BEIJING (Bloomberg) - China's central bank said it will lower short-term borrowing costs for smaller banks, the latest in a series of steps aimed at preventing sharp fluctuations on the money market when liquidity runs short.

The People's Bank of China cut its seven-day standing lending facility (SLF) interest rate to 3.25 per cent for local financial institutions, according to a statement posted Thursday on the central bank's social media account. The overnight SLF rate was reduced to 2.75 per cent for some local financial institutions.

The announcement marks the latest move toward creating what the central bank calls an interest-rate corridor to guide borrowing costs after policy makers scrapped a deposit-rate ceiling last month.

PBOC officials including research bureau chief economist Ma Jun have mapped out such a move toward setting the SLF rate as the ceiling and interest on excess bank reserves as a floor for rates.

"This is the first time the PBOC explicitly said it will use SLF rates as the ceiling of the interest-rate corridor," said Becky Liu, Hong Kong-based senior rates strategist at Standard Chartered Plc. "It shows the central bank is under way to form a new policy rates framework."

The central bank is shifting from a tightly regulated system where the PBOC conceived policy with quantitative outcomes in mind - such as the amount of new loans extended each month - to one where liquidity is determined by the price of capital.

Mr Ma gave a primer on China's monetary policy evolution in a paper in conjunction with the International Monetary Fund earlier this year, writing that a "main task in the reform of China's macroeconomic management during the next five-year plan is the transition from a quantity-based monetary policy framework to a price-based one."

Establishing a rate corridor would also help ensure banks can get easy access to cheap funds, even at times when cash runs short - cases that have typically caused a spike in short-term lending rates.

"This will help stabilize market expectation of liquidity, and avoid big volatility in money rates," Liu Dongliang, a senior analyst at China Merchants Bank Co. in Shenzhen, wrote in a note. He said the announcement is also a signal the central bank is trying to support medium- and small-sized banks.

The reduction is partly to "discover the function of Standard Lending Facility rate as the ceiling of the interest rate corridor," the PBOC said in the statement on the Weibo microblog website. The PBOC didn't say what the rates had been before the adjustment.

'Less Effective' The SLF cut is another step toward improving the transmission of monetary policy after its primary policy tools, the benchmark rates on bank lending and deposit rates, "have become less effective," according to Mark Williams, chief Asia economist at Capital Economics in London. The lending facility was previously used only intermittently and solely as a tool to manage liquidity, he wrote in a note to clients.

"The road map that the People's Bank has been following requires it to find a way to transmit policy signals through China's increasingly diverse financial system," Williams said. "The benchmark lending and deposit rates did not fulfill that role." With output on pace for the slowest expansion in a quarter century, the PBOC has cut the lending rate six times in the past year, most recently last month when it was set at a record low 4.35 percent. Policy makers have also reduced the required reserve ratio for the biggest banks.