Returning to normal

RBI starts taking liquidity measure back to July

The Reserve Bank of India (RBI) on Monday announced a reduction of the marginal standing facility (MSF) rate by 50 basis points to nine per cent. This is consistent with its intentions to return the liquidity adjustment facility (LAF) corridor to its pre-July 15 dimensions, where the MSF rate was 100 basis points above the repo rate and the reverse repo rate 100 basis points below it. On July 15, the MSF rate was raised by 200 basis points. The rate was reduced by 75 basis points on September 20, when the repo rate was also raised by 25 basis points. After Monday's action, the gap is now 150 basis points. This suggests that another reduction is on the cards, on or before the next quarterly policy review on October 29. This could be 50 basis points or less if the repo rate is raised again. Along with the rate action, term repos, which allow banks to borrow money for seven to 14 days rather than just overnight, were also announced as a way of further easing the extremely tight liquidity conditions. These are to be auctioned, so the effective rate is not yet known. But, as a result of all these measures, the overnight call rate will come down to at least the MSF rate; if the term repos receive a good response, it will come down even further.

While at one level, this can be seen as monetary easing, it is really only a normalisation of the liquidity situation from the "exceptional" measures that were taken during July-August. Part of the motivation for this is certainly that the rupee has stabilised within a relatively narrow range after having recovered about 10 per cent from its low. Consequently, those measures are no longer needed. It is not at all clear whether they actually helped to contain the downward spiral of the rupee; perhaps that question will never be answered. But, be that as it may, global developments have certainly helped the rupee to recover and stabilise. First, it was the US Federal Reserve Board's decision to delay its tapering; and then, more recently, the US government shutdown has pushed funds out of the US, causing the dollar to depreciate against virtually all currencies. All said and done, this is a good opportunity for the RBI to revert to a more conventional inflation management stance. And, on that, the best indication of future direction is the repo rate hike in September. The odds for October 29 are tilted towards more tightening. Once liquidity conditions - including the LAF corridor - return to normal, the repo rate will determine the call rate.

What is now uncertain is how the RBI will deal with future rupee instability. Clearly, the US government stalemate on expenditure and debt will not last forever. As soon as it is resolved, the dollar will also correct. Beyond that, the Fed's tapering will begin at some point. Both these point to some downward pressure on the rupee over the next few months. Is the main takeaway for the RBI from the experience with exceptional measures is that they may do more harm than good? If so, rate and liquidity actions will be driven entirely by the inflation trajectory. The "normal" for monetary policy appears to be more repo rate hikes.