: maintain structurally long liquidity; some fine-tuning OMOs may still be required.
  - Mid-corridor systems (variable-price fixed-quantity or fixed-rate full-allotment): more frequent fine-tuning OMOs are needed than with floor systems; without reserve averaging, OMOs may be required daily; with averaging, OMOs can be done less frequently but always on the last day of the RMP.

### Box 1. Structuring the Main Open Market Operations within the Reserve Maintenance Period
- Effects of reserve averaging on timing and interest rate stability:
  - Reserve averaging over a long RMP tends to stabilize short-term interest rates in the earlier part of the period because banks can offset early shortfalls by holding more reserves later in the RMP, provided reserve balances do not become negative.
  - The stabilizing “flat segment” of the demand curve exists only if the expected interbank interest rate on the last day of the RMP stays fixed; shifts in that expectation change bank behavior earlier in the RMP and cause deviations from the implicit target.
  - As the RMP progresses:
    - The flat part of the demand curve shortens.
    - Market trading, interest rate volatility, and recourse to standing facilities tend to increase toward the end of the RMP.
    - If the interbank market is segmented, same day interest rate spreads tend to increase toward the end of the RMP.
- Liquidity management implications and recommended OMO timing:
  - Central banks must ensure average “liquidity conditions” (i.e., excess reserves) during the RMP are at the appropriate level.
  - In principle one OMO with an overnight instrument on the last day could be sufficient, but in practice this is inadequate because:
    - Banks tend to underutilize averaging flexibility.
    - Expectations for liquidity and short-term interbank rates for the latter part of the RMP can become unanchored if excess reserves vary sharply.
  - Good practice: conduct OMOs at the beginning, the middle, and on the last day of the RMP.
  - The maturity of OMO instruments should be sufficiently long so that maturities cover the full RMP without overlapping instruments.
- Example setup for a four-week RMP (Wednesday–Tuesday):
  - Wednesday 1. Auction of seven-day OMO instrument.
  - Wednesday 2. Seven-day OMO1 repaid in the morning; auction of new seven-day OMO instrument.
  - Wednesday 3. Seven-day OMO2 repaid in the morning; auction of new seven-day OMO instrument.
  - Wednesday 4. Seven-day OMO3 repaid in the morning; auction of new seven-day OMO instrument.
  - Tuesday (last RMP day). Auction of one-day OMO instrument. Repaid in morning of first day of next RMP.
- Operational-framework considerations and transitional approaches:
  - The floor and the fixed-rate full-allotment systems are the easiest to operate:
    - They do not require highly accurate short-term forecasts of changes in autonomous factors.
    - They are robust to changes in banks’ demand for excess reserves.
    - They tend to impose lower short-term liquidity risks on banks, reducing the need for interbank activity and anchoring the yield curve.
    - Potential trade-off: may hamper development of the short-term interbank money market while supporting development of other financial markets and policy transmission.
  - In transition:
    - Both the floor and the fixed-quantity variable-rate mid-corridor systems can be adopted without publicly announcing a change in the operating framework.
    - RMT requires using fixed-quantity variable-rate OMOs.
    - The central bank can introduce a minimum bid rate for short-maturity OMOs that inject reserves and a maximum bid rate for short-maturity OMOs that mop up excess reserves; these minimum and maximum rates will be the de facto policy rate and implied target for the interbank market rate even if not explicitly communicated initially.
    - To transition toward a floor system, when appropriate to lower rates, adjust OMOs so excess reserves increase and let market rates drift toward the floor of the corridor without announcing a framework change; subsequently move the floor to adjust market rates.
- Setting and adjusting the initial interest rate operating target:
  - Considerations for setting the initial level in the context of flexible inflation targeting include: economic theory, observed real short-term interest rates, inflation and exchange rate developments, and changes in inflation expectations.
  - Real market rates:
    - Above the neutral or short-run equilibrium rate are contractionary.
    - Below the neutral or short-run equilibrium rate are expansionary.
  - Guidance when precise equilibrium estimates are difficult:
    - Expected real interest rates should at least be positive in real terms to reduce inflation and stabilize the exchange rate.
    - The expected profit of holding local currency assets should be higher than the expected return on holding foreign exchange-denominated assets.
    - Estimates of productivity growth, expected return on investment in capital equipment, and households’ internal discount rates provide further guidance.
    - Statistical methods exist for estimating the neutral rate.
  - Erring on the high side for initial policy rates may reduce inflation more quickly, boost central bank credibility, and allow interest rates to be lowered sooner.
- Adjusting the interest rate target:
  - Deviations of inflation from target and evolving inflationary pressures indicate a need to adjust interest rates.
  - Developing a forecasting and policy analysis system with a core medium-term forecasting and monetary policy analysis model helps guide timing and magnitudes of adjustments.
  - Initially, simpler inflation forecasts, standard monetary policy analysis models, statistical indicators, and assessment of the current and cyclical position of the economy may suffice.
- Practical steps in a gradual transition (summary):
  - Step 1. Reduce undue interest rate volatility:
    - Sources of volatility include: operations focused on period-end quantitative targets; daily path-focused operations; weak capacity to offset autonomous liquidity changes; and misalignment of OMO timing/frequency/maturity with the RMP and reserve averaging.
    - Key actions:
      - Stabilize excess reserves while keeping total reserves close to the reserve money path.
      - Continuously monitor total and excess reserves.
      - Design instruments, liquidity management, and communication to increase certainty about liquidity conditions (e.g., allow averaging over a sufficiently long period; improve liquidity forecasting).
    - Note: these measures reduce high-frequency volatility but may not fully resolve lower-frequency volatility tied to RMT.
  - Step 2. Set up a corridor without specifying a point target for interest rates, while retaining reserve money as the operating target:
    - Implement corridor with unlimited access overnight standing lending facility (ceiling) and overnight standing deposit facility (floor).
    - Facilities are one day duration; initial corridor could be relatively wide—somewhere around 500 basis points when interest rates are in high single digits and even wider at higher interest rates.
    - Narrow the corridor as volatility falls and the focus shifts from money aggregates to interest rates.
    - Resolve conflicts when rates are at one edge of the corridor for a prolonged period by revising the reserve money target and/or repositioning the corridor:
      - Shift the corridor upward (downward) if rates are at the ceiling (floor), RM growth is above (below) target, and indications are that inflation is trending above (below) target.
      - Raise (lower) the RM target if rates are at the ceiling, RM growth is at or above target, but other information indicates that inflation is trending below (above) target.
  - Step 3. Announce a point policy rate as the operating target:
    - Signal policy through changes in the “policy rate” and drop references to monetary quantities.
    - Continue narrowing the corridor and shift central bank communication to short-term interest rates.
    - Liquidity management operations should align market rates with the announced policy rate.
    - Choose between the mid-corridor and floor operational frameworks and design/calibrate monetary instruments consistent with the chosen framework.
    - Policy rate determination becomes more forward-looking and relies less on indicator variables like monetary aggregates.

