Gap between repo and reverse repo rates may fall further to 100 basis points.
When Duvvuri Subbarao took charge of Mint Road in September 2008, the gap between the two key policy rates was as much as 300 basis points (bps).
On Tuesday, by raising the reverse repo rate by 50 bps and the repo rate by 25 bps, the Reserve Bank of India (RBI) has narrowed the gap to 125 bps, lower by 25 bps than in the previous round of rate hikes earlier this month. The move is aimed at curbing volatility and taking the operational rate closer to the repo rate.
In RBI’s own admission, there is no unique way to determine the appropriate width of the corridor, but it should not be so wide that interest rates become so volatile as to distort policy signals. The central bank also emphasises that the corridor should be broad enough so as not to unduly incentivise market participants to place their surplus funds with RBI.
In a meeting with bankers on Tuesday, RBI officials said such a gap was kept wide when there was volatility and that a narrowing down indicated return to stability. Bankers who attended the meeting said RBI did not give any indication that the gap would be further reduced.
In its marcoeconomic and monetary development report released yesterday, the central bank said the current tightness in liquidity would ease, but calibrated normalisation of monetary policy might not lead to the return of the persistent easy liquidity conditions that prevailed last year. on Tuesday’s measure reinforces the view that RBI will ensure that interest rates have an upward bias even if liquidity eases somewhat as the government starts spending, say analysts.
Madan Savnabis, chief economist at CARE ratings, who expected policy rates to be raised by 25 bps each, said, “The additional 25 bps increase in reverse repo may be viewed more as a measure to reduce volatility and rein in call rates within the width of the LAF corridor.”
Analysts now expect the corridor will further narrow down to 100 bps.
“We were expecting the liquidity adjustment facility corridor to narrow. The narrowing suggests RBI is concerned about inflation. We expect this narrowing to continue and reach 100 bps by the next policy review,” B Prasanna, vice-president, ICICI Securities Primary Delearship, told a news agency.
Overnight interest rates, which remained around the floor of the LAF corridor up to May, moved up to the ceiling in June and July as banks’ liquidity demand went up, mainly to fund airwave auctions.
To study the changing liquidity dynamics further, RBI proposes to set up a working group to review the current operating procedure of monetary policy, including LAF. “As systemic liquidity transits from a uni-directional surplus mode to a bi-directional mode, it will have implications for the effectiveness of monetary transmission. In the context of the changing liquidity dynamics, the operation of LAF needs to be studied,” RBI said.
The central bank also sounded caution on large capital inflows, which can make tackling inflation more difficult. RBI has reasoned that central banks in advanced economies are likely to maintain accommodative monetary policies for an extended period which could trigger large capital inflows into emerging economies like India where potential for growth is strong.
“Large capital inflows above the absorptive capacity of the economy will pose a challenge for monetary and exchange rate management. This also has implications for asset prices. In this scenario, a widening current account deficit will help absorb a larger proportion of the inflows,” RBI said.
