RBI’s Open Market Operation plan

Subject: Economy

Section: Monetary Policy

Context: RBI announces OMO plan, leaves markets surprised.

Key Points:

RBI on October 6th announced its plan to consider the Open Market Operation (OMO) sale of government securities to manage liquidity in the system. (When government securities are sold by the RBI, liquidity is sucked out.)
The move was not expected given that inflation is in the RBI’s comfort band of 4 ± 2%, and liquidity generally peaks around festival season.
This in turn caused the yield on the benchmark 10-year government bonds to shoot up by 12 basis points to 7.34 per cent as the market now anticipates an OMO shortly.
As the market expected bond supply to increase with the OMO, their prices fell (price and rate on a bond are inversely related). Alternatively in view of liquidity reducing after OMO, the interest rate on government bonds increased.

Why was the market surprised?

The announcement took the bond market by surprise as the central bank did not reveal any specific timeline for the proposal.
Though the retail inflation was at 6.83 per cent in August, the market was not expecting this measure from the RBI to suck out excess liquidity, adding a hawkish tint to the monetary policy.
Liquidity is expected to tighten due to cash withdrawal from the banking system due to the forthcoming festival season.
Historically, the October-May period is observed to have high cash withdrawals due to the festive and wedding seasons.
With absence of any near term liquidity risk, when will OMO begin is open to speculation in the bond market.

What’s OMO?

The RBI uses Open market operations (OMOs) in order to adjust the rupee liquidity conditions in the market on a durable basis.
When the Reserve Bank feels that there is excess liquidity in the market, it resorts to the sale of government securities, thereby sucking out the rupee liquidity.
Similarly, when the liquidity conditions are tight, the central bank buys securities from the market, thereby releasing liquidity into the market. It’s used as a tool to rein in inflation and money supply in the system.
However, when liquidity is sucked out, it can lead to a spike in bond yields as the RBI will release more government securities into the market and bond buyers demand more interest rate on these securities.

Why is RBI going for OMO?

RBI’s objective of anchoring inflation at 4 per cent. But after having elevated inflation levels for much of the year, now RBI’s approach is clear: merely keeping inflation below the upper band of the target range (at 6 per cent) is insufficient. RBi will try to bring the rate closer to 4%.