### Frequently asked questions (key points)
- Which interest rate should be the operating target?
  - A short-term interest rate that is frequently traded, observable, and relevant for transmission; often the overnight unsecured interbank market rate in many developing environments.
  - Secured rates (repo rates) can be used if sufficient market activity exists; using secured rates removes the credit risk premium implicit in interbank rates.
- Can an interest rate and a monetary quantity be targeted at the same time?
  - Interest rates and monetary quantities cannot be the operational target at the same time.
  - A level of interest rate can be consistent with a targeted level of reserve money; a margin around this rate can be targeted (as in Step 2).
  - Under strict RMT, monetary quantities take precedence; de facto targeting of short-term rates without announcing it is possible.
  - Policy rate announcements must be backed by operations aligning market conditions with the announced rate.
- How is the initial width of the corridor determined and when should it be narrowed? What is the optimal width post transition?
  - Start relatively wide to provide flexibility to meet the reserve money target and reduce frequent repositioning. Narrow as operational experience and liquidity forecasting improve and as interest rate volatility declines.
  - No firm rule for optimal post-transition width; a 200-basis point corridor is “quite narrow” when interest rates are at 20 percent but relatively wide when interest rates are just 1 percent.
- What should be done if the interest rate trades persistently on one side of the corridor?
  - Indicates inconsistency between interest rates and the reserve money target; resolve by revising the reserve money target and/or repositioning the corridor per the policy decision rules above.
- How should shifts in the corridor be communicated?
  - Repositioning can signal policy adjustment; whether to explicitly communicate depends on the central bank’s transition status and readiness to acknowledge de facto steering of market interest rates.
- Should transactions through standing facilities be constrained?
  - Banks should be able to borrow freely from the lending facility if procedural and collateral requirements are met.
  - Frequent borrowing by an individual institution may reflect system-wide liquidity shortages or payment/settlement inefficiencies, not necessarily idiosyncratic liquidity problems.
  - Extended reliance on central bank funding by some banks should be discouraged in the medium-term through liquidity regulation, supervisory actions, and market development measures.
  - There should be no limit on the amount banks can deposit in the overnight deposit facility; where a two-tiered deposit facility exists, there should be no limit on volumes remunerated at the lower rate.

### Technical assistance (TA) guidance
- TA on transitioning operational targets should be part of a broader program to modernize the monetary policy framework and emphasize:
  - A well-sequenced strategy and starting as soon as possible to transition to an interest rate-focused operating framework.
  - Clear communication guidance on content and style.
  - Market development support for foreign exchange and domestic money markets to improve transmission.
- TA should assess and, if needed, help the central bank obtain sufficient operational independence and:
  - Get a clear mandate and operational independence within the context of public accountability (which may require legal changes and public education).
  - Start a gradual transition toward an interest-rate focused framework (three steps).
- Irrespective of transition pace, TA should provide guidance on:
  - Design of standing facilities and corridor width in transition.
  - Setting the initial level of the interest rate and how to adjust the target.
  - Choice of operational framework: (i) flexible-price fixed-quantity mid-corridor; (ii) fixed-price full-allotment mid-corridor; and (iii) a conventional floor or a two-tier floor system.
  - Structuring OMOs within the RMP, including maturity of instrument(s) and timing and frequency of operations.

