RBI panel for one policy rate to tame inflation, promote growth

A Reserve Bank working group today suggested that the short-term lending rate (repo) be made the single policy rate to signal the monetary policy stance, to effectively deal with inflation without hurting growth.

Mumbai: A Reserve Bank working group today suggested that the short-term lending rate (repo) be made the single policy rate to signal the monetary policy stance, to effectively deal with inflation without hurting growth.
At present, there are three rates -- repo, reverse repo and bank rate -- through which RBI injects or absorbs liquidity from the system.
The proposal is aimed at aligning the Indian monetary system with international best practices. RBI has invited comments from the stakeholders till March-end on the proposal.
"The repo rate should be the single policy rate to unambiguously signal the stance of monetary policy to achieve macroeconomic objectives of growth with price stability," the RBI working group said.

Under the proposed system, reverse repo and bank rate would adjust automatically with change in the repo rate, which would be announced by the RBI with a view to tame inflation and promote growth.

All the rates will operate within a corridor of 150 basis points, said the working group which was headed by RBI Executive Director Deepak Mohanty.

While the bank rate would be 50 basis points above the single policy rate (repo rate), reverse repo rate would be 100 basis points below it, the report said.

The panel further said that bank rate, which has remained dormant since April 2003, should be re-activitated as a monetary management instrument.

"The bank rate be activated as a discount rate with a spread over the repo rate. Once the policy rate changes, the Bank Rate should change automatically with a fixed spread over the repo rate", it added.

Bank rate is the rate at which banks can borrow long-term funds from the RBI to overcome liquidity shortage. Banks, however, have been borrowing mainly from repo window, which is a short-term instrument.

Currently, the repo rate is 6.5 percent, reverse repo (short-term borrowing) rate 5.5 percent and bank rate 6 percent. Although the RBI has raised key policy rates seven times since March 2010 to tame inflation, it has kept the bank rate unchanged since April 2003.

The methodology for RBI`s internal liquidity forecast should be strengthened, the report said.

It added that the information on government cash balances should be put in public domain with minimum time lag for better liquidity assessment by market participants.

The report further said, "Collateral pool for reverse repo operation under the Liquidity Adjustment Facility (LAF) could be extended to include oil bonds."

RBI holds Special Bonds including oil bonds, apart from government securities, in its portfolio. Oil bonds are treated as non-SLR securities.

With effect from July 27, 2010, government securities obtained under reverse repo are not reckoned for the purpose of SLR of banks.

Therefore, the collateral pool for reverse repo operation under the LAF could be extended to oil bonds issued by the Government to oil marketing companies and held by the central bank or any other security as notified by the RBI from time to time, the report said.

It also said LAF, with some modifications, should be the key element in the operating framework of the Reserve Bank.

The empirical exercise carried out by the Group found that the interest rate channel of monetary transmission has the strongest impact on the money market in the existing LAF framework.

"The modified LAF should operate in a deficit liquidity mode and the liquidity level should be contained around (+)/(-) one percent of net demand and time liabilities (NDTL) of banks for optimal monetary transmission," it said.

To make transmission of the monetary action swift, the report also suggested that the minimum level of reserves to be maintained on any day by banks with the RBI during a fortnight should be raised from 70 percent at present to 80 percent of the required cash reserve ratio (CRR).

CRR is the percentage of total deposits which banks have to keep with the Reserve Bank. This is direct tool to manage liquidity in the system.

RBI constituted the Working Group to review the framework of the operating procedure of monetary policy in India in the First Quarter Review of Monetary Policy for 2010-11 in July, 2010.