Economists at DBS Bank and HSBC expect RBI's MPC to raise the repo rate by 25 basis points at its October meeting, with a second 25 bp hike projected for December, taking the repo rate to 5.75 per cent. Excess liquidity, which peaked near ₹10–11 lakh crore, has narrowed below ₹5 lakh crore after RBI used VRRR auctions, OMO sales, and FX swaps. CRR hikes and MSS issuance remain under active consideration to tighten conditions further.

This article captures a critical phase in RBI's monetary tightening cycle, where two distinct levers — the policy rate and liquidity management — are being deployed simultaneously. Understanding why both matter requires grasping the LAF corridor mechanics.

The repo rate is the rate at which RBI lends overnight to banks. When excess liquidity floods the banking system, the effective overnight rate (Weighted Average Call Rate, or WACR) drifts toward the reverse repo rate — the floor of the LAF corridor — rather than staying anchored to the repo rate. This weakens monetary policy transmission: even if RBI raises the repo rate, banks that are already flush with cheap funds may not fully transmit the rate signal to borrowers.

To fix this, RBI employs liquidity absorption tools: VRRR (Variable Rate Reverse Repo) auctions absorb surplus at a market-determined rate; OMO sales (selling government securities) permanently drain liquidity; FX spot/swap sales reduce rupee liquidity by selling dollars. The article notes that these operations brought surplus liquidity from ₹10–11 lakh crore down to below ₹5 lakh crore, pulling the WACR closer to the repo rate — a sign of improved transmission.

For the October MPC meeting, the concern is dual: inflation remains elevated, and excess liquidity itself has a modest positive relationship with core inflation (more money chasing goods). CRR hikes and MSS (Market Stabilisation Scheme) bonds are additional tools — CRR locks bank reserves with RBI, while MSS bonds sterilise liquidity more permanently. Aspirants must know the distinction between all these tools and when each is deployed.