Beginners imagine the central bank "sets interest rates" by decree. It does not; it sets one rate by controlling the supply of reserves and bracketing the overnight market with a floor and a ceiling. Understanding the mechanism is what lets you read a policy that changes liquidity without changing the headline rate — a move the newspaper misses and the bond market does not.
What are the policy rate and the operating target?
The operating target. Every modern central bank picks a very short interest rate as its operating target and steers it to a chosen level (the policy rate). In India the operating target is the weighted average call rate (WACR), the rate at which banks lend reserves to each other overnight in the call-money market. The RBI's aim is to keep the WACR close to the repo rate (the policy rate, 5.25% as of mid-2026, check at rbi.org.in; it was cut through 2025 from 6.5%, and raised to 5.50% on 7 October 2026). In the US the operating target is the effective federal funds rate (EFFR), steered into the fed funds target range the FOMC announces (roughly 3.5%–4.0% as of mid-2026, check at federalreserve.gov and on FRED; the Fed cut from a 5.25–5.50% peak starting in late 2024, held at 3.50–3.75% from December 2025, and turned the cycle with a hike to 3.75–4.00% on 16 September 2026). Note the format difference an analyst must not fumble: the RBI names a point (5.25%); the Fed names a 25-bp-wide range (e.g., 3.75–4.00%) and steers the effective rate inside it.
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How does the corridor work?
The corridor: floor and ceiling. The central bank does not leave the overnight rate to wander; it builds a corridor around the policy rate using two standing facilities that any bank can use at its own initiative, which mechanically cap and floor the market:
- The ceiling (a lending facility). If a bank is short of reserves overnight, it can always borrow from the central bank at a rate slightly above the policy rate, so no bank will ever pay more than that in the market. In India this is the Marginal Standing Facility (MSF), set at repo + 25 bps, where banks borrow against their government-securities (SLR) holdings. In the US the analogous ceiling is the discount window (primary credit rate), and, more importantly for day-to-day control, the standing repo facility.
- The floor (a deposit facility). If a bank has spare reserves, it can always park them at the central bank and earn a rate slightly below the policy rate, so no bank will ever lend in the market for less than that. In India this is the Standing Deposit Facility (SDF), set at repo − 25 bps (introduced in April 2022; before it, the reverse-repo was the floor). In the US the floor is interest on reserve balances (IORB), buttressed by the overnight reverse-repo (ON-RRP) facility for money funds that have no reserve account.
So India's corridor as of mid-2026: SDF 5.00% (floor), repo 5.25% (policy), MSF 5.50% (ceiling), a symmetric 50-bp-wide corridor centered on the repo rate. The overnight rate is trapped inside this corridor by arbitrage (no bank borrows above the ceiling or lends below the floor), and the central bank manages where inside the corridor it sits by adjusting the quantity of reserves, which is what OMOs do.
What are open-market operations?
Open-market operations (OMOs): managing the quantity. An OMO is the central bank buying or selling government securities in the open market to change the quantity of reserves in the system, and thereby nudge the overnight rate within the corridor and manage overall liquidity:
- To inject liquidity (push the overnight rate down toward the floor, or relieve a cash shortage), the central bank buys G-secs from banks and pays with newly created reserves: an OMO purchase. More reserves chasing the same demand → the overnight rate softens.
- To drain liquidity (push the rate up, or mop up excess cash), it sells G-secs and extinguishes the reserves it receives: an OMO sale.
Two flavours matter. A repo (repurchase agreement) is a temporary injection: the central bank buys securities today and the bank agrees to buy them back in, say, 14 days, so it is a collateralized short-term loan of reserves (the RBI's variable-rate repo/reverse-repo auctions fine-tune day-to-day liquidity). An outright OMO, buying the bond and keeping it, is a durable injection of reserves that stays in the system. This distinction is the seed of QE (see quantitative easing): QE is simply outright OMO purchases done in enormous size and long-dated collateral, on purpose, to affect long rates rather than just overnight liquidity. Learn the ordinary tool and QE stops being mysterious.
Can a central bank tighten without changing the rate?
The analyst's takeaway: when you read that the RBI "kept the repo rate unchanged but conducted variable-rate reverse-repo auctions to absorb ₹X lakh crore of surplus liquidity," you should understand that it tightened at the margin (drained reserves, nudging the overnight rate up toward the repo rate from the floor) without touching the headline rate — a real policy move the casual reader misses entirely.