Estimating The ‘Shadow Policy Rate’ For India

The repo rate hasn't changed since August 2020. But financial conditions have been eased. What is India’s ‘Shadow Policy Rate’?

A commuter's shadow is cast on the ground. (Photographer: Brent Lewin/Bloomberg)
A commuter's shadow is cast on the ground. (Photographer: Brent Lewin/Bloomberg)

The severity of the pandemic shock to the economy forced the Reserve Bank of India to lean significantly on non-standard measures to deliver additional accommodation beyond conventional policy.

A menu of such measures, including long-term repo operations, targeted LTROs, ‘twist’ operations, purchases of state government bonds, and the government securities acquisition programme, were experimented with. The difference was that, in India, these measures were taken while we were still far away from zero lower bound, typically defined as the point when policy rates fall to zero.

Even as repo rate was cut to 4%, lower than post-global financial crisis low of 4.75%, the RBI wasn’t prepared for trade-offs associated with lower policy rate. And so, it took to non-standard measures.

Did the impact of these accumulate to significant easing nonetheless?

Mapping the impact of non-standard measures in terms of policy rate easing is an exercise fraught with wide error bands. However, such exercises have been conducted in developed markets and we borrow a construct from these economies to understand the impact of the RBI's unconventional measures.

We aim to construct a ‘shadow policy rate’ for India. This, basically, is a gauge that fluctuates not just because of the monetary policy tweaks to the repo rate, but also on account of RBI’s liquidity stance.
Estimating The ‘Shadow Policy Rate’ For India

The Realised Effective Policy Rate

First, extending our proprietary I-Sec PD Financial Conditions Index (I-Sec PD FCI), we construct a Monetary Policy Index, which is a weighted average of three variables closely linked with monetary policy:

  1. Repo rate

  2. Net deposits under RBI’s liquidity adjustment facility (to measure liquidity easing)

  3. Spread between weighted average overnight rate and repo rate (to measure impact of ‘stealth easing’).

As can be expected, MPI has drifted lower, suggesting further accommodation, even as policy rates have been flat for more than a year.

Next, we use the monetary policy index to calculate the ‘realised effective repo rate’. That is done by identifying the level of repo rate setting needed to achieve conditions similar to those reflected by the Monetary Policy Index, while holding the other two variables constant in line with averages during normal pre-crisis period.

This math reveals the rate to be as low as (-)0.7%, as of August, well below the repo rate of 4% and the reverse repo rate of 3.35%. This, then encapsulates significant accommodation delivered by RBI, on top of policy settings fixed by the MPC.
Estimating The ‘Shadow Policy Rate’ For India

Stealth Easing Vs. The Impact Of Liquidity

The above rate has to be unpacked further if one needs to judge the impact of liquidity easing measures alone. This is because India operates under a corridor rate system, booked-ended by the repo rate and the reverse repo rate. While the former is the benchmark policy rate, the latter becomes the effective policy rate when liquidity is in surplus.

Over the course of the Covid-19 crisis, the RBI has delivered ‘stealth easing’ by first cutting the reverse repo rate (which becomes the operative rate during surplus liquidity conditions) more sharply, and then allowing the weighted average overnight rate to dip further below that lower bound.

We wish to quantify this stealth easing, in order to further assess the impact of liquidity measures alone.

Accordingly, we subtract the spread between weighted average overnight rate and the repo rate (which is the component of stealth easing) from realised effective policy rate computed above.

After these adjustments, we arrive at a 0.2% rate, which we term as the ‘shadow policy rate’ for August.

The gap between the repo rate and the shadow policy rate turns out to be 3.8% and that could then be seen as a proxy for RBI’s liquidity easing.

It is also useful to compare the realised effective policy rate and the shadow policy rate in historical context. While the former is in-line with the period after the global financial crisis, the latter is far lower in the current cycle. Such an outcome, in turn, reflects the fact that liquidity spigots have been opened to a greater extent in current crisis, while stealth easing was more prevalent in the earlier cycle.

At its peak, liquidity being absorbed at the RBI's liquidity adjustment facility during the global financial crisis was just above 4% of deposits, compared to 5% now. This will likely rise further as record government cash balances may unwind over the coming months and add to liquidity surplus.

This time, the liquidity surplus also looks poised to persist for longer given high level of government deficits, implying that RBI’s work is cut out when it tries to normalise policy.

Lessons From The Exercise

It is precisely because the true accommodation of unconventional monetary policy is so large that the probability of an accident is high, if normalisation is pushed through without planning and preparation of markets.

We don’t claim that the solution is to delay any normalisation, rather that a large gap between the shadow policy rate and repo rate cannot be bridged rapidly but only in baby steps.

The first step in this process would be to stop active liquidity injection. However, liquidity easing undertaken by RBI is largely unplanned, unlike in case of developed market central banks pursuing quantitative easing or QE. Partly, it is a consequence of ‘impossible trilemma’. Significant current account surplus (or zero current account balance), an overvalued real effective exchange rate and strong capital flows have necessitated heavy intervention in forex markets.

Interestingly, between February 2020 and March 2021, liquidity injected through the forex intervention route more than fully accounted for the rise in ‘core (durable) liquidity’ in this period (~Rs 5 lakh crore).
Estimating The ‘Shadow Policy Rate’ For India

That is to say that even as RBI’s bond market interventions have been prominent, those have been comfortably overwhelmed by forex purchases, when viewed from prism of liquidity easing. This situation may endure.

While RBI may not be able to refrain from forex intervention it has to actively sterilise the same. A short-term solution is to intervene via the forwards market but a more durable solution has to be found in medium term.

There are no such complications about stopping outright bond purchases. The recent decision to pair G-SAP operation with sales of short-end securities is a pointer and we expect RBI to only undertake liquidity neutral operations in bond market in H2.

In the sequencing of events, the next simultaneous step would be to shift a major part of liquidity absorption into variable rate reverse repo auctions instead of fixed rate auctions. Again this has been evident in last few weeks and is likely to continue.

Such a mix of liquidity absorption will help RBI to enforce the floor of the interest rate corridor and limit any stealth easing.

The last step in normalisation will have to come through reverse repo hikes. When RBI narrows the corridor to 25 basis points much of the stealth easing would be unwound. With the first two steps already underway the final step can’t be too far away.

The key insight in our sequence is that active liquidity absorption should not be a part of early steps in normalisation. It is for this reason developed market central banks such as the U.S. Federal Reserve consider outright asset sales to shrink balance sheets only well after rate hike are underway.

Otherwise the transition from a low shadow policy rate or realised effective policy rate to the policy rate would be abrupt and could lead to financial accidents.

For RBI, the right approach would be to allow accommodative impact of liquidity to ebb passively, by stopping liquidity addition over time.


The ‘realised effective policy rate’ and ‘shadow policy rate’ measures help benchmark the quantum of total monetary policy accommodation.

While the effective policy rate i.e. reverse repo rate has been cut by 155 basis points during the pandemic, the total accommodation estimated on the basis of fall in real effective policy rate is 2.5x that value, at 390 basis points.

Benchmarking this not only helps understand the extent of easing but also the need for sequencing the exit from emergency monetary policy to normal monetary policy, and its timing.

As downside risks to growth dissipate with vaccination progress, core inflation stays high, and external environment looks set to turn less benign, it is important RBI calibrates monetary policy deftly to avoid the risk of falling behind the curve again like in the post-global financial crisis years.

A Prasanna is head of research at ICICI Securities PD. Abhishek Upadhyay is senior economist at ICICI Securities PD.

The views expressed here are those of the authors, and do not necessarily represent the views of BloombergQuint or its editorial team.