Explained: What are repo rate, reverse repo and monetary policy

RBI Monetary Policy May 2022, Governor Shaktikanta Das
RBI governor Shaktikanta Das in Mumbai on Friday. (PTI PHOTO)(HT_PRINT)
RBI governor Shaktikanta Das in Mumbai on Friday. (PTI PHOTO)(HT_PRINT)
Updated on May 04, 2022 03:14 PM IST
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The Reserve Bank of India on Wednesday increased the repo rate by 40 basis points - setting it at 4.4 per cent in an unscheduled policy review meeting as it intensifies the battle against inflation levels that have outpaced expectations for much of the year so far. RBI governor Shaktikanta Das said global economic recovery seemed to be losing momentum and persistent inflation pressures were becoming more acute. As a result, he indicated, the central bank would withdraw an accomodative stance held for the past two years.

READ: RBI hikes repo rate by 40 bps to 4.0% with immediate effect - Governor

The bank's last rate review was on April 8 and the next wasn't till June 8.

The April monetary policy report - the first for FY 2022/23 - kept both repo and reverse repo unchanged at 4 per cent and 3.35 per cent.

READ: RBI holds key rates at record lows, ups inflation forecast

The surprise repo rate hike today also sent the markets crashing; the Sensex nosedived by 900 points and the Nifty fell below 16,800.

READ: Sensex nosedives over 900 points after RBI's surprise repo rate hike

Here is an explainer of some of the terms used by governor Shaktikanta Das.

What is the monetary policy?

Essentially the monetary policy is a collection of financial tools and measures available with the RBI (or the central bank of any country) to safeguard and promote economic growth. While there are other ways for central banks to do this, monetary policy reviews are among the most effective. 

Monetary policies basically control the overall supply of money available to commercial banks and, indirectly, to individual users and companies.

According to the RBI, the primary objective of a monetary policy is to maintain price stability while keeping in mind objective of growth. Price stability is a necessary precondition to sustainable growth, the RBI has noted on its website.

What is repo rate?

Repo rate is the interest charged by the RBI when commercial banks borrow from them by selling their securities to the central bank. Essentially it is the interest charged by the RBI when banks borrow from them - much like commercial banks charge you interest for a car loan or home loan.

What is reverse repo rate?

As the name suggests, this is the interest rate the RBI pays to commercial banks when they store excess cash reserves with the central bank. This is used by the RBI to control the flow of cash money in the economy. 

Basically this allows the RBI to 'mop up' excess cash money by making it more profitable for commercial banks to store cash reserves with the central bank.

Why is repo rate usually higher than reverse repo?

Like all banks, the RBI must earn more than it pays - this means the interest it charges the commercial banks is higher than the interest it pays out to the same banks.

READ: RBI keeps key lending rates unchanged, real GDP growth projected at 7.2%

Why are repo and reverse repo rates key?

They are essential to boosting credit and investments by businesses as the Indian economy pushes to emerge from the twin blows of the pandemic and the conflict in Ukraine. The Monetary Policy Committee's review of the economy is key to markets and general business sentiment.

The RBI uses repo and reverse repo rates to gently nudge interest rates offered throughout the banking sector and, therefore, the broader economy. 

For example, by reducing the repo rate (the rate at which borrows from commercial banks) it can encourage economic activity because it allows your bank to reduce the interest rate on business loans, car loans, home loans, etc., as well as savings interest rate. 

This encourages people to spend money because they see lesser value in keeping cash in the banks.

Reverse repo does the opposite - by incentivising commercial banks to store its reserves the RBI 'mops up' cash and increases interest rates for you. This encourages people to store rather than spend, and reduces the amount of cash in circulation and, thereby, also controls inflation.

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Tuesday, June 28, 2022