From UPSC perspective, the following things are important :
Prelims level : Liquidity Adjustment Framework
Mains level : Paper 3- Standing Deposit Facility
The first bi-monthly meeting of the Reserve Bank of India’s Monetary Policy Committee (MPC) for the current financial year reaffirmed its focus on inflation management.
Towards the normalisation of monetary policy
- The MPC voted to keep the policy rate unchanged at 4 per cent and retained its accommodative stance.
- However, the wording was changed to “remain accommodative while focusing on withdrawal of accommodation to ensure that inflation remains within the target going forward, while supporting growth.”
- This statement sets the stage for a shift to a neutral stance in the next meeting and policy rate hikes in subsequent meetings.
- RBI has announced the withdrawal of some of the steps taken during the pandemic to support the economy.
- These will foster the normalisation of monetary policy.
- The central bank has acknowledged that the disruptions caused by the Russia-Ukraine crisis have upended their growth and inflation outlook.
- It has steeply revised its inflation projection from 4.5 per cent earlier to 5.7 per cent now for the current financial year.
- The projection is based on an average global crude oil price of $100 per barrel.
- The Food and Agriculture Organisation’s (FAO’s) Food Price Index, a gauge of global food prices, posted a record growth of 12.6 per cent from February.
Formalisation of Liquidity Adjustment Framework (LAF)
- The RBI has been managing liquidity infused into the system during the pandemic through the Variable Rate Reverse Repo Auctions (VRRR) to withdraw liquidity and Variable Rate Repo auctions to inject liquidity.
- RBI has now formalised the Liquidity Adjustment Framework (LAF).
- The LAF is a framework to absorb and inject liquidity into the banking system.
- The LAF is now a symmetric corridor with a width of 50 basis points.
- The policy repo rate is at the centre of the corridor, with the MSF 25 basis points above the policy rate and the SDF 25 basis points below the policy rate.
What is a Standing Deposit Facility
- The RBI has introduced the Standing Deposit Facility (SDF) as the lower bound of the LAF corridor to absorb liquidity.
- The idea of the SDF was first mooted by the Urjit Patel Committee report on the monetary policy framework.
- The RBI Act was amended through the Finance Act of 2018 to allow RBI to use this instrument.
- The SDF will be a facility available to banks to park their funds.
- The SDF will serve as the standing liquidity absorption facility at the lower end of the LAF corridor.
- At the upper end of the corridor is the Marginal Standing Facility (MSF) to inject liquidity.
- Through the SDF, the RBI can absorb liquidity without placing government securities as collateral, hence it will give greater flexibility to the central bank.
- The change also marks a shift away from reverse repo being the effective policy rate.
- While on the face of it, there are no rate hikes, the shift from the reverse repo rate to the SDF signals a tightening of monetary policy.
- There is a 40 basis points increase in the floor rate.
- In the medium run, the call money rate would move towards the new LAF corridor, thus bringing orderly conditions in the money market.
- As RBI begins to normalise liquidity in a calibrated manner, its ability to manage bond yields will likely be limited.
- Yields on bonds are likely to inch up and remain above the 7 per cent mark.
- Going forward, the trade-off between managing inflation and the borrowing programme of the government will become challenging.
For now the RBI has rightly decided to place top priority on inflation management. This will help in maintaining the credibility of the inflation targeting framework.