### Appendix I. Setting and Adjusting Interest Rates
- Setting the Initial Level of the Interest Rate Operating Target:
  - Core insight: If real money market rates are below the expected real return on real investments or below households’ internal discount factor (the “natural rate” or real equilibrium interest rate), borrowing to finance consumption, investment, or foreign-exchange‑denominated asset purchases becomes profitable, increasing output, inflation, and weakening the exchange rate.
  - Practical guidance and rules of thumb:
    - Expected real interest rates should at least be positive in real terms (say 2-5 percent) to reduce inflation and stabilize the exchange rate.
    - The expected profit of holding local currency assets should be higher than the expected return on holding foreign exchange‑denominated assets; the latter may be approximately equal to expected depreciation.
    - Additional guidance may come from actual observed real short-term market interest rates, recent inflation, exchange rate developments, and changes in inflation expectations.
    - Erring on initially setting policy rates on the high side may reduce inflation more quickly, boost the central bank’s credibility, and allow market interest rates to decline sooner than otherwise.
- Adjusting the Interest Rate Target:
  - Triggers for adjustment:
    - Inflation diverging from target with inflationary pressures building or subsiding indicates a need to adjust interest rates.
  - Models and analytical systems:
    - Useful to have a forecasting and policy analysis system with a core medium-term forecasting and monetary policy analysis model (e.g., the New‑Keynesian Gap model, referred to as the quarterly projection model, or QPM), although not strictly required at the outset.
    - Historical note: pioneering inflation targeting countries and advanced countries that later looked like they practiced inflation targeting did not necessarily have such models at the early stage of adoption.
  - Key behavioral insight from QPM and related models:
    - Inflation is primarily driven by domestic demand pressure (besides shorter‑lived shocks).
    - Domestic demand pressure is proxied by:
      - the output gap: deviation of output from its longer-term equilibrium/non-inflationary/potential level (ŷ_t),
      - the real exchange rate gap: deviation of the real exchange rate from its longer-run trend (a proxy for import price pressure).
    - Combining output and real exchange rate gaps into a real marginal cost index can provide a forward‑looking inflation indicator when a fully operational monetary policy model is not available.
  - Monetary aggregates as supplementary indicators:
    - Deviation of broad money growth from its equilibrium or longer-run trend (a “broad money gap”) can provide a forward‑looking inflation indicator, as used in flexible monetary targeting (e.g., historical practice in Germany).
    - The broad money gap may coincide with the output gap if credit and broad money creation are mainly driven by actual and/or expected real output growth.
- The Taylor Rule, the Taylor Principle, and Practical Variants:
  - Original backward‑looking Taylor rule (as presented):
    - i_t = r_t^n + π_t^4 + 0.5(π_t^4 − π^T) + 0.5 ŷ_t
  - Forward‑looking Taylor rule with interest‑rate smoothing (as presented):
    - i_t = c_1 i_{t−1} + (1−c_1)(i_t^n + c_2(E_t π_{t+4}^4 − π_T) + c_3 ŷ_t),  i_t^n = r_t^n + E_t π_{t+4}^4
  - Definitions and notes preserved from source:
    - π_t^4 = E_t(π_{t−3} + π_{t−2} + π_{t−1} + π_t)/4, where π_t is the on‑quarter inflation rate.
    - The rule ensures nominal interest rates are raised by more than inflation in response to an increase in inflation (the Taylor Principle), i.e., real interest rates are increased.
    - The forward‑looking version includes interest‑rate smoothing (c_1 i_{t−1}) and bases adjustments on a weighted average of the expected inflation gap (E_t π_{t+4}^4 − π_T) and the current output gap.
    - The original backward‑looking Taylor rule can be procyclical if used mechanically because monetary policy mainly impacts future inflation.
  - Policy implication:
    - A good understanding of the current and cyclical position of the economy is a pre‑condition for effective forward‑looking policymaking. Output growth above potential (a closing or positive output gap) and a depreciating real exchange rate relative to trend (a closing or positive real exchange rate gap) suggest raising interest rates.

