RBI's Increase in Repo Rate to Counter Inflation Pressure

RBI Will Keep Raising The Repo Rate To Counter Inflation Pressure 

Repo rate is the rate at which banks borrow funds from the Reserve Bank of India (RBI). The cost of funds for banks goes up when the repo rate is increased. The cost of borrowing for retail and other borrowers goes up after the repo rate is hiked by the RBI.

The RBI on 8th June raised its main policy rate or the Repo Rate — the rate at which it lends money to commercial banks — for the second time in over a month by an expected 50 basis points (bps) in its bid to tame runaway inflation. It is estimated by The Monetary Policy Committee (MPC) of the RBI that inflation rate will average 7.5% in the current April-June quarter. It has projected inflation to remain above its upper tolerance band of 6% through the first three quarters of FY22 (April-December 2022).

As per RBI a large part of the rise in inflation is primarily due to a series of supply shocks caused by the Ukraine-Russia war. 

RBI is optimistic of getting over inflation on the assumption of a normal monsoon in 2022 and average crude oil price (Indian basket) of $105 per barrel. Inflation based on the Consumer Price Index (CPI) was now projected by the RBI at 6.7% in 2022-23, with Q1 at 7.5%; Q2 at 7.4%; Q3 at 6.2%; and Q4 at 5.8%, with risks evenly balanced.

In reality the war in Europe is lingering and we are facing newer challenges each passing day which is accentuating the existing supply chain disruptions. As a result, food, energy and commodity prices remain elevated.

Countries across the world are facing severe inflation and persistent demand-supply imbalances. The war has led to globalisation of inflation.  

However, it has become necessary for the RBI and central banks all over the world to reorient and recalibrate their monetary policies.

The central bank, the RBI has now raised, in a matter of five weeks, the Repo rate by 90 basis points (including 50 bps last Wednesday) to 4.90 per cent. 40 bps was raised on 4th May. The rate hike will force banks and non-banking finance companies to increase lending rates and result in higher equated monthly instalments (EMIs) of existing borrowers. Thus the hike is set to raise the lending rates in the banking system and impact the demand in the economy. When interest rates are raised, it makes money more expensive, thereby resulting in reduction of demand in the economy and bringing down inflation.

To put it in short, RBI raises the repo rate or call it lending rate to commercial banks, to check demand and thereby allow inflation to recede. Less the demand less the pressure on inflation.

The RBI aims to bring inflation down to its targeted 4% (±2%). RBI is more concerned about dealing with inflation than its sole support for economic recovery from the impact of the pandemic. Therefore further raise in repo rates are likely to be announced by RBI in the months to come.

The borrowing rates have already been raised after hike of 40 bps in May, now borrowers and depositors are expected to see a further hike in lending rates and offering on deposit rates, respectively, over the coming days and weeks, due to RBI raising 50 bps last Wednesday. Borrowers are likely to be impacted earlier.

In today's context, for example, if the rate on your home loan goes up by 100 basis points your interest on borrowing is sure to jump from 7% in April to 8% in the next couple of weeks!!! 

Given the RBI’s projected inflation of 6.7% for 2022-23 and enhanced concerns around it, market participants feel it may go for an additional hike of 50-100 bps over the remaining part of the year.

In a report released after the RBI’s rate hike, Bank of Baroda expect another 50-75 bps rate hike in the current cycle. HSBC Global Research report has estimated that RBI may soon further hike repo rates by 60 bps. 

Should the rates rise by 150 bps by the end of the year (which is expected given RBI’s enhanced concerns around inflation), the loan rate would go up to 9.5%.

The RBI had pumped huge liquidity into the system in 2020 to counter the impact of the pandemic. While this did support economic recovery, it has also been the main reason for the rise in inflation.