Repo Rate Riddle: How RBI’s Monetary Policy Affects Your Life

On Wednesday, the Reserve Bank of India (RBI) held its monetary policy committee meeting and raised the repo rate, raised inflation projections and kept growth forecasts unchanged.

Announcements dominated the morning news cycle as such rate hikes, in addition to inflation and growth forecasts, impact our lives. And, sometimes, they impact us in more ways than we often notice.

Let’s unpack them one by one.

THE REPO ENIGMA

What is the repo rate?

The repo rate is the rate at which the RBI lends money to commercial banks. On Wednesday, the RBI raised its repo rate by 50 basis points to 4.9%. This is the second hike in two months. Previously, the RBI raised the rate from 4% to 4.4%.

So what Wednesday’s announcement means is that 4.9% is the new interest rate the RBI will now charge on money borrowed by commercial banks.

But why is the repo rate increased?

A country’s central bank, the RBI in India’s case, raises its repo rate to control inflation (we’ll discuss inflation in more detail later in the article). An increase in the repo rate discourages banks from borrowing from the RBI. Reducing the money supply in the economy helps control inflation. Because less money in circulation, for the same quantity of goods and services, lowers prices. And we save more.

A higher interest rate also means more investors are buying government bonds and interest rate products due to higher yields. And since more people can opt for fixed deposits, it also takes a bit more money out of circulation. The rupee is more in demand and its value will increase (we will also discuss the rupee issue shortly).

When is the repo rate reduced?

The RBI, which issues and regulates the currency, cuts the repo rate when it needs to pump more money into the market and support economic growth.

What’s the downside?

An increase in the repo rate makes government borrowing such as home and auto loans equivalent to monthly installments (EMI) more expensive as banks pass on the RBI repo rate hike when they lend you money. the money to buy a four-wheeler or an apartment. So even if you spend less on, say, tomatoes, you have more money deducted from your account through EMI to your bank.

There is also a reverse repo rate. Yes, but don’t get bogged down yet.

The reverse repo rate is simply the rate the RBI pays commercial banks to park their excess funds with the central bank. It is also part of monetary policy to regulate the flow of money in the market.

Before moving on to inflation, a question: Why is the repo rate called that?

The repo is used for a ‘call option’ or ‘call agreement’ between the banks and the RBI for the latter to lend them money.

NOW INFLATION

On Wednesday, the RBI raised its inflation projection for the current fiscal year to 6.7% from 5.7% forecast in April and 4.5% in February. The latest forecast is well above the RBI’s target range of 2-6%. In real terms, inflation hit an eight-year high of 7.79% in April.

It has been above 6% since January 2022. But what do all these numbers mean? Let’s break them down.

First of all, what is inflation?

Inflation is the rate of increase in the prices of goods and services consumed and purchased. The Mehngai Dayain we are rightly obsessed with, never tiring of talking about.

How is it calculated?

To monitor and calculate inflation, the authorities use the Consumer Food Price Index (CPI), which measures changes in the price of food consumed by a typical family in India. It gives an idea of ​​the increase in the cost of living.

So when you see an inflation figure like 6.7%, that means food prices are 6.7% higher, compared to a given period.

Is there an ideal inflation rate?

Low inflation is always better than runaway inflation, as any of us might imagine. And zero inflation sounds too good, but it could have consequences. For one thing, when prices don’t move, people put off buying. The economy is slowing down. We will also come back to this.

Then there are the dangers of deflation: The value of everything, wages, stocks, houses goes down. A recession is a logical outcome, and it is a disaster. To answer the question, the government has instructed the RBI to keep medium-term inflation at 4.4% (+/- 2%).

What causes inflation?

The Russian-Ukrainian war is an important factor. High crude oil prices not only mean that gasoline, diesel, CNG and cooking gas are more expensive, but it also means more expensive to transport commodities. All of this leads to inflation.

Next, we have a weakening Rupee against the US Dollar, which has been in high demand. Due to global uncertainties, the Rupee fell as foreign investors withdrew money from the stock and bond markets. A weakened rupee has reduced purchasing power. A falling rupee also makes your education abroad and travel more expensive because your fees and tickets cost more than the dollar value.

What else does inflation do?

Inflation depletes our foreign exchange reserves because we send more dollars on crude oil, which reduces our ability to import other goods we need. As we are an import-oriented country, this leads to fewer and more expensive foreign goods, and further weakening of the Rupee. If you shop, you spend more.

If you put the brakes on spending, it leads to lower demand for goods and services – activities like construction, manufacturing, and imports slow down. Companies can hire fewer employees. The global economy takes a hit. You feel the pinch of the rupee slide.

In other words, less manpower and machinery will be needed. The government will have a reduced ability to spend on building infrastructure and other social projects. If the government borrows too much to compensate for all this, international agencies can give the country bad marks. This makes subsequent borrowings more difficult. And investments are falling. This aggravates the jobs crisis. And we know that ordinary citizens are the most affected.

Wholesale price-based inflation has also remained in double digits for 13 months and hit a record high of 15.08% in April.

FINALLY, GROWTH FIGURES

On Wednesday, the RBI expected India’s GDP (gross domestic product) to grow by 7.2% this fiscal year, as previously forecast. In April, the RBI cut its economic growth forecast to 7.2% for 2022-23 from 7.8% earlier. In 2021-2022, India’s GDP growth was estimated at 8.7%.

GDP is nothing but a monetary measure of the market value of all final goods and services produced during a given period. It’s the whole economy.

A downgrade in growth projections, which happens often, means that core sectors, including agriculture, services and manufacturing, won’t do as well as expected.

In this scenario, we are back to the slowing economy. It’s a vicious circle, but it can be broken by, say, a good monsoon. And bumper crops.