This is the second instance of a repo rate cut since the announcement of the monetary and credit policy for the first half of 1998-99. On April 29, the RBI cut the repo rate from 7 per cent to 6 per cent.

RBI governor Bimal Jalan has been using the repo rate as the main instrument to signal interest rate movements. This is a sharp departure from the traditional stance when the bank rate and open market operations were used to signal rates.

The RBI has been using a combination of fixed rate repos as well as auctions making it the most potent weapon to regulate markets. "Interest rates will not rise after the repo rate cut. The overnight call rates are expected to headdownwards and the six-month annualised forward premiums will come down by 100-150 basis points from the existing level of 10 per cent," ICICI Bank's executive vice-president (treasury) PH Ravikumar said. According to him, the call rates will dip to the new floor rate of 5 per cent and bond prices are bound to go up. Forward premia has been on the rise as market players have been arbitraging between the overnight market and the forwards market, taking advantage of the low call rates. After the RBI issued a stern warning to banks to stay away from arbitraging, forwards are all set to dip. "The repo rate cut will only add to the realignment of the rate," a forex dealer said.

Hectic activities were witnessed in the government securities market and prices across all maturities moved up by 20 to 25 paise. According to dealers, the RBI wants to push interest rates downwards on short-dated papers. "By reducing the interest rate, the RBI has sent a signal to the market that it wants to lower the interest rates,"said PNB Gilts' vice-president Pradip Madhav.

Money market dealers said the call rates are likely to crash to 5 per cent level on Monday. On Saturday, the overnight call money rates moved in a narrow range. It opened at the repo level of 6 per cent and closed at 6.5 per cent with most deals struck in the range of 6-6.5 per cent.

Insight

The repo rate cut is yet another signal by the RBI that there is enough liquidity in the system, and that interest rates are headed downwards. The central bank's dilemma is to reconcile its concerns and the stability of the rupee with its determination to hold down interest rates.

The traditional way to defend a currency is by raising interest rates, as the RBI did in January. This time, however, the apex bank is keen to avoid doing the same thing, as the government wants to kickstart growth. To ensure that the lower interest rates do not lead to speculation against the rupee, the RBI has already warned banks not to arbitrage between the money and forex markets.