RBI policy takes a step towards normalcy, without calling it so
- Given that the amount that banks may end up parking at daily fixed-rate reverse repo may remain elevated, short-term rates could continue to be a problem. Analysts expect more measures towards this goal
Every central bank worth its salt knows that market expectations can make or break policy efficacy. The Reserve Bank of India (RBI) seems to have started on its hesitant reverse course from accommodation through tactical liquidity measures while vehemently denying the notion of withdrawal.
While its six-member monetary policy committee (MPC) voted to keep rates unchanged as widely expected, the central bank took to tactical measures through which it can manage the mammoth idle funds sloshing in the banking system. Starting next week, the size of the variable reverse repo rate auction (VRRR) would be progressively hiked to a fortnightly level of ₹4 trillion by September end. But despite these increases, the amount that banks may end up putting into fixed rate daily reverse repo auctions would be sizeable simply because the liquidity surplus is very large. As such, this surplus has surged to ₹8-10 trillion rupees currently.
Through this move, the RBI is dealing with the cost of liquidity through its quantity, which is interesting. The quantity of liquidity surplus is unlikely to come down. But what the central bank wants to do is bring short-term interest rates, especially overnight rates to a reasonable level. Short-term rates have been unhinged over the past several months due to the rising liquidity. The weighted average call money rate has been below the reverse repo rate of 3.35% and other money market rates too have hardly been able to rise towards the repo rate of 4%. For the RBI to trigger any withdrawal of accommodation, it will first need the market rates to come at its lowest policy rate. This also explains why Governor Shaktikanta Das does not believe the VRRR measure to be one of reversal of monetary policy stance. Indeed, it does not materially reverse the course of monetary policy. “Enhanced VRR auctions should not be read as reversal of accommodative policy stance,” Das said in his statement.
But it is a tentative step towards normalisation since the overnight rates are getting normalised through this. Of course, given that the amount that banks may end up parking at daily fixed-rate reverse repo may remain elevated, short-term rates could continue to be a problem. Analysts expect more measures towards this goal. “We expect additional liquidity normalisation measures like overnight VRRR, increased quantum of higher tenure VRRR in the months ahead before expecting a reverse repo rate hike in December,” wrote Upasna Bhardwaj, senior economist at Kotak Mahindra Bank in an email response.
Ultra-low short-term rates for prolonged periods do not sit well with the RBI’s inflation-targeting mandate, especially when retail inflation has edged up steadily. While the cause of inflation is not liquidity, cheap funds are certainly making market intermediaries take large risks when it comes to financial assets. The buoyant equity markets and the slew of initial public offers are getting financed through cheap funds. Therein lies the trouble for the RBI.
Das will need to battle the expectations on asset price inflation even as that of goods and services begins to pinch. If that means normalising policy in stealth mode, so be it.
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