Issue related to Monetary Policy
Source: The Indian Express
Context:
The author talks about tackling surplus liquidity in the upcoming months.
Editorial Insights:
- Recently Monetary Policy Committee (MPC) has met to decide the future course of action.
- Because of the pervasive uncertainty led by the Omicron variant, the MPC decided to maintain the status quo on policy rates.
- Therefore, the repo is maintained at 4% & the reverse at 3.35%, while the forecasts of FY22 GDP growth & CPI inflation are retained at 9.5% & 5.3% respectively.
RBI towards the policy of normalization:
Though the major expectation has been a move towards policy normalization & there is a subtle shift in policy guidance towards this objective.
At the same time, RBI intended a greater emphasis on both anchoring inflations & addressing potential financial stability risks arising from the policy of tightening global central banks.
Liquidity Management:
- RBI since the onset of COVID had moved proactively to cut the repo & reverse the repo rate & inject unprecedented amounts of funds into banks & other intermediaries.
- Due to this, excess liquidity in the financial system had increased from Rs 2-3 lakh crores daily to Rs 6-7 lakh crores.
- This led to a decrease in short-term market interest rates on Para with a reverse repo rate.
- At the same time, both the repo & reverse repo rates had cut down to 4% & 3.35%, further widening the corridor gap.
- In theory, the central bank’s main role is to determine the basic overnight interest rate inconsistent with prevailing macroeconomic conditions & in balancing the sustained growth ecosystem together with price stability.
- This can be achieved through buying & selling very short-term funds from banks to keep a specified operating rate very close to the policy rate.
- However, post-COVID, RBI’s decision of lowering reverse repo & the large liquidity injection resulted in a drop in various short-term rates down to the reverse repo making it operating rate of monetary policy.
- Liquidity management in the extended banking & financial system such as NBFCs will now play a key role in normalization.
- This involves calibrating both the surplus volume of funds in the system & associated interest rates.
- Further RBI has used multiple instruments to absorb this liquidity surplus over the year.
There are two sources of liquidity additions:
- Exogenous, largely due to inflow of foreign currency funds to the extent absorbed by RBI & outflows of currency circulation from the baking sector.
- Voluntary is the result of the creation of base money by RBI through buying & selling bonds results in injecting or extracting money.
- Post-October, RBI had stopped buying bonds under G-Securities Asset Purchase & done negligible OMOs, thereby stopping the addition of voluntary liquidity injection into the system.
Managing surplus system liquidity overhang:
RBI has used the reverse repo window to absorb maximum liquidity surplus from banks.
At the same time, it allowed banks the option to prepay the outstanding borrowings from the Targeted Long Term Repo Operations (TLTROs), thereby extracting Rs 70k crores.
On Interest Rates:
- RBI has gradually guided short-term rates in between reverse & repo rates.
- It has shifted its liquidity absorption operations from the predominant use of fixed-rate reverse repos (FRRR) into 140day variable rate reverse repo (VRRR) auctions to guide a rise in interest rates.
- Since October, the weighted average rate on the VRRR had steadily moved up to 3.5%-3.8% following RBI acceptance of the auctions close to reverse repo levels.
- At the same time, moving up of VRRR rates also resulted in moving up of various short-term funding interest rates like CDs, CPs & T-Bills.
- Further, the OMO & GSAP operations have also helped in managing medium- and longer-term interest rates in the yield curve.
Way-Ahead:
In the upcoming days, there would be further additions to exogenous system liquidity, through foreign currency funds.
Subsequently, there will be a need for other instruments to absorb these surpluses apart from VRRR auctions.
At the same time, managing liquidity surpluses of the non-banking intermediaries will be a major challenge due to their lack of access to VRRR operations.
The following actions move towards the normalization phase:
- Hiking reverse repo rate,
- Changing stance from accommodative to neutral,
- In later stages shifting to the tightening phase by hiking repo rates.
