Monday, August 2, 2010

I don’t understand you, so YOU must be confused.

Mythili Bhusnurmath thinks the RBI is confused. I think she is.

Let me elaborate.

Ms. Bhusnurmath believes the unequal change in the Reverse Repo and Repo Rates is a sign of RBI’s diffidence since it doesn’t give an unambiguous signal of the RBI’s intent to hike rates in the war against inflation. As I have mentioned in an earlier post (many posts, actually), the difference between the Reverse Repo and the Repo rate is potential volatility in overnight rates which, for the efficient transmission of monetary policy actions, needs to be kept at a minimum. A narrowing of the corridor was, and is, needed to impart a modicum of stability to overnight rates and taking it as a sign of anything else is a mistake.

The we have the statement that given the inflation environment, the RBI should be in liquidity absorption mode rather than liquidity injection mode. This implies utter confusion in Bhusnurmath’s mind on how the overnight markets actually function. The market’s need for liquidity is something the RBI does not control. At any given time, it exists regardless of RBI policy stance. What the RBI does control is the manner in which the liquidity is made available with the intention of influencing future need.

It can either maintain liquidity in excess of such requirements and absorb the excess every day by borrowing at the Reverse Repo rate. If the RBI wouldn’t borrow at this rate, there would be no takers for the excess, which would result in the overnight rate falling below the Reverse Repo rate. This is the liquidity absorption mode and the operative rate here is the rate at which the RBI borrows, the Reverse Repo Rate, which provides a floor to overnight rates.

The other way to provide the banking system with the required liquidity is called the liquidity injection mode. In this mode, market liquidity is maintained at a level short of system requirements and the RBI injects liquidity everyday by lending to banks at the Repo rate. If the RBI did not lend at this rate or if system liquidity requirements are greater than its capacity to borrow, the shortage of liquidity would drive rates up to levels beyond the Repo rate which is the operative rate in this mode and provides a ceiling to overnight rates.

The liquidity absorption mode is characterized by excess system liquidity which needs to be absorbed by the RBI at the lower of the two policy rates resulting in lower overnight rates. The liquidity injection mode is characterized by deficient system liquidity which needs to be injected by the RBI at the higher of the two policy rates resulting in, well, higher overnight rates. Bhusnurmath’s contention that the RBI should be in liquidity absorption mode to combat inflation more effectively, therefore, defies logic.

There is also the contention that the RBI should have hike rates more sharply but let’s look at reality. Ever since the RBI started hiking rates this year, the Reverse Repo rate has been increased by 1.25% and the Repo Rate by 1.00%. The RBI has also moved from liquidity absorption to liquidity injection. The combined impact has resulted in overnight rates rising from the Reverse Repo floor of 3.25% earlier to the Repo ceiling of 5.75% now, an increase of 2.50% in just 4 1/2 months. How much sharper do rate hikes get?

This is precisely the reason why the LAF corridor needs to be narrowed further. Despite the fact that the RBI has used the width of the corridor to its advantage and achieved an effective increase of 2.50% in overnight rates, for an observer, it has hiked rates its policy rates by merely 1.25%. This results in accusations that the RBI isn’t doing enough, when in reality, it has done a whole lot more. If the corridor had been narrower, the RBI would have had to actually hike rates by 2.50% to achieve a similar result, but since these hikes would have been explicit, unfounded accusations such as these would have been avoided.

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