The Reserve Bank of India (RBI) plays a crucial role in the Indian economy by controlling the money supply through key tools such as the Repurchase Agreement (Repo) and Reverse Repo Agreement. Among recent developments, the State Bank of India has projected the arrival of a Reverse Repo Normalisation phase. This article aims to shed light on these prominent terms and discuss their significance in the monetary policy system.
Understanding Repo and Reverse Repo Rates
Repo rate refers to the rate at which the central bank of a country, in this case, the RBI, lends money to commercial banks during a shortfall of funds. During these transactions, the central bank purchases the security. On the other hand, the reverse repo rate is the interest rate that the RBI pays to the commercial banks when they deposit their surplus liquidity with the RBI.
In a healthy and growing economy, the repo rate becomes the benchmark interest rate as it is the lowest borrowing cost. This rate impacts all other interest rates in the economy including car loans, home loans, and interests earned on various deposits.
However, when there is excess liquidity in the market and banks shy away from lending due to a lack of genuine demand, the focus shifts from the repo rate to the reverse repo rate. Banks are more inclined to deposit their surplus liquidity with the RBI, making the reverse repo rate the new benchmark interest rate.
Reverse Repo Normalisation: An Overview
Reverse Repo Normalisation signifies an increase in reverse repo rates, possibly in one or two stages. With inflation on the rise, we have seen central banks worldwide escalating interest rates or hinting at this move shortly. India also anticipates the RBI to raise the repo rate. Before this, it is expected that the RBI will increase the reverse repo rate and narrow the gap between the two rates.
This normalisation process primarily targets inflation control. It will not only decrease excess liquidity but also lead to higher interest rates throughout the Indian economy. This, in turn, would reduce consumer demand for money (since saving would be more profitable) and amplify the cost for businesses seeking fresh loans.
Monetary Policy Normalisation Explained
The RBI consistently modifies the total amount of money circulating in the economy for its smooth functioning. When there is a need to stimulate economic activity, it adopts a ‘loose monetary policy.’ This policy comprises two aspects: injecting liquidity into the economy by purchasing government bonds and reducing the interest rate or repo rate charged on bank loans.
Both these actions work together to augment consumption and production in the economy. From a consumer perspective, it’s less beneficial to save money since interest rates are low—this encourages immediate consumption. For companies and entrepreneurs, borrowing becomes attractive due to lower interest rates.
The antithesis of a loose monetary policy is a ‘tight monetary policy’ which involves the RBI increasing interest rates and draining liquidity from the economy by selling bonds. When a loose monetary policy becomes counterproductive (such as leading to high inflation), the central bank ‘normalises the policy’ by adopting a tighter stance on monetary policies.
