Context

Monetary Policy Committee (MPC) voted to maintain status quo on policy rates, with one member continuing to dissent on the “accommodative” stance of policy.

What is accommodative stance of policy?

Accommodative monetary policy is when central banks expand the money supply to boost the economy. Monetary policies that are considered accommodative include lowering the Federal funds rate. These measures are meant to make money less expensive to borrow and encourage more spending.

Overview of RBI policy measures during Covid-related lockdown

• Cut in policy rates and injection of liquidity: The RBI had moved proactively to cut the repo and reverse repo rate and inject unprecedented amounts of funds into banks and other intermediaries.
• The short-term interest rate at reverse repo level: a combination of the lower reverse repo rate and the large liquidity injection had resulted in a drop in various short-term rates down to (and occasionally below) the reverse repo rate, making it the effective operating rate of monetary policy.
• Gap between repo and reverse repo increased to 65 bps: In addition, both the repo and reverse repo rates had been cut to 4.0 and 3.35 per cent, respectively, with the gap – the “corridor” – between the rates widening from the usual 25 basis points to 65 bps.

Central bank’s role in modern monetary policy

• Determining basic overnight interest rate: A central bank’s main role in modern monetary policy operating procedures is to determine the basic overnight interest rate, deemed to be consistent with prevailing macroeconomic conditions and their economic policy objectives, in balancing the ecosystem for sustained growth together with moderate inflation.
• This is achieved through buying and selling very short-term (predominantly overnight) funds (mainly) from banks to keep a specified operating rate (the weighted average call rate in our case) very close to the policy rate.

Liquidity management: Key pillar of monetary policy normalisation

• Liquidity management: Liquidity management in the extended banking and financial system (which includes non-banking intermediaries like NBFCs, mutual funds and others) will now be the key pillar of normalisation.
• This process is the domain of RBI and not MPC.
• These operations will be conducted within RBI’s liquidity management framework.
•  There are two sources of liquidity additions:
• (i) Exogenous: which are largely due to inflows of foreign currency funds and outflows of currency in circulation (cash) from the banking sector.
• (ii) Voluntary or endogenous: which is the result of the creation of base money by RBI through buying and selling of bonds, thereby injecting or extracting rupee funds.

How RBI is managing liquidity surplus?

• Stopped GSAP and OMOs: Post the October review, RBI had stopped buying bonds under the Govt Securities Asset Purchase (GSAP) and done negligible Open Market Operations (OMOs), thereby stopping addition of voluntary liquidity injection into the system, our own version of “tapering”.
• Union government balances with RBI, arising from cash flow mismatches between receipts and expenditures, has hybrid characteristics and also impacts liquidity.
• Use of reverse repo window: RBI has used the reverse repo window to absorb almost all this liquidity surplus from banks.
• Allowed repaying TLRTOs: It has again allowed banks the option to prepay the outstanding borrowings from the Targeted Long Term Repo Operations (TLTROs), thereby potentially extracting another Rs 70,000 crores.

How RBI is managing interest rate in the policy normalisation process

• Increased rates and closed the gap between repo and reverse repo: RBI – post the October review – has gradually guided short-term rates up with a sure hand from near the reverse repo rate to close to the repo rate.
• It has shifted its liquidity absorption operations from the predominant use of fixed rate reverse repos (FRRR) into (largely) 14-day variable rate reverse repo (VRRR) auctions to guide a rise in interest rates.
• Since early October, these rates had steadily moved up in a smooth and orderly fashion up to 3.75-3.9 per cent.
• The VRRR rates moving up have also resulted in various short-term funding interest rates like 90-day Treasury Bills, Commercial Papers (CP) and banks’ Certificates of Deposits (CD) moving up from the reverse repo rate or below in September to 3.5 per cent and higher since December.
• The OMO and GSAP operations have also helped in managing medium- and longer-term interest rates in the yield curve.

Way forward

• There is a likelihood of further additions to exogenous system liquidity.
• Other instruments to absorb surpluses: There might consequently be a need for other instruments to absorb these surpluses apart from VRRR auctions.
• Liquidity surplus of non-banking intermediaries: Managing liquidity surpluses of the non-banking intermediaries, especially mutual funds, will be another challenge since they do not have direct access to VRRR operations.

Consider the question “Since the onset of the Covid-related lockdowns, RBI had moved proactively to cut the repo and reverse repo rate and inject unprecedented amounts of funds into banks and other intermediaries. In this context, what are the challenges in monetary policy normalisation as RBI plans to absorb the excess liquidity and increase the interest rates ?”

Conclusion

The shift to the tightening phase, with hikes in the repo rate, is likely towards the late months of FY23, with shifts “if warranted by changes in the economic outlook”.

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Back2Basics: Monetary Policy Corridor

• The Corridor in monetary policy of the RBI refers to the area between the reverse repo rate and the MSF rate.
• Reverse repo rate will be the lowest of the policy rates whereas Marginal Standing Facility is something like an upper ceiling with a higher rate than the repo rate.
• The MSF rate and reverse repo rate determine the corridor for the daily movement in the weighted average call money rate.

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