Rate rise by sleight of hand: Monetary Policy says bye to easy money

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RBI governor Shaktikanta Das is increasingly revealing himself as a master of the Panglossian spin. He has raised the base lending rate in the economy by 40 basis points, while seeming to hold the policy rate static: the repo rate stays at 4%, where it has been since the beginning of the pandemic.

When a magician makes some moves he does not want the audience to notice, he diverts attention — normally by turning the spotlight on some manoeuvres by his attractive assistant. Some such magic has been performed by the Monetary Policy Committee of the RBI. Nominally, it has kept the repo rate and the reverse repo rate untouched, at 4% and 3.35% respectively.

However, the reverse repo rate is no longer what it used to be. Its former function has been handed over to a new member of the monetary policy cast: the standing deposit facility (SDF) rate, which has been pegged at 3.75% — 40 basis points higher than the reverse repo rate when it used to serve as the base lending rate. So, effectively, the MPC has started tightening monetary policy, even while giving the impression to the general public that policy rates have been kept unchanged.

Accommodative, with a rider

The monetary policy stance stays accommodative, but with a rider. “The MPC also decided unanimously to remain accommodative while focussing on withdrawal of accommodation to ensure that inflation remains within the target going forward, while supporting growth”.

If you are an inflation hawk, you pick on this bone thrown at you: the policy stance is focused on withdrawing accommodation to stifle inflation, should it go out of hand. If you are an industry association seeking the oxygen of low interest rates and easy access to credit, as you struggle not to drown in a turbulent sea of rising commodity and energy prices and shrinking global growth, you can look at other items on the Panglossian smorgasbord: static repo and reverse repo rates, accommodative policy stance.

The repo rate has been static at 4% since the onset of the pandemic two years ago. The repo rate is the rate at which banks can get an overnight loan from the RBI. The reverse repo rate is, or used to be, the rate at which banks could deposit surplus funds at the RBI. It thus forms the zero-risk lending rate for a bank — after all, you face no risk of default when you lend to the central bank.

The rate at which a bank can borrow from the RBI has to be kept above the rate the bank can get on the money it lends to the RBI — otherwise all a bank needs to do to turn in a profit is to borrow from the RBI and lend the amount back to the RBI. The reverse repo rate serves as the minimum rate at which a bank would lend to anyone — even if you are an industrialist with a name that has three syllables and begins with an A, you carry some risk and, so, will bear a borrowing cost higher than the deposit rate offered by the RBI.

Lending rates

When the rate offered by the RBI for deposits goes up, the base lending rate goes up, and so will all other lending rates that are pegged higher, depending on the degree of risk attached to the borrower in question.

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The rate offered by the RBI for depositing money with it is now the SDF rate, no longer the reverse repo rate, or, to give the outcast its full name for an honourable exit, the fixed rate reverse repo rate. The RBI says it will retain the fixed rate reverse repo rate in its toolkit but the SDF rate will serve as the floor rate for the liquidity adjustment facility (LAF), the ceiling rate being the Marginal Standing Facility (MSF) rate, the rate at which a bank can borrow from the RBI over and above what it can borrow at the repo rate. The MSF is set at 25 basis points above the repo rate, and the SDF rate, 25 basis points below the repo rate. This restores the width of the policy interest rate corridor to the 50 basis points that had ruled before the pandemic.

Easy money to tide over the worst of the pandemic has resulted in a liquidity overhand of ₹8.5 lakh crore, says Governor Das. This money would gradually be sucked out of the system, making asset prices fall, using the variable-rate reverse repo auctions for variable terms. At the same time, money would not be lacking to finance growth, promises the Governor.

Being all possible things to all possible people is magic — or politics, in a more prosaic world.

The RBI strategem

So how do we assess the RBI’s attempts at magic/politics? Growth needs investment. Capacity utilisation of industry has gone up from pre-pandemic lows, but remains below 75%. Except in some sectors, industry is unlikely to add to capacity — unless they see demand being generated by an exogenous push.

Such a push is what the promise of stepped-up capital expenditure by the government represents. The RBI has introduced a stratagem of allowing banks to hold more bonds to maturity, hoping this would be an incentive for banks to invest in new issues of government bonds, to help finance the government’s borrowing programme.

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When bonds are held to maturity, these are exempt from being marked to the market. When interest rates go up, bond prices would fall, and bonds marked to the market would reflect a loss. If you cushion this by allowing a larger proportion of bonds to be exempt from being marked to the market, banks might be persuaded to invest more in fresh government bonds. Then, the government would be able to meet its stepped-up capital investment targets.

Supply side price shocks should not be choked off with higher policy rates. These need to filter through the economy, and force adjustments all along. The second-round price increases are the ones that have to be squeezed out with higher rates of interest. Some prices have already risen. The RBI’s timing of policy tightening cannot be faulted overmuch.

We might fault the RBI for its illusion of holding rates steady, possibly to soothe the nerves of stock market investors, even as it effectively raises rates, to keep the bond market viable. But it has to keep calibrating its policy response, to keep price rise reasonable while still making liquidity available to feed growth and maintaining financial stability.

Increasingly, the RBI is openly chasing its real, multiple goals, rather than obsessing over inflation alone. This is a good thing.

(TK Arun is a senior journalist based in Delhi)

(The Federal seeks to present views and opinions from all sides of the spectrum. The information, ideas or opinions in the articles are of the author and do not reflect the views of The Federal)