Reverse Repo Normalisation

In Context 

• State Bank of India believes the stage is set for a Reverse Repo Normalisation in India.

What does Reverse Repo Normalisation?

• It means the reverse repo rates will go up.
• Over the past few months, in the face of rising inflation, several central banks across the world have either increased interest rates or signalled that they would do so soon.
• In India, too, it is expected that the RBI will raise the repo rate. 
  • But before that, it is expected that the RBI will raise the reverse repo rate and reduce the gap between the two rates.
• Significance: 
  • The process of normalisation is aimed at curbing inflation.
  • It will reduce excess liquidity and also result in higher interest rates across the board in the Indian economy.
    •  Thus reducing the demand for money among consumers (since it would make more sense to just keep the money in the bank) and making it costlier for businesses to borrow fresh loans.

What is monetary policy normalisation?

• India’s central bank, the Reserve Bank of India, keeps tweaking the total amount of money in the economy to ensure smooth functioning. 
• As such, when the RBI wants to boost economic activity it adopts a so-called “loose monetary policy”. 
• There are two parts to such a policy.
  • The RBI injects more money (liquidity) into the economy. It does so by buying government bonds from the market. 
    • As the RBI buys these bonds, it pays back money to the bondholders, thus injecting more money into the economy.
  • The RBI also lowers the interest rate it charges banks when it lends money to them; this rate is called the repo rate.
    •  By lowering the interest rate at which it lends money to commercial banks, the RBI hopes that the commercial banks (and the rest of the banking system), in turn, will feel incentivised to lower interest rates. 
    • Lower interest rates and more liquidity, together, are expected to boost both consumption and production in the economy. 
    • For a consumer, it would now pay less to keep the money in the bank — thus it incentivises current consumption. For firms and entrepreneurs, it would make more sense to borrow money to start a new enterprise because interest rates are lower.

• The reverse of a loose monetary policy is a “tight monetary policy” and it involves the RBI raising interest rates and sucking liquidity out of the economy by selling bonds (and taking money out of the system).
  • When any central bank finds that a loose monetary policy has started becoming counterproductive (for example, when it leads to a higher inflation rate), the central bank “normalises the policy” by tightening the monetary policy stance.

Source: IE