Context: In a recent report, State Bank of India, which is the largest public sector bank in the country, has stated that the stage is set for a reverse repo normalisation.
About Monetary Policy Normalisation
The RBI keeps tweaking the total amount of money in the economy to ensure smooth functioning by two types of policies:
(I) Loose Monetary Policy

• As such, when the RBI wants to boost economic activity it adopts a so-called “loose monetary policy”.

There are two parts to such a policy

• RBI injects more money (liquidity) into the economy: It does so by buying government bonds from the market. As the RBI buys these bonds, it pays back money to the bondholders, thus injecting more money into the economy.
• RBI also lowers the interest rate: that it charges banks when it lends money to them; this rate is called the repo rate. Lower interest rates and more liquidity, together, are expected to boost both consumption and production in the economy.

(II) Tight Monetary Policy

• It involves the RBI raising interest rates and sucking liquidity out of the economy by selling bonds (and taking money out of the system).
• When any central bank finds that a loose monetary policy has started becoming counterproductive in reducing inflation, the central bank “normalises the policy” by tightening the monetary policy stance.

What is Reverse Repo?

• The reverse repo is the interest rate that the RBI pays to the commercial banks when they park their excess “liquidity” (money) with the RBI.
• The reverse repo, thus, is the exact opposite of the repo rate.
• Under normal a circumstance, that is when the economy is growing at a healthy pace, the repo rate becomes the benchmark interest rate in the economy.
• That’s because it is the lowest rate of interest at which funds can be borrowed.
• As such, the repo rate forms the floor interest rate for all other interest rates in the economy — be it the rate you pay for a car loan or a home loan or the interest you earn on your fixed deposit etc.

How does Reverse Repo fit into policy normalization?

• Imagine a scenario where the RBI pumps more and more liquidity into the market but there are no takers of fresh loans.
• This is because the banks are unwilling to lend or because there is no genuine demand for new loans in the economy.

In such a scenario, the action shifts from repo rate to reverse repo rate because banks are no longer interested in borrowing money from the RBI.

• Rather they are more interested in parking their excess liquidity with the RBI. And that is how the reverse repo becomes the actual benchmark interest rate in the economy.

What does reverse repo normalization mean?
Simply put, it means the reverse repo rates will go up.

• Over the past few months, in the face of rising inflation, several central banks across the world have either increased interest rates or signalled that they would do so soon.

In India, too, it is expected that the RBI will raise the repo rate.

• But before that, it is expected that the RBI will raise the reverse repo rate and reduce the gap between the two rates.
• In the immediate aftermath of Covid, RBI had increased this gap.

Implications of such policy

• Doing this will incentivise commercial banks to park excess funds with RBI, thus sucking some liquidity out of the system.
• The next step would be raising the repo rate.
• This process of normalisation, which is aimed at curbing inflation, will not only reduce excess liquidity but also result in higher interest rates across the board in the Indian economy.
• This will help reducing the demand for money among consumers (since it would make more sense to just keep the money in the bank) and making it costlier for businesses to borrow fresh loans.