Interest rate signal

The Reserve Bank of India has finally bitten the bullet. Its decision to increase the cash reserve ratio (CRR) by 50 basis points is a clear signal that it has reversed its long-standing easy money policy. Plainly, the central bank has been rattled by the sharp rise in inflation.

The first hint that it was concerned at excess liquidity as a contributory factor to inflation came in the RBI's Annual Report, where, among the supply-side factors such as oil and commodity prices, it also identified the "liquidity overhang" as one of the reasons.

The Prime Minister, at his recent press conference, also alluded to excess liquidity while discussing the causes of inflation.

Given this backdrop, and with the benefit of hindsight, the central bank's decision to tighten monetary policy should not have surprised anyone.

But the announcement has come as a jolt to the bond market, which seems to have been lulled into a false sense of complacency by talk about the temporary and "imported" nature of the inflationary spike.

In spite of its decision to reverse policy, the RBI is still being cautious, raising the CRR in two baby steps of 25 basis points each. That will suck out about Rs 8,000 crore from the money markets at a time when the total amount lying in repos is around Rs 40,000 crore. Obviously, the tightening will have only a small impact on liquidity. But bond prices may decline because of the blow to "sentiment".

Why has the RBI not raised repo rates? Given the fact that the repo rate has become the prime signalling mechanism for the RBI, the message is that the RBI doesn't actually want interest rates to go up in a hurry, a point which is also conveyed by the cautious manner in which liquidity is being tightened.

The trouble with the repo rate, as an internal committee of the RBI has pointed out, is that it has become more than just a signalling device. It is also treated as an absorber of funds of the first resort by market participants.

Raising the repo rate in conditions of excess liquidity would merely result in even more money being parked in repos, and at a greater cost to the RBI. It is, therefore, essential for the central bank to suck out excess liquidity before it hikes the repo rate.

The decision to hike the CRR prepares the ground for an eventual rise in the repo rate.

As far as the lower returns on CRR balances are concerned, these balances currently act as a passive approximation of the standing deposit facility which the RBI has asked for, and which is envisaged as a floor to the interest rate corridor under the Liquidity Adjustment Facility (LAF).

Since the RBI's objective is to set the repo rate around the middle of the corridor, obviously CRR balances will have to be remunerated at a rate lower than the repo rate.

This was also the point made by the RBI's internal group on the LAF. In sum, the decision to tighten liquidity one notch is just yet another warning from the RBI to market participants to prepare for higher interest rates.