The Reserve Bank of India’s (RBI’s) monetary policy committee (MPC) on Thursday decided to raise the reverse repo rate, at which it drains excess liquidity from the banking system, by 25 basis points, reflecting its steadfast pursuit of inflation management.
The unanimous decision by the six-member committee to raise the rate to 6% is largely to ensure that banking system liquidity is consistent with the neutral monetary policy stance RBI adopted in February. One basis point is one-hundredth of a percentage point.
RBI reiterated that it would use the many tools at its disposal, such as cash management bills and market stabilization bonds, to ensure that liquidity is brought close to a neutral (neither surplus nor deficit) level. It also said another tool, the so-called Standing Deposit Facility, under which banks can park their funds with RBI without receiving bonds as a collateral, was being examined by the government.
Average surplus liquidity in the banking system was Rs4.4 trillion in March as the invalidation of high-value currency notes in November led to a flood of deposits, prompting economists to express concern that this would fuel inflation in the days ahead.
“When it comes to inflation, the MPC is choosing to be conservative," said Gaurav Kapur, chief economist at IndusInd Bank. “It has reiterated 4% inflation in the medium term as a core objective. Raising the reverse repo rate is a step towards ensuring that the liquidity management is in line with the neutral stance."
While the committee noted that risks to inflation are “evenly balanced" currently, it also listed several threats. The main upside risks come from the uncertainty surrounding the monsoon, the implementation of the house rent allowance component of the seventh pay commission award and one-off effects from the goods and services tax. “The general government deficit, which is high by international comparison, poses yet another risk for the path of inflation, which is likely to be exacerbated by farm loan waivers," said the monetary policy statement.
Wholesale inflation soared to a 39-month high of 6.55% while retail inflation too inched up to 3.65% in February, signalling that inflation continues to be a concern for the regulator. Many economists expect no further rate cuts this financial year.
“The policy has highlighted the upside risks to inflation despite the fact that global risks have subsided. This means the central bank is keeping a close watch on domestic risks. We are therefore looking at a prolonged pause before any action is taken this year," said Upasna Bhardwaj, senior economist at Kotak Mahindra Bank Ltd.
In a separate report , RBI’s staff economists have projected 4.9% consumer price inflation in the quarter ending March 2018 and 4.6% in the three months ending March 2019, both higher than its medium-term target.
Two other facts highlight this risk.
One, household inflation expectations continue to rise. The March round of RBI’s survey of urban households showed an increase of 20-50 basis points in inflation expectations over the December round, when they had declined.
Two, the central bank has projected gross value added growth of 7.4% for the current financial year and 8.1% for fiscal 2018-19.
“The output gap (the gap between potential output and what the economy is actually producing) is gradually closing. Consequently, aggregate demand pressures could build up, with implications for the inflation trajectory," the policy statement said.
What does this mean for lending rates?
RBI has kept the repo rate, at which it infuses liquidity into the banking system, unchanged, while it has reduced the marginal standing facility rate (at which banks borrow from RBI beyond what is allowed under the repo window) by 25 basis points to 6.5%.
“Banks have reduced lending rates, although further scope for a more complete transmission of policy impulses remains, including for small savings/administered rates," the statement said.