*Source: transitioningoperationaltargets - EXECUTIVE SUMMARY (IMF), https://www.imf.org/-/media/files/publications/miscellaneous/english/2022/transitioningoperationaltargets.pdf*

### EXECUTIVE SUMMARY ______________________________________________________________________________ 5

### EXECUTIVE SUMMARY

### Covered Sections
- I. CONTEXT AND ISSUES
- II. CONCEPTUAL BACKGROUND
- III. STEPS IN THE TRANSITION
  - A. Background Considerations
  - B. Main Steps Toward Adopting an Interest Rate-Based Framework
  - C. Steps Involved in a Gradual Transitioning
- IV. FREQUENTLY ASKED QUESTIONS
- V. TECHNICAL ASSISTANCE APPROACH
- REFERENCES
- APPENDIX
  - I. Setting and Adjusting Interest Rates

### Structural Elements
- BOXES
  - 1. Structuring the Main Open Market Operations within the Reserve Maintenance Period
- FIGURES
  - 1. A Stylized Reform Agenda
  - 2. Monetary Policy Transmission Channels
  - 3. The Demand for Bank Reserves
- TABLES
  - 1. Simplified Central Bank Balance Sheet
- GLOSSARY entries listed on page 4–5

### Key Topics Indicated by Headings (document scope)
- Transitioning operational targets from reserve money to interest rates
- Conceptual foundations for moving to an interest rate-based framework
- Practical steps and sequencing for adoption, including gradual transition options
- Operational design elements: open market operations, reserve maintenance period (RMP), reserve management
- Technical assistance considerations and approach
- Frequently asked questions and an appendix on setting and adjusting interest rates

### Glossary (as presented)
- IT  Inflation Targeting
- MT Monetary Targeting
- OMO Open Market Operation
- QPM Quarterly Projection Model
- RMP Reserve Maintenance Period
- RMT Reserve Money Targeting
- TA Technical Assistance

*Source: transitioningoperationaltargets - EXECUTIVE SUMMARY (IMF), https://www.imf.org/-/media/files/publications/miscellaneous/english/2022/transitioningoperationaltargets.pdf*

### Executive Summary

### transitioningoperationaltargets - Executive Summary

### Executive summary and key recommendation
- Countries that still formally use reserve money as the operating target should transition to an interest rate-focused framework as soon as possible.
- Reserve money targeting (RMT) is in almost all circumstances suboptimal and associated with:
  - unclear and multiple policy objectives,
  - volatile inflation,
  - high interest-rate volatility and high liquidity risk,
  - weak policy transmission,
  - underdeveloped financial markets,
  - underdeveloped central bank analytical capacity.
- Transition is preferably done as part of modernization to a full monetary policy framework based on the principles of effective monetary policy frameworks in IMF (2015), with the most important principle being that the primary objective of monetary policy is price stability.
- There are no preconditions for adopting an interest rate-focused operating framework, except that the central bank should have the operational independence to set interest rates.
- Most countries can move quickly to a full-fledged interest rate-focused framework, which involves:
  - Choosing an operational framework that allows the central bank to control the short-term interest rates that banks transact at when placing excess reserves or obtaining short-term funding, either from each other or the central bank.
  - Establishing rules and procedures for: (i) setting the level of the central bank’s interest rate target; and (ii) adjusting the target (when, in what direction, and by how much) to achieve the policy objective. The policy objective must first be clarified internally.
  - Shifting the focus of the central bank’s high-frequency liquidity management operations from money aggregates to market interest rates.
- Clear communication is essential; it strengthens market understanding and policy transmission. Announcing reforms and then not following through can be very damaging to central bank reputation. In some instances, it may be better to de facto implement reforms before publicly communicating them.

### I. Context and issues
- Definition: The operating target is a variable that can be sufficiently controlled by the central bank to serve as a guide for day-to-day liquidity management operations; it should facilitate communication of the policy stance and be clearly linked to the policy objective.
- RMT is only appropriate under limited circumstances, for example:
  - absence of central bank independence to set and adjust short-term interest rates,
  - high risk of severe fiscal dominance,
  - opaque monetary policy objectives,
  - immediate aftermath of very high inflation.
- RMT weaknesses:
  - monetary relationships underpinning RMT are much weaker at lower levels of inflation,
  - rigid RMT implementation results in volatile interest rates, undermining transmission and market development.
- Migration to an interest rate operating target should preferably be part of broader reforms, typically including:
  - moving to greater exchange rate flexibility,
  - reforms to ensure operational independence and clear accountability,
  - developing analytical tools for policymaking,
  - enhancing monetary policy communication,
  - developing and deepening domestic financial markets,
  - enhancing policy transmission.
- No preconditions other than de facto operational independence to set an appropriate interest rate target; monetary aggregates can be reclassified as information variables or intermediate targets.

