The prices of government bonds rose and yields dropped on Tuesday, the most in two months, celebrating the Reserve Bank of India’s mid-year review of monetary policy. The equity market too was not unhappy; the bellwether equity index Sensex ended flat.

In some sense, it was a please-all policy. The Indian central bank raised its policy rates by 25 basis points each, the sixth such hike since March, in line with market expectations but laced it with a rare commitment not to raise the rates again, at least in the immediate future. One basis point is one-hundredth of a percentage point.

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The Reserve Bank of India’s (RBI) repo rate, or the the rate at which it infuses liquidity in the system, is now 6.25% and the reverse repo rate, or the rate at which it drains liquidity is 5.25%—still much below the prevailing inflation rate.

In an interview with Mint, RBI governor D. Subbarao clarified that the central bank will not hike the rate in the next three months, unless there is a compelling reason to do so.

A three-month guidance on its policy stance, a day ahead of the US Federal Reserve’s decision on the second round of quantitative easing, is indeed a bold step.

The other bold step taken by Subbarao is his emphatic statement on liquidity management.

India’s financial system has been running a deficit of around Rs62,000 crore daily and banks have been borrowing money from RBI to take care of their daily cash requirement.

RBI has committed to contain the liquidity deficit “within a reasonable limit". It said the stance of the monetary policy is to ensure that the liquidity “remains broadly in balance, with neither a surplus diluting monetary transmission nor a deficit choking off fund flows".

It has even gone to the extent of giving a target on how much deficit or surplus liquidity is acceptable—around Rs50,000 crore or 1% of the deposit liability of the banking system. The daily average cash deficit in the system in September was Rs24,000 crore. It rose to Rs61,700 crore in October and on one particular day it zoomed to Rs1.29 trillion.

Minutes after announcing the policy, the Indian central bank walked the talk by deciding to conduct open market operations (OMOs) to infuse liquidity into the system.

Under this, it buys bonds from the market. In October, it had announced an OMO programme, but that was very different to the latest one. At that time, the Indian government announced a plan to buy back bonds worth Rs28,553 crore from the market. It is to be funded from the government’s surplus cash balances kept with RBI. So far, the government has bought back bonds worth Rs2,148 crore.

There are two key differences between the OMOs announced in October and now. First, the government is the buyer of bonds in the October OMO plan while RBI is the buyer in the latest plan.

Second, the government wants to buy back bonds maturing in the current fiscal year. This means the liquidity generated out of this is short term as the bonds will be redeemed by March 2011.

But RBI is buying bonds maturing in five, six and even 10 years. In that sense, this is also quantitative easing, even though the Indian context is very different. One can even dub it as back-door monetization.

Inflation continues to remain high, much above RBI’s comfort level, and the growth story of the Indian economy is still intact. But surprisingly, the growth aspect has not found place in the central bank’s monetary policy stance that has chosen to focus on three key issues—containing inflation, maintaining an interest-rate regime consistent with price, output and financial stability and managing liquidity. It could either mean that RBI’s priority has changed or the growth momentum in the world’s third fastest growing major economy is so strong that it’s a given and doesn’t need to be separately highlighted.

In its September mid-quarterly review too RBI had given a guidance by saying the interest rates reached a near-normal stage. Many analysts interpreted that as an indication for pause in November. But that hasn’t happened. So, Subbarao’s statement on “relatively low" probability of a rate hike in the future should be taken at face value. The inflation rate is still very high in India and inflation expectations are even higher.

On top of that, the real interest rate continues to be negative even after the latest round of hikes. In fact, the gap between the inflation rate and the interest rate is the highest in India among all major economies. In that sense, the monetary policy is still accommodative.

The flood of money to be released by the US Federal this week, apart from increasing the capital flow, can also impact the global commodity prices, particularly oil, in a big way and that will feed into inflation.

So, the celebrations may not last long. After three months, if not earlier, RBI may have to hike its rate again.

Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as Mint’s deputy managing editor in Mumbai. Please email your comments to

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