MUMBAI The Reserve Bank of India surprised markets on Thursday by raising a secondary rate while holding the key rate steady, a move to help mop up liquidity and signal its worries about a potential spike in inflation.
As widely expected, the RBI kept the repo rate at 6.25 percent, where it's been since October. But it raised the reverse repo rate - what banks get for deposits at the RBI - by 25 basis points to 6.00 percent.
Narrowing the gap between those two rates reduces volatility in short-term money market rates which track the difference between them.
Importantly, it also encourages banks to increase their deposits at the RBI, setting up the RBI to start withdrawing some of the big cash pile accumulated in the banking system since Prime Minister Narendra Modi in November banned circulation of big currency-notes.
"With inflation set to accelerate further, we think that hikes to the repo rate will come onto the agenda much sooner than is generally anticipated," said Capital Economics.
For sure, inflation is central to future monetary policy.
"Although we expect the RBI to remain on hold for some time, if domestic food prices increase on weak monsoons and/or oil prices spike up, we would expect the RBI to hike the repo rate to manage inflationary expectations," Quantum Debt Fund told clients.
Although Thursday's repo decision had been widely expected, the hike in the reverse repo marked a surprise, continuing a pattern of unexpected decisions at RBI meetings since Urjit Patel became governor in September.
In February, the central bank unexpectedly held the key rate, instead of cutting, and changed its policy stance to "neutral" from "accommodative", reasserting its concerns about inflation.
India's benchmark 10-year bond yield spiked 12 basis points, its biggest single-day rise since Feb. 8 when the RBI changed its stance, after the RBI held rates and signalled the cash draining moves.
Meanwhile the rupee strengthened to 64.52, its strongest level against the dollar in 20 months, from its 64.88 close after the RBI held rates, in line with other Asian central banks this month that have opted to do the same.
India's consumer inflation climbed to 3.65 percent in February from a year earlier, from its lowest levels in at least five years.
On Thursday, the RBI slightly raised its inflation projections for the year started in April, saying it expected the consumer price index to average 4.5 percent in the first half, from its previous forecast 4.0 to 4.5 percent, and then 5.0 percent in the second half, up from 4.5 to 5.0 percent.
That would place inflation above the RBI's 4 percent target.
"The MPC remains committed to bringing headline inflation closer to 4.0 per cent on a durable basis and in a calibrated manner," the RBI said.
The central bank is concerned that food prices could spike should India experience a below-average monsoon season this year. It is also monitoring core inflation, which has stubbornly stayed around 5 percent for several months.
As part of tackling inflation, the RBI pledged steps to drain liquidity, given cash in the banking system has soared to around 4 trillion rupees ($61.59 billion), doubling from January.
The RBI said it would consider measures such as additional treasury bill sales, outright open market operations bond sales, or a special facility that would allow the RBI to soak up the liquidity without collateral.
The central bank said it is "committed to reverting system liquidity to a position closer to neutrality, consistent with the stance of monetary policy."
(Reporting by Suvashree Dey Choudhury and Rafael Nam; Editing by Richard Borsuk)