RBI Monetary Policy: Has The Central Bank Effectively Raised Rates?

The status quo on policy rates comes with a number of buts.

<div class="paragraphs"><p>A sign for the Reserve Bank of India (RBI) sign is displayed inside central bank's headquarters in Mumba Photographer: Dhiraj Singh/Bloomberg</p></div>
A sign for the Reserve Bank of India (RBI) sign is displayed inside central bank's headquarters in Mumba Photographer: Dhiraj Singh/Bloomberg

The Monetary Policy Committee voted to keep the repo rate unchanged.

That status quo on policy rates, however, came with a number of 'buts'. Stripped of all those complexities, the effective takeaway is this—the Reserve Bank of India has raised rates and is now more worried about inflation than growth.

Have They Raised Rates? Yes? No? Maybe?

Yes, the RBI has raised rates. Here's why.

The RBI sends signals to the market through three policy rates—the rate at which they take in surplus liquidity from banks; the rate at which they supply liquidity to banks; and the rate at which they supply liquidity when conditions are very tight.

When liquidity is surplus, as it is now, the rate at which the RBI takes liquidity from banks is the effective rate which forms the benchmark for most bank deposit and lending rates.

Which rate is this? And what is it set at?

Till February, the RBI absorbed liquidity through the reverse repo facility at the reverse repo rate, which was set at 3.35%.

Now, the RBI has introduced a new standing deposit facility. This window is where banks will now park their surplus liquidity. What is the rate the RBI will offer banks here? 3.75%.

So, the effective floor rate in the market is now 3.75% (because why will banks part with their money at anything lower than that) compared to 3.35% earlier.

In short—yes, the RBI has raised the effective rate.

But Why Did The RBI Move From Reverse Repo To Standing Deposit Facility?

If you have stayed with us this far, you probably want us to back up and explain why the RBI introduced the standing deposit facility to begin with.

There is a reason.

The reverse repo window was a collateralised one. So when banks parked their money at that window, the RBI gave them securities in return to hold.

But given the large amount of surplus liquidity, the RBI was running out of securities to offer.

The standing deposit facility is a non-collateralised window. So the RBI can absorb liquidity without offering securities now. That takes away RBI's one headache.

Is The SDF Rate Really The Effective Rate?

This is where it gets interesting.

So, technically the SDF rate of 3.75% is the floor rate.

But, but, but...

The RBI has been absorbing most liquidity through variable rate reverse repo auctions. These auctions have seen cut-offs close to the repo rate of 4%.

So, the real effective rate is already close to 4%.

Why Don't They Just Hike The Repo Rate And Be Done With It?

Why can't the RBI just raise the 'real' policy repo rate? It will, probably, over the next few policies. It has raised its inflation forecast and said that inflation now gets greater priority than growth. The next step, should conditions remain as they are, will be a hike in the repo rate. And then the SDF rate will also automatically get hiked since it is now pegged 25 basis points below the repo rate.

Also since the RBI has specified that the "width of the interest rate corridor has been restored to 50 basis points", which is the norm, from here on when the repo rate moves, the SDF rate will adjust automatically and stand 25 basis points below the repo rate.

So, in some ways, the RBI is moving to restore the dominance of the Monetary Policy Committee as well through this move.

Confused? So are economists but here are some views coming in:

Rise In Floor Rates

The RBI has definitely raised the floor rate in the system, Suvodeep Rakshit, senior economist at Kotak Institutional Equities, said. But there will likely be only marginal shifts in market interest rates given that effective reverse repo rate was much higher than 3.35%. This move helps in anchoring the lower end of the corridor around 3.75% and maintaining the corridor at 25 basis points, he explained.

Short-Term Rates To Rise

This is the first step in bringing up overnight rates, R Sivakumar, head of fixed income at Axis Mutual Fund, said.

The RBI has said that the extraordinary steps taken during the pandemic need to be withdrawn. Reverse repo was dropped well below repo during the pandemic, so this is now normalisation of those steps, he explained. Even the level of repo rate is well below pre-pandemic levels.

"Since inflation has been revised upward, we can expect policy repo rate normalisation to happen and it is something we should watch out for. The signal from the RBI seems to be that short-term rates need to go up."

Signalling Effect

There is no doubt that the RBI has raised rates at the shorter end of the curve. Slowly, the reverse repo will become redundant and the new rate will be the SDF, Soumyajit Niyogi, director at India Ratings & Research, said.

"The signal is very clear." While the impact will be more pronounced on money market rates, the 10-year benchmark bond yield, too, will see an impact, he said.

The growth-inflation conundrum has intensified and the move will give confidence to financial and forex markets, he added.

Rate Hikes Beckon

"SDF as a tool is meant to absorb liquidity without collateral. It was introduced last during demonetisation due to the low availability collateral to absorb excess liquidity in system," Ajay Manglunia, managing director & head-institutional fixed income at JM Financial, explained. Due to inflation inching up and the need for maintaining the right level of liquidity, the RBI has introduced this now.

The regulator might be preparing the market for a rate action in the future, he said, adding that it is not expected anytime soon. The market seems to be overly worried about the supply of government securities. "Without any RBI action, too, we can expect the rates to go up by about 25-50 basis points," Manglunia said. Rest assured, the RBI will maintain an orderly functioning of the markets without much volatility, he added.

No Longer A Stout Dove

The journey from current about Rs 8 trillion+ system liquidity to a pre-Covid Rs 2 trillion+ will be a long-drawn one and new tools like SDF will be needed to manage durable liquidity and any idiosyncrasies amid collateral constraints under VRRRs, Madhavi Arora, lead economist at Emkay, said.

The fixed reverse repo rate at 3.35%—even though it adds a lower overnight bias to the policy corridor—now becomes largely redundant as now it is going to be used at the discretion of the RBI, she said. "Nutshell, the move would ensure the call money rate would eventually edge towards the new effective corridor of 25 basis points -/+ repo rate.

"Thus, to that extent RBI no longer remains a stout dove and the reaction function is now evolving with fluid macro realities," she said. The stance could formally change in the following policy even as the RBI crawls towards normalisation of liquidity, according to Arora. This, she said, also raises chances of rate hikes commencing from the August policy.