The RBI has hiked the repo rate by 0.25 percentage point to 5.75 per cent and the reverse repo rate by 0.50 percentage point to 4.50 per cent.
The repo rate is the rate at which the central bank lends to banks while the reverse repo is the rate it pays to banks for parking funds with it.
The repo and reverse repo are supposed to indicate the ceiling and floor for short-term rates. In practice, however, market participants are not under any compulsion to abide by these rates, which are therefore called signals.
If liquidity is tight, the repo rate becomes significant while in times of abundance the reverse repo comes into play. The RBI's decision to ‘narrow the liquidity corridor' — the difference between the repo and reverse repo rates — is significant. The reverse repo has been hiked by a higher margin than the repo rate. Liquidity is tight at the moment. The reference point for banks would be the repo rate, the rate at which they can borrow.
The narrowing of the corridor is meant to bring about some stability in short-term rates. Of course, reverse repo rates will matter when liquidity improves. Other than the policy rate hikes, the other significant announcement relates to the stepping up of the frequency of monetary policy reviews. As against the present four, the RBI has scheduled eight statements. The additional four will be mid-quarterly reviews, roughly at intervals of one and a half months. This is an extremely significant announcement and is a big step forward towards demystifying monetary policy.
