Volatility in short-term rates should abate

With the 50 basis points increase in the reverse repo and 25 bps in the repo rate, the Reserve Bank of India (RBI) has further narrowed the gap in the rate corridor to 100 basis points, similar to what existed during early to mid- 2000.

The width between the key policy rates, as economists suggest, tend to remain broad during uncertain times. The narrowing of the gap indicates normalcy returning to the domestic economy.

In July, during the first quarter review of the monetary policy, the raise in reverse repo was double the repo one, which reduced the corridor to 125 bps. RBI had maintained a gap of 150 bps since November 2008, when a financial crisis engulfed the world.

On Thursday’s further narrowing is also seen to be reducing the volatility of short-term rates. “The asymmetric hike narrows the LAF (liquidity adjustment facility) corridor to 100 bps and will likely reduce the volatility in overnight rates. Short-end rates will likely be anchored at a higher rate,” said Rohini Malkani, economist, Citi India.

Economists say over the past month or so, liquidity in the system has fluctuated between excess and deficit, inducing volatility in overnight interest rates.

“We emphasise that the 50 bps hike in the reverse repo rate is aimed at reducing volatility at the short end of the curve and improving monetary policy transmission, and does not necessarily demonstrate an aggressive, tightening stance,” said Samiran Chakrabarty, regional head of research of Standard Chartered Bank.

Since the normalisation of the rate cycle, the repo and reverse repo rates have been raised by 125 bps and 175 bps, respectively. In the pre-crisis period, the repo and reverse repo stood at nine per cent and six per cent, respectively.

The central bank recently set up a committee to review its monetary policy operations, which will particularly focus on the rate corridor. Headed by RBI executive director Deepak Mohanty, it will examine, among other things, if there is need for an LAF corridor and if so, whether the width should be fixed or flexible.

LAF, introduced in June 2000, has emerged as the principal operating instrument for modulating short-term liquidity. Consequently, the repo and the reverse repo rates have become the key instruments for signaling policy stance.

“We have not determined what would be a comfortable corridor in an equilibrium situation. That is something the group will be looking at. In the future, a zero-width corridor is a distinct possibility,” RBI governor D Subbarao had said in July while announcing such a committee would be set up.