### II. Conceptual background and transmission
- Transmission under MT and other frameworks (including inflation targeting) operates via the same channels; key influences include:
  - banks’ perceived risk of ending the reserve maintenance period long or short of excess reserves,
  - interest rates on central bank standing lending and deposit facilities.
- These factors determine liquidity risk, overnight interbank rates, bid rates for OMOs and government securities, and other short-term market rates, thereby influencing credit expansion, deposit creation, broad and reserve money growth, output, and inflation.
- Reserve requirements create an automatic feedback loop from deposit/broad money growth to excess reserves and short-term interest rates:
  - With required reserves set as a ratio to reservable liabilities, increased bank lending increases required reserves (L2) and decreases excess reserves (L3), increasing liquidity risk and short-term interbank rates.
- Central bank choices when facing reserve-driven rate changes:
  - Rely on automatic feedback loop to indirectly steer short-term rates (textbook RMT).
  - Use OMOs to offset changes in excess reserves and keep them broadly constant at the targeted level, and directly steer short-term interest rates by changing rates on standing facilities.
- Benefits of stable short-term rates:
  - discrete changes in the policy rate have greater impact on banks’ pricing,
  - improved reflection of policy rate changes in deposit/lending rates,
  - facilitates development of longer-term securities markets and strengthens transmission along the yield curve.
- Simplified central bank balance sheet notation (Table 1):
  - Assets: A1. Net international reserves; A2. Net lending to government; A3. Lending to banks (OMO); A4. Lending to banks (standing facilities).
  - Liabilities: L1. Currency in circulation; L2. Required reserves = f(retail deposits); L3. Excess reserves (includes overnight deposit facilities); L4. Central bank bills and substitutes (OMO); L5. Capital and reserves.
  - Reserve money: (L1 + L2 + L3) = (A1 + A2 + (A3 + A4 - L4) - L5)
  - Total reserves: (L2 + L3)
  - Endogenous components (autonomous factors): L1, L2, L5; A1, A2, A4
  - Exogenous components (central bank instruments): A3, L4
  - Directly controlled by central bank through use of its instruments: L3

### III. Steps in the transition
- Background considerations:
  - Major steps in the transition: (i) setting the initial level of the interest rate target; (ii) developing procedures for determining when, and by how much, the interest rate target should be adjusted; (iii) choosing a particular configuration of the operating framework, including structure and calibration of OMOs.
  - A quick transition brings benefits even in difficult circumstances, but risks include market rates deviating from targets, need to recalibrate OMOs, and risk of setting the initial interest rate too high or too low.
  - The main reputational risk is overselling initial benefits rather than not getting everything perfectly right.
  - Circumstances warranting a gradual approach include need to build capacity and/or acquire necessary operational independence.
  - Central banks should carefully consider timing and modality of public communication; do not announce changes until ready to shift operational focus from monetary quantities to market interest rates. A less risky strategy can be to de facto adopt an interest rate-focused framework before public announcement.

- Three steps in a gradual transition (pace should be carefully considered):
  - Reduce undue interest rate volatility by moving away from period-end reserve money targets and by calibrating OMOs so that excess reserves and total reserves are kept stable and on the path implied by the reserve money target.
  - Set up a corridor without specifying a point target for interest rates while retaining reserve money as the operating target. Use a standing lending facility to cap rates and a standing deposit facility to set a floor; set corridor width guided by the level and observed volatility of nominal interest rates.
  - Announce a point policy rate as the operating target once operational capacity has improved, the capacity to set interest rates has been gained, and short-term interest rate volatility has subsided.

### IV. Configuring an interest rate-based operating framework
- Ways to implement an interest rate-based operational framework:
  - Announcing a target for a market rate (the “policy rate”):
    - Usually entails fixed-quantity variable-rate OMOs to align a market rate (generally secured or unsecured overnight interbank rate) with the policy rate.
    - The policy rate is typically positioned in the middle of the corridor formed by standing lending and deposit facilities; facility rates are moved in tandem with the policy rate.
    - Requires a robust short-term liquidity forecasting framework and understanding of banks’ demand for excess reserves; requires a well-functioning interbank market.
  - Attaching the “policy rate” to a central bank instrument:
    - Floor system: central bank’s standing deposit facility rate serves as the policy rate.
      - Simple to operate and robust to market imperfections and liquidity forecasting weaknesses common in low- and lower-middle-income countries.
      - Requires maintaining a structural liquidity surplus; anchors the short end of the yield curve and helps develop longer-term securities markets.
      - A parsimonious floor system targets the minimum structural liquidity surplus necessary to keep rates at the floor so the central bank balance sheet is no larger than required.
    - Fixed-rate, full-allotment, mid-corridor system: OMOs conducted at the policy rate set in the middle of the corridor; central bank supplies the full amount demanded by banks.
- Role of OMOs under an interest rate-focused framework:
  - OMOs are aimed at offsetting changes in liquidity conditions caused by autonomous factors so that excess reserves are kept constant at the targeted level.
  - OMO instruments can be the same as under RMT but may be structured differently.
- Maturity and frequency of OMOs depend on operating framework and interaction with other instruments (including reserve requirement):
  - Floor systems: maintain structurally long liquidity; some fine-tuning OMOs may still be required.
  - Mid-corridor systems (variable-price fixed-quantity or fixed-rate full-allotment): more frequent fine-tuning OMOs are needed than with floor systems; without reserve averaging, OMOs may be required daily; with averaging, OMOs can be done less frequently but always on the last day of the RMP.

