RBI Policy: Central bank is not done with tightening just yet

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This liquidity absorption would essentially work by improving transmission of previous rate increases, leading to some upward repricing pressure on both deposit and lending rates in the economy. Monetary policy tools do not work in silos and there are some externalities at play. Even as the primary
objective of OMO sales in this case is argued to be liquidity management, the nature of the tool would imply a significant impact on bond yields. The 10-year benchmark moved by almost 14bps post the policy announcement to 7.35 percent today. This follows a rather rangebound movement in Indian yields in comparison to global peers over the last two months. To recall, the US 10-year yield has risen by 70bps since August, while the Indian benchmark has moved up by just 20bps during this period.

Consequently, the nominal interest rate differential between US and India yield is now down to 260bps compared to almost 500bps in 2019. Furthermore, in real terms, using average projected inflation for
2023, the difference between US and India real yields is just about 50bps.

Fundamentally, this reducing “carry” has implications for foreign flows, puts pressure on the rupee, and squeezes dollar-rupee forward premiums. Therefore, a move up or firmness in domestic yields – a consequence of OMO sales -- could then work towards supporting financial stability and creating a defacto defence for the rupee going forward.

Then there is the question of the quantum of the OMO sales which would hinge on a few factors. For one, liquidity conditions tend to tighten in the second half of the year as currency in circulation (CIC) rises during the festive season. This year, election season could imply a further drag on liquidity. Trend analysis of the last five years shows that currency in circulation tends to rise by 2-3 percent between June and December each year. In a pre-election year, CIC increases by 15-20 percent compared to the previous year.

This would be liquidity draining. Moreover, with a rise in the dollar index and consequent pressure on the rupee, the RBI has been intervening by conducting dollar sales and absorbing rupee liquidity from the system. This could continue in the coming months as the US central bank has refrained from signalling an end to its inflation fight just yet – meaning the dollar index remains king. On the flipside, higher government spending, reversal of the ICRR and foreign flows (in Q4 FY24) in the run-up to the inclusion in the bond index could add to domestic liquidity.

The withdrawal of the Rs 2000 note alone is estimated to have increased system liquidity by close to Rs 1 lakh crore – assuming not all notes deposited have stayed in the banking system. The netting of these forces would determine the extent to which RBI conducts OMO sales so that liquidity conditions on balance remain tight.

If there was one message from this policy, it was that the central bank is not done with tightening just yet. Beyond the repo rate, it has alternate tools to reach its monetary policy goals and instill financial stability – for inflation, the rupee, and now bond yields.