Home >Opinion >Raghuram Rajan’s pivot to liquidity management

Monetary policy operates on three pillars—the policy rate, daily liquidity management in the money market and communication. The most interesting parts of the new monetary policy announced by Raghuram Rajan are in the structural changes to liquidity management.

The reason why the Reserve Bank of India (RBI) had to move is widely known. Bank lending rates have not fallen to the same extent as policy rates have. There was a growing clamour for easier liquidity in the money market to help monetary policy transmission, but that could have been done with open market operations, or releasing liquidity by buying government bonds. The Indian central bank has gone beyond that to announce some important structural changes in the way it will manage liquidity.

The first change is to keep liquidity in neutral rather than deficit mode, as was the wont of the central bank till now. The earlier decision to maintain a liquidity deficit was also ironically justified as essential for better monetary policy transmission, albeit at a time when interest rates were being pushed up to battle inflation.

The change from deficit to neutral mode means that the RBI will have to aggressively buy dollars as well as government securities to release money into the money market. The size of its balance sheet seems set to increase. ICICI Securities Primary Dealership chief economist A. Prasanna has estimated in this newspaper that the RBI will have to inject 3 trillion of liquidity over the next year. It would not be incorrect to say that the central bank has now shifted its attention from the price of money to the quantity of money, which is why some writers have described the new policy as a mild form of quantitative easing.

The second big change is that the corridor between the two main policy rates has been halved to 50 basis points. Central banks use such policy corridors to keep overnight call money rates within a desired band. The most obvious result is a reduction in the volatility of short-term interest rates. Many central banks in recent years have been busy narrowing their interest rate corridors. RBI is but the latest.

Lower volatility in the interbank money market could have an important effect on bank behaviour. Banks tend to hoard liquidity when interest rates are jumping around. An anchored call money rate will ensure that banks are more comfortable trading with each other for overnight money rather than depending on the central bank for emergency funds. What this also means is that short-term interest rates will not be hostage to the liquidity forecasting errors of commercial banks, and even perhaps the unexpected movements in the cash balances that the government maintains.

There is no doubt that volatility in call money rates have come down over the years. The monetary policy report released by the RBI on the day of the policy announcement says that the rolling standard deviations of call money rates—a measure of volatility—have come down to a 20th of what they were in 2006. The new policy changes announced this week should further help the Indian central bank improve its liquidity marksmanship.

The success of the new liquidity policy will depend not just on its theoretical structure but also how it is translated into practice. The credibility of the Indian central bank was dented during the defence of the rupee in July 2013 when its liquidity moves were at odds with its rate actions. It eased liquidity just when tighter money market conditions were making it more expensive for traders to take short positions in the Indian currency.

Now consider a similar possibility under the new liquidity policy. The elimination of the liquidity deficit in the money market may make it difficult for the RBI to defend the repo rate as its policy rate. A sudden gush of capital inflows could send the domestic money market into surplus mode, and thus make the reverse repo the effective policy rate. Such an inadvertent switch can confuse the markets as well as reduce the effectiveness of monetary policy.

Will elimination of the liquidity deficit lead to better policy transmission? Tell us at

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