*Source: Executive Summary, transitioningoperationaltargets - Executive Summary*

### Box 1. Structuring the Main Open Market Operations within the Reserve Maintenance Period

### Box 1. Structuring the Main Open Market Operations within the Reserve Maintenance Period

### Effects of reserve averaging on timing and interest rate stability
- Reserve averaging over a long RMP tends to stabilize short-term interest rates in the earlier part of the period because banks can offset early shortfalls by holding more reserves later in the RMP, provided reserve balances do not become negative.
- The stabilizing “flat segment” of the demand curve exists only if the expected interbank interest rate on the last day of the RMP stays fixed; shifts in that expectation change bank behavior earlier in the RMP and cause deviations from the implicit target.
- As the RMP progresses:
  - The flat part of the demand curve shortens.
  - Market trading, interest rate volatility, and recourse to standing facilities tend to increase toward the end of the RMP.
  - If the interbank market is segmented, same day interest rate spreads tend to increase toward the end of the RMP.

### Liquidity management implications and recommended OMO timing
- Central banks must ensure average “liquidity conditions” (i.e., excess reserves) during the RMP are at the appropriate level.
- In principle one OMO with an overnight instrument on the last day could be sufficient, but in practice this is inadequate because:
  - Banks tend to underutilize averaging flexibility.
  - Expectations for liquidity and short-term interbank rates for the latter part of the RMP can become unanchored if excess reserves vary sharply.
- Good practice: conduct OMOs at the beginning, the middle, and on the last day of the RMP.
- The maturity of OMO instruments should be sufficiently long so that maturities cover the full RMP without overlapping instruments.

### Example setup for a four-week RMP (Wednesday–Tuesday)
- Wednesday 1. Auction of seven-day OMO instrument.
- Wednesday 2. Seven-day OMO1 repaid in the morning; auction of new seven-day OMO instrument.
- Wednesday 3. Seven-day OMO2 repaid in the morning; auction of new seven-day OMO instrument.
- Wednesday 4. Seven-day OMO3 repaid in the morning; auction of new seven-day OMO instrument.
- Tuesday (last RMP day). Auction of one-day OMO instrument. Repaid in morning of first day of next RMP.

### Operational-framework considerations and transitional approaches
- The floor and the fixed-rate full-allotment systems are the easiest to operate:
  - They do not require highly accurate short-term forecasts of changes in autonomous factors.
  - They are robust to changes in banks’ demand for excess reserves.
  - They tend to impose lower short-term liquidity risks on banks, reducing the need for interbank activity and anchoring the yield curve.
  - Potential trade-off: may hamper development of the short-term interbank money market while supporting development of other financial markets and policy transmission.
- In transition:
  - Both the floor and the fixed-quantity variable-rate mid-corridor systems can be adopted without publicly announcing a change in the operating framework.
  - RMT requires using fixed-quantity variable-rate OMOs.
  - The central bank can introduce a minimum bid rate for short-maturity OMOs that inject reserves and a maximum bid rate for short-maturity OMOs that mop up excess reserves; these minimum and maximum rates will be the de facto policy rate and implied target for the interbank market rate even if not explicitly communicated initially.
  - To transition toward a floor system, when appropriate to lower rates, adjust OMOs so excess reserves increase and let market rates drift toward the floor of the corridor without announcing a framework change; subsequently move the floor to adjust market rates.

### Setting and adjusting the initial interest rate operating target
- Considerations for setting the initial level in the context of flexible inflation targeting include: economic theory, observed real short-term interest rates, inflation and exchange rate developments, and changes in inflation expectations.
- Real market rates:
  - Above the neutral or short-run equilibrium rate are contractionary.
  - Below the neutral or short-run equilibrium rate are expansionary.
- Guidance when precise equilibrium estimates are difficult:
  - Expected real interest rates should at least be positive in real terms to reduce inflation and stabilize the exchange rate.
  - The expected profit of holding local currency assets should be higher than the expected return on holding foreign exchange-denominated assets.
  - Estimates of productivity growth, expected return on investment in capital equipment, and households’ internal discount rates provide further guidance.
  - Statistical methods exist for estimating the neutral rate.
- Erring on the high side for initial policy rates may reduce inflation more quickly, boost central bank credibility, and allow interest rates to be lowered sooner.
- Adjusting the interest rate target:
  - Deviations of inflation from target and evolving inflationary pressures indicate a need to adjust interest rates.
  - Developing a forecasting and policy analysis system with a core medium-term forecasting and monetary policy analysis model helps guide timing and magnitudes of adjustments.
  - Initially, simpler inflation forecasts, standard monetary policy analysis models, statistical indicators, and assessment of the current and cyclical position of the economy may suffice.

