RBI hikes reverse repo to suck out excess liquidity

CREDIT POLICY Focusses on inflation management; keeps repo rate unchanged

The Reserve Bank of India’s prime focus continues to be inflation management. The six-member monetary policy committee’s (MPC) decision to raise the reverse repo rate by 25 basis points to 6.25% is largely to ensure that banking system liquidity is consistent with its neutral monetary policy stance.

The reverse repo rate is the rate at which the central bank sucks out excess liquidity from the system. The RBI reiterated that it would use several tools at its disposal such as cash management bills, market stabilisation scheme (where it sells bonds) to ensure that liquidity is brought close to a neutral (neither surplus nor deficit level). It also said that another tool, a so-called Standing Deposit Facility, where banks could park their funds with RBI without getting bonds as a collateral, was under examination by the government.

Average surplus liquidity in the banking system was ₹4.4 lakh crore in March and economists expressed concern that this would fuel inflation in the days ahead. It also led to inappropriate signalling in the money market.

“When it comes to inflation, the MPC is choosing to be conservative,” said Gaurav Kapur, economist, IndusInd Bank. “They have reiterated 4% inflation in the medium term as a core objective. Raising the reverse repo rate is a step towards ensuring that liquidity management is in line with the neutral stance.”

While the committee noted that risks to inflation are “evenly balanced” currently, it also listed several threats. The main upside risks come from the uncertainty surrounding the monsoon, the implementation of the house rent allowance component of the seventh central pay commission award, and one-off effects from the goods and services tax.

“The general government deficit, which is high by international comparison, poses yet another risk for the path of inflation, which is likely to be exacerbated by farm loan waivers,” said the monetary policy statement.

Wholesale inflation soared to a 39-month high of 6.55% while retail inflation too inched up to 3.65% in February, signalling that inflation continues to be a concern for RBI. Majority of economists therefore expect no further rate cuts this financial year.

“The policy has highlighted the upside risks to inflation despite the fact that global risks have subsided. This means the central bank is keeping a close watch on domestic risks. We are therefore looking at a prolonged pause before any action is taken this year,” said Upasna Bharadwaj, senior economist, Kotak Mahindra Bank.

In a separate policy report , RBI’s staff economists have projected 4.9% consumer price inflation in the quarter ending March 2018 and 4.6% in the three months ending March 2019, both higher than its medium term target.

Two other facts also highlight this risk. One, household inflation expectations continue to rise. The March round of the central bank’s survey of urban showed an increase of 20-50 basis points in inflation expectations over the December round, when they had declined.

Two, the central bank has projected gross value added (GVA) growth of 7.4% for the current fiscal and 8.1% for fiscal 2018-19. More importantly, the monetary policy statement had to say this: “The output gap (the gap between potential output and what the economy is actually producing) is gradually closing. Consequently, aggregate demand pressures could build up, with implications for the inflation trajectory.”

“The future course of monetary policy will largely depend on incoming data on how macroeconomic conditions are evolving,” the statement added.

The central bank meanwhile kept the repo rate unchanged, while reducing Marginal Standing facility (MSF) rate (at which banks borrow from RBI beyond what is allowed under the repo window) by 25 bps to 6.5%.