There is a Buzz around Repo rate when RBI announces its Monetary Policy

By BWA Envoy
December 13, 2021
2 Minutes Read

Monetary policy refers to the use of monetary instruments under the control of the central bank to regulate magnitudes such as interest rates, money supply and availability of credit with a view to achieving the ultimate objective of economic policy.

What are - Repo Rate and Reverse Repo Rate (Five Rs!)

Repo rate is the interest rate at which the Reserve bank of India (RBI) lends to – banks, against the collateral of government and other approved securities (such as treasury bills or government bonds). In this case a repurchasing agreement is signed by both parties, stating that the securities will be repurchased at a predetermined price at a given date. Repo stands for ‘repurchase option’ or ‘repurchase agreement’. Currently the repo rate stands at 4%.

Reverse repo rate is the interest offered by RBI to banks who deposit funds with them. For example, when the banks generate excess funds, they may deposit it with RBI and earn interest on the same. Currently the reverse repo rate stands at 3.35%. Repo rate is always higher than reverse repo rate.

Repo rate is an effective and efficient tool used by the RBI under its Liquidity Adjustment Facility (LAF) window to manage liquidity in the system, inflation, and country’s money supply.

In the event of inflation, RBI increases repo rate as this acts as a disincentive for banks to borrow from the central bank. This in turn helps reducing the money supply in the economy and thus supports in arresting inflation. The central bank takes the contrary position in the event of a fall in inflationary pressures.

Current repo and reverse repo rates are respectively 4% and 3.35%. The MPC has been driving down the repo rate since January 2019, when the rate was at 6.5%. The rate had been cut to 5.15% by February 2020, around the time the Covid-19 pandemic struck. By May 2020, the MPC had cut the repo rate further by 115 basis points to an all-time low of 4%. Similarly, the reverse repo rate was also reduced from 6.25% during January 2019 to 3.35% by May 2020. Since then both the rates have been kept unchanged.

Repo Rate, interest rate and GDP - Relation

Changes in Repo rate have a strong influence on market interest rates and the economy. There is no direct and binding linkage between the Repo rates and banks’ lending or deposit rates but has a strong indirect influence. When repo rate is increased by the RBI, the banks have to pay more to borrow from RBI. Alternately, these banks would increase the interest on loans offered by them to the public. Thus, increase in Repo rate hamper demand for credit and restrain economic growth due to decrease in consumption resulting from lower money supply in the economy.

The interest rates may be lowered with repo rate cuts
When the RBI is lowering the Repo rate it is sending a strong and clear signal that the banks’ lending rates must go down. When the banks reduce the lending rates, it is called transmission of policy rate cuts. As a result, there is increase in lending, increase in money supply, increase in demand and resultant increase in GDP. But this also leads to inflation risks. Thus, the importance of monetary policy lies in setting the policy rates which influences aggregate demand – a key determinant of inflation and growth.