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RBI’s Surprise Announcement to Conduct Open Market Operations Catches Bond Market Off-Guard
Introduction
- RBI recently announced plans to conduct open market operations (OMOs) to manage liquidity, surprising markets as it could reduce liquidity when liquidity usually rises around festivals.
The Reserve Bank of India (RBI) recently surprised markets by announcing plans to conduct open market operations (OMOs) to manage liquidity in the system. This move could potentially reduce liquidity at a time when liquidity usually rises due to the upcoming festival season. The announcement caught the bond market off-guard and prompted the benchmark 10-year bond yield to immediately shoot up by 12 basis points to 7.34%.
RBI’s stance has added a hawkish tint to monetary policy even though retail inflation in August was 6.83%, within RBI’s comfort band. The prospect of RBI sucking out excess liquidity through OMOs points towards a tightening bias to rein in inflationary pressures.
Sections | Details |
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RBI’s Perspective | RBI’s stance on liquidity has turned hawkish despite inflation being in target range. |
OMO Activities |
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Current Liquidity Situation |
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Future Indications |
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Reasons Behind RBI’s Move
Tightening Stance to Control Inflation
- Retail inflation rose to 7% in August, beyond RBI’s target range.
- RBI wants to tighten liquidity to control inflation and money supply.
Retail inflation has been elevated for most of 2023. The August reading of 7% exceeded RBI’s inflation target range of 2-6%. While RBI has so far focused on keeping inflation below the 6% upper tolerance limit, it now wants to proactively tighten policy to bring inflation closer to the 4% target.
RBI is concerned about large government borrowing and abundant liquidity fueling inflation pressures. It now wants to use liquidity management tools like OMO more actively to control money supply and inflation expectations.
Preparing for Liquidity Changes Ahead of Festive Season
- Liquidity usually tightens October onwards as government spending falls but currency demand rises for festivals.
- RBI preemptively tightening liquidity to avoid cash crunch later.
Liquidity in the banking system usually tightens during October-December due to seasonal rise in currency demand and slowing government expenditure. Even as advance tax outflows and GST payments have drained out liquidity over September, the upcoming festival season is expected to further withdraw liquidity from the system.
RBI’s plan to conduct OMO sales is a preemptive action to avoid a liquidity crunch later during peak festival season. It provides RBI a window to proactively manage liquidity through the year and avoid situations of excess or shortage of cash.
Explaining Open Market Operations
Definition
- RBI buys/sells government securities from/to banks to inject/reduce liquidity.
Open market operations (OMOs) refer to the buying and selling of government securities by the RBI from/to commercial banks. OMOs are used by RBI to manage rupee liquidity conditions in the market.
When RBI feels there is excess liquidity, it sells securities to suck out rupee liquidity from the system. Conversely, when liquidity conditions are tight, RBI buys securities to release liquidity into the system.
Impact on Liquidity and Bond Yields
- OMO purchase injects liquidity, lowers bond yields.
- OMO sale reduces liquidity, raises bond yields.
OMO purchases by RBI inject fresh liquidity into the banking system as it pays for securities by releasing money. This helps bring down interest rates in the economy. Bond yields fall as prices of securities rise due to RBI’s buying.
On the other hand, OMO sales absorb liquidity from the market. Bond yields rise as the increased supply of securities by RBI lowers their market prices. With reduced liquidity, banks demand higher yields on bonds.
Current Liquidity Conditions
- System liquidity in deficit due to tax outflows, high govt cash balance.
- But could improve with lower govt spending, reduced CRR.
- Though currency demand for festivals may offset liquidity growth.
In recent weeks, systemic liquidity has been in deficit due to quarterly tax outflows and high government cash balances with RBI. However, liquidity is expected to improve as government spending picks up in the second half of the fiscal year.
Further relief will come from the gradual rollback of the cash reserve ratio (CRR) hike announced in August. On the flip side, the upcoming festival season could lead to heightened currency demand and offset some of the incoming liquidity.
Final Thoughts
- RBI signally more active liquidity management to control inflation.
- OMO sales likely ahead to reduce liquidity preemptively.
- Bond yields expected to rise as additional securities supplied to market.
The RBI is signaling a more active stance towards liquidity management after a prolonged accommodative policy. Open market operations, both liquidity injection and absorption, will likely be deployed more frequently to align liquidity conditions with the inflation outlook. The central bank wants to preemptively tighten liquidity to retain control over money supply and inflation expectations. The bond market is anticipating OMO sales in the near term, which could further push up bond yields as additional securities are supplied to the market.