### Practical steps in a gradual transition (summary)
- Step 1. Reduce undue interest rate volatility:
  - Sources of volatility include: operations focused on period-end quantitative targets; daily path-focused operations; weak capacity to offset autonomous liquidity changes; and misalignment of OMO timing/frequency/maturity with the RMP and reserve averaging.
  - Key actions:
    - Stabilize excess reserves while keeping total reserves close to the reserve money path.
    - Continuously monitor total and excess reserves.
    - Design instruments, liquidity management, and communication to increase certainty about liquidity conditions (e.g., allow averaging over a sufficiently long period; improve liquidity forecasting).
  - Note: these measures reduce high-frequency volatility but may not fully resolve lower-frequency volatility tied to RMT.
- Step 2. Set up a corridor without specifying a point target for interest rates, while retaining reserve money as the operating target:
  - Implement corridor with unlimited access overnight standing lending facility (ceiling) and overnight standing deposit facility (floor).
  - Facilities are one day duration; initial corridor could be relatively wide—somewhere around 500 basis points when interest rates are in high single digits and even wider at higher interest rates.
  - Narrow the corridor as volatility falls and the focus shifts from money aggregates to interest rates.
  - Resolve conflicts when rates are at one edge of the corridor for a prolonged period by revising the reserve money target and/or repositioning the corridor:
    - Shift the corridor upward (downward) if rates are at the ceiling (floor), RM growth is above (below) target, and indications are that inflation is trending above (below) target.
    - Raise (lower) the RM target if rates are at the ceiling, RM growth is at or above target, but other information indicates that inflation is trending below (above) target.
- Step 3. Announce a point policy rate as the operating target:
  - Signal policy through changes in the “policy rate” and drop references to monetary quantities.
  - Continue narrowing the corridor and shift central bank communication to short-term interest rates.
  - Liquidity management operations should align market rates with the announced policy rate.
  - Choose between the mid-corridor and floor operational frameworks and design/calibrate monetary instruments consistent with the chosen framework.
  - Policy rate determination becomes more forward-looking and relies less on indicator variables like monetary aggregates.

### Frequently asked questions (key points)
- Which interest rate should be the operating target?
  - A short-term interest rate that is frequently traded, observable, and relevant for transmission; often the overnight unsecured interbank market rate in many developing environments.
  - Secured rates (repo rates) can be used if sufficient market activity exists; using secured rates removes the credit risk premium implicit in interbank rates.
- Can an interest rate and a monetary quantity be targeted at the same time?
  - Interest rates and monetary quantities cannot be the operational target at the same time.
  - A level of interest rate can be consistent with a targeted level of reserve money; a margin around this rate can be targeted (as in Step 2).
  - Under strict RMT, monetary quantities take precedence; de facto targeting of short-term rates without announcing it is possible.
  - Policy rate announcements must be backed by operations aligning market conditions with the announced rate.
- How is the initial width of the corridor determined and when should it be narrowed? What is the optimal width post transition?
  - Start relatively wide to provide flexibility to meet the reserve money target and reduce frequent repositioning. Narrow as operational experience and liquidity forecasting improve and as interest rate volatility declines.
  - No firm rule for optimal post-transition width; a 200-basis point corridor is “quite narrow” when interest rates are at 20 percent but relatively wide when interest rates are just 1 percent.
- What should be done if the interest rate trades persistently on one side of the corridor?
  - Indicates inconsistency between interest rates and the reserve money target; resolve by revising the reserve money target and/or repositioning the corridor per the policy decision rules above.
- How should shifts in the corridor be communicated?
  - Repositioning can signal policy adjustment; whether to explicitly communicate depends on the central bank’s transition status and readiness to acknowledge de facto steering of market interest rates.
- Should transactions through standing facilities be constrained?
  - Banks should be able to borrow freely from the lending facility if procedural and collateral requirements are met.
  - Frequent borrowing by an individual institution may reflect system-wide liquidity shortages or payment/settlement inefficiencies, not necessarily idiosyncratic liquidity problems.
  - Extended reliance on central bank funding by some banks should be discouraged in the medium-term through liquidity regulation, supervisory actions, and market development measures.
  - There should be no limit on the amount banks can deposit in the overnight deposit facility; where a two-tiered deposit facility exists, there should be no limit on volumes remunerated at the lower rate.

### Technical assistance (TA) guidance
- TA on transitioning operational targets should be part of a broader program to modernize the monetary policy framework and emphasize:
  - A well-sequenced strategy and starting as soon as possible to transition to an interest rate-focused operating framework.
  - Clear communication guidance on content and style.
  - Market development support for foreign exchange and domestic money markets to improve transmission.
- TA should assess and, if needed, help the central bank obtain sufficient operational independence and:
  - Get a clear mandate and operational independence within the context of public accountability (which may require legal changes and public education).
  - Start a gradual transition toward an interest-rate focused framework (three steps).
- Irrespective of transition pace, TA should provide guidance on:
  - Design of standing facilities and corridor width in transition.
  - Setting the initial level of the interest rate and how to adjust the target.
  - Choice of operational framework: (i) flexible-price fixed-quantity mid-corridor; (ii) fixed-price full-allotment mid-corridor; and (iii) a conventional floor or a two-tier floor system.
  - Structuring OMOs within the RMP, including maturity of instrument(s) and timing and frequency of operations.

