RBI MPC keeps repo rate unchanged

RBI MPC keeps repo rate unchanged

Last updated: 09 Oct, 2020 | 07:41 am

RBI MPC keeps repo rate unchanged
  • The  RBI's Monetary Policy Committee (MPC) has kept the repo rate unchanged at 4% in its bi-monthly policy meeting held today. The reverse repo rate too stands unchanged at 3.35%. 
  • Repo rate is the rate at which the RBI lends to commercial banks, and reverse repo is the rate at which it borrows from them. 
  • The MPC also decided to continue with the accommodative stance as long as it is necessary to revive growth and mitigate the impact of COVID-19 on the economy while ensuring that inflation remains within the target going forward. 
  • RBI said that these decisions are in consonance with the objective of achieving the medium-term target for consumer price index (CPI) inflation of 4% within a band of +/- 2%; while supporting growth.
  • The latest MPC decision came even as CPI inflation continues to remain higher than RBI’s upper tolerance range of 6%. It has stayed stubbornly above 6 per cent, at 6.69 per cent in August and 6.73 per cent in July. 
  • Going forward, RBI expects CPI inflation to be around 6.8% for Q2:2020-21. The inflation is expected to ease in the second half of FY21 to about 4.5-5.4%.
  • “This policy decision by the RBI to keep rates unchanged remains in line with our assessment (published last month)  that we are nearing the bottom of a rate cut cycle although policy will remain dovish (low rates) in the medium term.”
  • RBI expects India’s FY21 real GDP to contract by 9.5%, with risks tilted to the downside

Additional steps by RBI

  • RBI has announced that it will conduct Open Market Operations worth ₹20,000 crore next week 
  • From December 2019  onwards, RBI has been conducting OMOs in which it is simultaneously selling short-term securities and buying long-term securities. 
  • Here, the objective of OMO has been to manage the yield curve (reduce the difference in short term and long term rates) rather than managing liquidity. 
  • RBI has also announced targeted long-term repo operation (TLTRO) worth ₹1 lakh crore, with tenors upto 3 years, at a floating rate linked to repo rate.

What is RBI trying to do?

  • By purchasing long term bonds through TLTRO’s, the RBI increases the demand for these and thus pushing up the prices which leads to a fall in yields and by selling short term securities, their prices fall, consequently raising their yields. 
  • This helps to flatten the curve by reducing the spread between long term and short term yields.
  • For the past few months, RBI has been extensively using Operation twist instead of direct OMO purchases to avoid adding more liquidity to the system which is already flush with liquidity after heavy liquidity pumping across Central Banks around the world.
  •  Inflation has been on a rise lately and is expected to shoot up over the next 2-3 years, thus limiting the RBI’s scope for further rate cuts, with less flexibility to use the interest rate mechanism RBI had to shift its focus on OMOs.
  • Flattening of the yield curve: Recent rate cuts have reduced the short term yields thus steepening the curve, a steep yield curve is not a good sign for the economy. The following chart shows how India’s yield curve has steepened over the last year.

 What’s happening in the current environment

  • Central Banks around the world are cutting interest rates to promote growth and liquidity. RBI has cut repo rate by 115 bps from 5.15% to 4% since January 2020. This is the lowest rate since 2000.
  • While the RBI has cut rates in the recent past increasing the availability of money in the economy, the effects of these cuts haven’t been felt to a large extent.
  • Despite the moves by RBI, banks have not been extending credit to the cash strapped economy. This is because of the heightened risk aversion by banks in lending, currently caused by a widespread disruption in the economy.

What can be expected going forward?

  • We are at the bottom of the rate cut cycle. Even if the economic pick up is slow, we don’t see rates falling by over 50 bps over the next 6 months.
  • Clearly the RBI has a problem of transmission. Rate cuts are having a limited impact in giving business and the economy a boost, since banks are unwilling to assume the credit risk in this choppy environment.
  • The government has resorted to a much needed Fiscal stimulus by schemes that directly put money in the hands of certain targeted sectors- Although much more is expected.
  • RBI is also implementing operation twists and open market operations to reduce the long term yields and speed up the effectiveness of transmission of rate cuts.
  • “The RBI remains constrained in its possible actions as rate cuts are having low impact on stimulating the economy while risk on impact to our currency remains high (lower interest rates lead to outflows from the country).”

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