Wednesday, July 28, 2010

Tightening Monetary Policy: Repo and Reverse Repo

It was impending and is not taken as a surprise…when on 27th July 2010, RBI Governor, D. Subbarao announced the increase in Repo and Reverse Repo rates by 25 and 50 basis points respectively, making it to 5.75% and 4.5%. The hike in policy rates is done keeping in mind the food and non food inflation which is still in double digit at glaring 10.4%.However it is expected that monsoon will moderate the food prices and will help the inflation rate to come down. As a part of monetary tightening policy, increase in the interest rates will make the credit dearer, reduce the spending, thereby tightening the liquidity in the market. Apart from this, there is also narrowing of LAF (Liquidity Adjustment Facility) corridor to 125 bps.

LAF can be simply defined as gap between the repo and reverse repo rate incorporated in 2000.The broad objectives of LAF are:

• To give RBI greater flexibility in determining both the quantum of adjustment as also the rates by responding to the system on a daily basis.
• To help RBI ensure that the injected funds are being used to fund day-to-day liquidity mismatches and not to finance more permanent assets.
• To help RBI set a corridor for short-term rates, which should ideally be governed by the reverse-repo (top band), and repo (lower band) rates. This would impart greater stability in the markets.

The exact quantum of liquidity to be absorbed or injected and the accompanying repo and reverse repo rates are determined after taking into consideration, the liquidity conditions in the market, the interest rate situation and the stance of monetary policy. The decisions are based on a numerous factors including net inflows and outflows on account of forex operations, current account balances of the banks against the CRR requirements, open market operations, redemption of loans and coupon payments, announcement of new issues by the government, un-drawn liquidity support on account of export refinance, collateralized lending facility to banks.
D. Subbarao, in the disclosure also talked about the LAF to be narrowed to 125 bps thereby reducing the volatility.

However, the change in the rates had empirically no impact on the growing sectors, i.e auto and real estate immediately. It may be because the hike was an expected event or it may be just a short phenomenon.
The question which becomes pertinent here is the impact of hikes in the long run on the growth sectors and on the inflation. It is also expected that deposit and lending rates are next on the list. What will be its impact?


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