RBI's gradual shift to a price stabilising strategy: Explained

In the final meeting of the Monetary Policy Committee (MPC) for FY21-22, it was concluded that the inflation rate would soon moderate and RBI chose to continue with a growth-focused accommodative strategy. 

However, in the most recently concluded first meet of FY22-23, the MPC has signaled an upcoming shift to a neutral strategy starting June 2022. 

RBI's stance has finally begun to indicate change after all the 'behind the curve' accusations. The banker’s bank has revised the inflation forecasts to 5.7% after an increase of 120 basis points from the earlier 4.5%. 

RBI has expected Consumer Price Index- CPI inflation (An index that indicates prices of common consumer goods and services) to average 6.3% in April-June and 5.8% in July-September. Furthermore, the forecasts for GDP growth have been slashed down to 7.2% from an earlier 7.8% for the fiscal year 2022-23. 

Justifying all the forecasts is the whopping surge in crude oil prices due to the Russia-Ukraine War. The reserve bank has assumed the crude oil price to maintain over $100 per barrel to quantify its inflation forecasts. 

Resultantly, the Reserve bank has decided to make a gradual shift to a price stabilising strategy. Although the key tool- repo rate remains unchanged at 4%, a new tool, Standing Deposit Facility (SDF) has been introduced allowing the banks to park their money with RBI at 3.75%. This would largely help in absorbing excess liquidity (estimated at around Rs. 8.5 Lakh crores) as it will now serve as the floor for the Liquidity Adjustment Facility Corridor (LAF). 

The SDF would also prove to diminish the already declining relevance of the Fixed Reverse Repo Rate (FRRR), which was unaltered at 3.35%. 

The SDF’s effect will be seen over the bond market as well. Since SDF is free of any collateral (G-secs) to be given by RBI to the banks, it will allow RBI to direct banks to maintain lesser SLR holdings. Banks would have the option to then direct this wealth to bond markets. The bond market can already be seen as fizzy as the 10-year benchmark yield jumped 19-basis points to 7.12%. 

As declared by the governor, "RBI will engage in a gradual and calibrated withdrawal of this liquidity over the multiyear time frame in a non-disruptive manner beginning this year."

It is only obvious to expect that RBI will start the hike in repo rates starting June 2022 to ensure an overall increase by 50-75 basis points in FY22-23. SDF rates would also be pushed up simultaneously. The move can be faster and more intense if inflation picks up an even faster pace.

Repo and Reverse Repo: Two pivotal tools for any Central Bank

A key factor in deciding the interest rate in the economy is the Repurchasing Option rate or the repo rate. The Repo rate is the rate at which the central bank (RBI, in the case of India) lends money to commercial banks. 

A lower repo rate would induce commercial banks to decrease the rate for commercial lending which incentivises businesses and industries to borrow more. This encourages economic activity in the economy. During the times of the pandemic, RBI had maintained a low repo rate of 4% for approximately two years to give an economic boost so that the economy can recover from the Covid slump.

A higher repo rate is an effective strategy during times of inflation. This is because a higher repo rate would disincentivise the industrial entities to borrow money from banks for investment purposes and it eventually, reduces the money supply in the market. 

The second tool is the reverse repo rate. Just like a person’s deposits in commercial banks yield some interest rates, deposits of commercial banks with the RBI yield certain interest. The interest received by commercial banks in such activity is the reverse repo rate. A higher reverse repo rate would induce commercial banks to park more money with the central bank allowing a lesser amount to be able to extend loans to consumers. In times of inflation, central banks usually increase the repo rate. 

The author is an economist and co-founder of ECON C&R, a pro bono research and consultancy initiative