There is more nuance now than ever before around interbank liquidity and how it impacts banks and markets. This follows the emergence of liquidity as the most important tool for the Reserve Bank of India to fight inflation ever since it stopped using interest rates as a tool.

But is the liquidity management giving the right cues to banks?

Interbank liquidity has been volatile in the past several months, and naturally, there is much confusion as to what policy signals it is emitting. The liquidity deficit had crossed ₹2.6 trillion, arguably the highest it has ever been if one goes with the net liquidity injection done by the RBI.

Does each time the weighted average call money rate rises to the Marginal Standing Facility rate of 6.75⁒ from the 6.50⁒ target as set by the policy repo rate indicate a de facto rate hike of 25 basis points? Or is the opposite true when the call rate slips below the repo rate?

The RBI, which had pledged to conduct open market operations to tighten liquidity, has tuned to injecting funds through variable rate repos this month. This has surprised markets as the RBI had in early December conducted variable rate reverse repos even when liquidity was tight.

How does one read that? Are liquidity operations a harbinger of an easing cycle?

Markets are, at times, quick to read deeper meanings even when there may be no depth on offer. Any deeper meaning will have to be read from factors driving liquidity in conjunction with the broader stance of the Reserve Bank of India's monetary policy. And, going by RBI Governor Shaktikanta Das's assertions, it does appear that RBI's stance will be to keep liquidity tight to keep inflation in check. It wants tightness to be contained but will not allow the balance to tilt.

Tight Liquidity

According to RBI data, it has net injected ₹2.6 trillion through its liquidity facilities, data showed Friday. This might be the highest ever.

According to RBI officials, liquidity injections have risen, and the overnight rates have touched the MSF rate of 6.75⁒ due to a frictional liquidity deficit caused by the government not spending the money it raised through tax collections or borrowings.

Earlier this month, Governor Shaktikanta Das said that liquidity was evening out due to a pickup in government spending.

However, as data showed, the RBI's liquidity infusion may be at an all-time high. Liquidity was in deficit for the first time in September 2023 after a gap of nearly four and a half years. The RBI had followed the system with liquidity to counter the economic impact of COVID-19 lockdown.

Apart from the build-up of the government cash balances, liquidity tightened also due to a rise in currency with the public during the festival season that began in October. Moreover, the RBI's interventions in the currency market also contributed to the tightness.

There also has been a paradoxical trend.

Some are seeking funds from the RBI via the MSF, and some are holding large balances under the Standing Deposit Facility with the RBI.

In order to enable better fund management by the banks, the RBI decided to allow the reversal of liquidity facilities under both the SDF and the MSF, even during weekends and holidays.

But Not Too Tight

December has seen the RBI conduct both variable rate repo as well as reverse repo operations.

What does it want?

The RBI wants liquidity to be restrictive but not too tight. As a policy, it wants overnight rates to hug the repo rate rather than the MSF or the SDF rates.

Deviations, if any, can only be temporary.

The RBI has conducted both variable repo and reverse repo operations to fine-tune liquidity. The RBI cannot do any better as it has no control over when and how the government will spend its money.

The RBI will drain out excess liquidity, but it does not want too much tightness or overnight rates above the MSF rates for too long. The RBI still believes that durable liquidity is in surplus. It is only a matter of time before government spending will flood the system.

The RBI will then again deploy variable rate reverse repo auctions and also act on its pledge to conduct open market operations.

"It would be wrong to assume that any kind of loosening et cetera is around the corner," Das said earlier this month about the stance of the monetary policy.

"That (loosening) is not on the table at the moment. Let me be very clear. It is not at all on the table. Look at the inflation numbers; look at the inflation trajectory. So, we still have a distance to cover."

The RBI is expected to keep liquidity on a tight leash. There may be no deeper meaning from its actions on liquidity till it decisively changes its stance to neutral.

And that is a possibility only in or after the April monetary policy review.