*Monetary Operations and Domestic Market Development: Transitioning Operational Targets—From Reserve Money to Interest Rates IMF | MCM Technical Assistance Handbook*

### Appendix I. Setting and Adjusting Interest Rates

### Appendix I. Setting and Adjusting Interest Rates

### Setting the Initial Level of the Interest Rate Operating Target
- Core insight: If real money market rates are below the expected real return on real investments or below households’ internal discount factor (the “natural rate” or real equilibrium interest rate), borrowing to finance consumption, investment, or foreign-exchange‑denominated asset purchases becomes profitable, increasing output, inflation, and weakening the exchange rate.
- Practical guidance and rules of thumb:
  - Expected real interest rates should at least be positive in real terms (say 2-5 percent) to reduce inflation and stabilize the exchange rate.
  - The expected profit of holding local currency assets should be higher than the expected return on holding foreign exchange‑denominated assets; the latter may be approximately equal to expected depreciation.
  - Additional guidance may come from actual observed real short-term market interest rates, recent inflation, exchange rate developments, and changes in inflation expectations.
  - Erring on initially setting policy rates on the high side may reduce inflation more quickly, boost the central bank’s credibility, and allow market interest rates to decline sooner than otherwise.

### Adjusting the Interest Rate Target
- Triggers for adjustment:
  - Inflation diverging from target with inflationary pressures building or subsiding indicates a need to adjust interest rates.
- Models and analytical systems:
  - Useful to have a forecasting and policy analysis system with a core medium-term forecasting and monetary policy analysis model (e.g., the New‑Keynesian Gap model, referred to as the quarterly projection model, or QPM), although not strictly required at the outset.
  - Historical note: pioneering inflation targeting countries and advanced countries that later looked like they practiced inflation targeting did not necessarily have such models at the early stage of adoption.
- Key behavioral insight from QPM and related models:
  - Inflation is primarily driven by domestic demand pressure (besides shorter‑lived shocks).
  - Domestic demand pressure is proxied by:
    - the output gap: deviation of output from its longer-term equilibrium/non-inflationary/potential level (ŷ_t),
    - the real exchange rate gap: deviation of the real exchange rate from its longer-run trend (a proxy for import price pressure).
  - Combining output and real exchange rate gaps into a real marginal cost index can provide a forward‑looking inflation indicator when a fully operational monetary policy model is not available.
- Monetary aggregates as supplementary indicators:
  - Deviation of broad money growth from its equilibrium or longer-run trend (a “broad money gap”) can provide a forward‑looking inflation indicator, as used in flexible monetary targeting (e.g., historical practice in Germany).
  - The broad money gap may coincide with the output gap if credit and broad money creation are mainly driven by actual and/or expected real output growth.

### The Taylor Rule, the Taylor Principle, and Practical Variants
- Purpose: Provide additional insight on how to respond to deviations of inflation and output from target/trend.
- Original backward‑looking Taylor rule (as presented):
  - i_t = r_t^n + π_t^4 + 0.5(π_t^4 − π^T) + 0.5 ŷ_t
- Forward‑looking Taylor rule with interest‑rate smoothing (as presented):
  - i_t = c_1 i_{t−1} + (1−c_1)(i_t^n + c_2(E_t π_{t+4}^4 − π_T) + c_3 ŷ_t),  i_t^n = r_t^n + E_t π_{t+4}^4
- Definitions and notes preserved from source:
  - π_t^4 = E_t(π_{t−3} + π_{t−2} + π_{t−1} + π_t)/4, where π_t is the on‑quarter inflation rate.
  - The rule ensures nominal interest rates are raised by more than inflation in response to an increase in inflation (the Taylor Principle), i.e., real interest rates are increased.
  - The forward‑looking version includes interest‑rate smoothing (c_1 i_{t−1}) and bases adjustments on a weighted average of the expected inflation gap (E_t π_{t+4}^4 − π_T) and the current output gap.
  - The original backward‑looking Taylor rule can be procyclical if used mechanically because monetary policy mainly impacts future inflation.
- Policy implication:
  - A good understanding of the current and cyclical position of the economy is a pre‑condition for effective forward‑looking policymaking. Output growth above potential (a closing or positive output gap) and a depreciating real exchange rate relative to trend (a closing or positive real exchange rate gap) suggest raising interest rates.

*Source: Appendix I. Setting and Adjusting Interest Rates, Monetary Operations and Domestic Market Development: Transitioning Operational Targets—From Reserve Money to Interest Rates*

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_Source: https://www.imf.org/-/media/files/publications/miscellaneous/english/2022/transitioningoperationaltargets.pdf_