Repo Rate (Policy Rate) and Reverse Repo Rate

Repo Rate and Reverse Repo Rate are the two most important short term quantitative credit control techniques adopted by the Reserve Bank of India, as the central bank of India. Quantitative credit controls are adopted by RBI to influence the volume of credit in market.  Both Repo Rate and reverse Repo rates were introduced consequent to financial sector reforms and as part of Liquidity Adjustment Facility (LAF).

What is Repo Rate (Policy Rate)?

Repo rate is the interest rate that is applicable for commercial banks when they borrow money from the central bank for short term.  In other words, Repo Rate is the rate at which the central banks lends money to commercial banks. The Repo rate was introduced in India in December 1992, as part financial sector reforms. In effect, when the Repo Rate is less, banks can borrow money from the central bank at low rate for on lending to customers. Repo rate is also known as Policy Rate.

What is Reverse Repo Rate?

Reverse Repo Rate, on the other hand,  is the rate offered by the central bank when the commercial banks  park their excess money with  the RBI. Reverse Repo Rate is thus the interest rate that the RBI extends to commercial banks for the excess money deposited with the central bank.   Reverse Repo Rate was introduced in November 1996.

What are the trends of Repo Rate and Reverse Repo Rate during periods of inflation?

One of the prime duties of the RBI is to maintain low and stable inflation. RBI ensures this by maintaining proper level of money supply in market. Both Repo Rate and Reverse repo Rates are important tools available with the RBI for this purpose. Normally, the central bank announces revision in these rates during monetary policy review.  At present, Reverse Repo Rate is fixed at 0.25 per cent (25 basis points) lesser than Repo Rate. During monetary policy review, the RBI announces revision in Repo Rate, if any,  and accordingly  the Reverse Repo Rate also varies automatically. Monetary policy reviews take place on bi-monthly basis.

One of the reasons for inflation is oversupply of money in the market. To control, the same,  during the periods of inflation RBI hikes Repo Rate. This hike gets reflected in Reverse Repo Rate too. When the Repo rate is high, the cost of borrowing by Banks from RBI increases and the cost of lending also increases. This makes borrowing from banks costly and money supply in market gets reduced.  In effect, excess liquidity in market is moped up by the central bank.
During the periods of deflation or when markets are facing shortage of money supply, RBI eases money supply by reducing Repo Rate.

When is policy rate transmission effective?

When the changes in policy rates gets reflected in the market in a speedy manner with similar change in bank  lending rate, the policy rate transmission is considered effective. But for various reasons, this transmission has not been happening. To address this issue, RBI over a period introduced different interest rate systems for arriving at credit interest rate. Prime Lending Rate (PLR) to Marginal Cost of Fund Based Lending Rate (MCLR) were the results of different attempts made by RBI. But, all these interest rate benchmarks, failed for one reason or other and RBI during the monetary Policy review of December 2018, suggested external benchmarking for arriving at the credit interest rate. Though banks were envisaged to shift to this regime by April 1, 2019 no final guidelines have been released by RBI so far and banks are continuing with the MCLR linked interest rates for lending.