As expected, given the widespread uncertainty that followed the Omicron variant, the Monetary Policy Committee (MPC) voted to maintain the status quo on policy rates, with one member continuing to oppose the “accommodative stance ” politics. The reverse repo rate is maintained at 4 percent and the reverse repo rate at 3.35 percent. The forecast for fiscal year 22 GDP growth and CPI inflation are held at 9.5% and 5.3%, respectively.
The main expectation was a shift towards a “normalization” of policies, and indeed there appears to be a subtle shift in policy direction towards this goal. While the need for sustainable growth remains paramount, the statement suggests a somewhat greater emphasis on both anchoring inflation and managing the potential risks to financial stability resulting from the tightening of policy in the countries. global central banks.
Since the start of the Covid-related lockdowns, the RBI had taken proactive steps to reduce the repo and reverse repo rate and inject unprecedented amounts of funds into banks and other intermediaries. The excess liquidity in the financial system has grown from average excess levels of around Rs 2-3 lakh crore per day in March ’20 to around Rs 6-8 lakh crore. This had the effect of driving short-term market interest rates down to the repo rate, and sometimes well below. In addition, the reverse repo and reverse repo rates had been reduced to 4.0% and 3.35%, respectively, with the spread – the “corridor” – between the rates widening by the usual 25 basis points. at 65 basis points.
The primary role of a central bank in the operational procedures of modern monetary policy is to determine the base overnight interest rate, considered consistent with prevailing macroeconomic conditions and their economic policy objectives, balancing the ecosystem for sustained growth with moderate inflation (“price stability”). This is achieved by buying and selling very short term (mostly overnight) funds from banks (mainly) to maintain a specified operating rate (the weighted average call rate in our case) very close to the key rate.
After February 20, a combination of the lower repo rate and the large cash injection caused various short-term rates to drop to (and sometimes below) the repo rate, resulting in which makes it the effective operating rate of monetary policy. . While this may have been appropriate during the initial stages of the crisis, it can now potentially create risks for the objective of financial stability.
Liquidity management in the broader banking and financial system (which includes non-bank intermediaries like NBFCs, mutual funds and others) will now be the key pillar of standardization. This will involve calibrating both the volumes of excess funds in the system, as well as the associated price of that liquidity (i.e. interest rates). Note that this process is the domain of RBI and not of MPC. These transactions will be carried out as part of RBI’s liquidity management.
RBI dynamically used several instruments to absorb this excess liquidity during the year. However, this is probably a slow process. There are two sources of liquidity inflows: (i) exogenous, which are largely due to inflows in foreign currency as they are absorbed by the RBI and outflows of currency in circulation (cash) from the banking sector , and (ii) voluntary or endogenous, which results from the creation of base currency by the RBI through the purchase and sale of bonds, thereby injecting or extracting funds in rupees. After the October review, the RBI stopped buying bonds under the Govt Securities Asset Purchase (GSAP) and carried out negligible open market operations (OMOs), thus stopping the addition of injections. voluntary liquidity in the system, our own version of “typing”. Union government balances with the RBI, resulting from the cash flow asymmetry between revenue and expenditure, have hybrid characteristics and also have an impact on liquidity.
How to manage excess liquidity in the system? The RBI used the reverse repurchase window to absorb almost all of this excess bank liquidity. It again allowed banks to prepay outstanding loans from Targeted Long-Term Repurchase Transactions (TLTROs), potentially extracting an additional Rs 70,000 crore. These will eventually mature in 2023 anyway.
On interest rates, the RBI – after the October review – has gradually guided short-term rates upward with a steady hand, moving from a rate close to the repo rate to a rate close to the repo rate. It shifted its liquidity-absorbing operations from the predominant use of fixed-rate reverse repurchase agreements (FRRRs) to (largely) 14-day variable-rate reverse repurchase agreements (VRRRs) auctions to guide a surge. interest rates. Since the start of 2021, the weighted average rate on VRRR auctions has hovered around 3.4%. Since the beginning of October, these rates have continued to increase in a regular and orderly manner, reaching 3.75 to 3.9 percent following the acceptance of the RBI in these auctions, close to “normal” levels of catch. in reverse board.
The increase in VRRR rates has also resulted in an increase in various short-term financing interest rates such as 90-day Treasury bills, commercial papers (CP) and bank certificates of deposit (CD) from banks. repo rate or less in September to 3.5 percent and more since December. The OMO and GSAP operations have also contributed to the management of medium and long-term interest rates on the yield curve.
There is a likelihood of further additions to the exogenous liquidity of the system, largely through the inflow of funds in foreign currencies, especially during FY23. It may therefore be necessary to have recourse to other instruments to absorb these surpluses outside of VRRR auctions. These options will depend on various trade-offs and political choices. Managing the excess liquidity of non-bank intermediaries, especially mutual funds, will be another challenge, as they do not have direct access to VRRR operations.
The next steps in the sequencing of the normalization phase will likely be reverse repo rate hikes, followed by a change in stance from “accommodative” to “neutral”. The subsequent transition to the tightening phase, with increases in the repo rate, is likely towards the latter months of FY 23, with changes “if warranted by changes in the economic outlook”.
The author is Executive Vice President and Chief Economist of Axis Bank. Views are personal