Repo rate riddle: How RBI's monetary policy impacts your lives

Repo rate, inflation & growth projections: Here’s how RBI's monetary policy impacts your lives in more ways than you quite notice.

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Reserve Bank of India (Photo: File)
Reserve Bank of India (Photo: File)

HIGHLIGHTS

  • RBI announced its monetary policy on Wednesday
  • The repo rate has been hiked and inflation projection raised
  • Here's how these numbers affect your life

The Reserve Bank of India (RBI) held its Monetary Policy Committee meeting and hiked the repo rate, raised inflation projection and kept growth forecast unchanged on Wednesday.

The announcements dominated the morning news cycle because such rate hikes, besides inflation and growth predictions, impact our lives. And, sometimes, they impact us in more ways than we often notice.

Let’s unpack them one by one.

THE REPO RIDDLE

What’s the repo rate?

Repo rate is the rate at which the RBI lends money to commercial banks. On Wednesday, the RBI hiked its repo rate by 50 basis points to 4.9 per cent. This is the second hike in two months. Earlier, the RBI had increased the rate from 4 per cent to 4.4 per cent.

So, what Wednesday’s announcement means is that 4.9 per cent is the new rate of interest the RBI will now charge on the cash borrowed by commercial banks.

But why is the repo rate hiked?

The central bank of a country, the RBI in India’s case, hikes its repo rate to control inflation (we will come back to inflation in greater detail later in the piece). An increased repo rate acts as a disincentive for banks to borrow from the RBI. Reduced money supply in the economy helps control inflation. Because less money in circulation, against the same quantum of goods and services, causes prices to cool. And we save more.

A higher interest rate also means more investors buy government bonds and interest-rate products because of higher returns. And since more people may opt for fixed deposits, this also takes out some more money from circulation. The Rupee is in greater 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 currency, reduces the repo rate when it needs to infuse more money into the market and support economic growth.

What’s the downside of it?

A repo rate increase makes public borrowings such as home and car loan Equated Monthly Installments (EMIs) costlier because banks pass on the RBI’s repo rate hike when they lend money to you to buy a four-wheeler or an apartment. So, while you may spend less on, say, tomatoes, you have more money deducted from your account by way of EMIs 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 to commercial banks to park their excess funds with the central bank. This is also part of the monetary policy to regulate money flow in the market.

Before we move to inflation, a question: Why is the repo rate called so?

Repo is used for ‘repurchasing option’ or ‘repurchase agreement’ between banks and the RBI for the latter to lend money to them.

NOW, INFLATION

On Wednesday, the RBI raised its inflation projection for the current fiscal year to 6.7 per cent, up from 5.7 per cent predicted in April and 4.5 per cent in February. The latest forecast is well above the RBI’s target range of 2-6 per cent. In actual terms, inflation was found to have surged to an eight-year high of 7.79 per cent in April.

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

First, what is inflation?

Inflation is the rate of increase in prices of goods and services consumed and bought. The Mehngai Dayain that we obsess over, and rightly so, never getting tired of cribbing about it.

How is it calculated?

To track and calculate inflation, authorities use the Consumer Food Price Index (CPI), which measures the change in the price of foods consumed by a typical family in India. It gives a sense of the increase in the cost of living.

So, when you see an inflation number like 6.7 per cent, what it means is food prices are 6.7 per cent higher, compared to a given time period.

Is there an ideal inflation rate?

Low inflation is always better than runaway inflation, as any of us would imagine. And zero inflation sounds too good, but it might have its consequences. For one, when prices don’t move, people postpone purchases. The economy slows. We will also come back to it.

Then there are dangers of deflation: The value of everything -- pay, stocks, homes -- declines. A recession is a logical result, and it is a catastrophe. To answer the question, the government has tasked the RBI to keep the mid-term inflation at four per cent (+/- 2 per cent).

What is causing inflation?

The Russia-Ukraine war is a significant factor. High crude oil prices not only mean costlier petrol, diesel, CNG and cooking gas, but transportation of essential commodities also costs more. All this leads to inflation.

Then we have a weakening of the Rupee against the US Dollar, whose demand has been high. As a result of global uncertainties, the Rupee has been falling due to foreign investors pulling out money from the stock and bond markets. A weakened Rupee has a reduced purchasing power. A falling Rupee also makes your overseas education and travel costlier because your fees and tickets cost more in line with the Dollar value.

What else does inflation do?

Inflation depletes our forex reserves because we’re sending out more dollars on crude oil, reducing our ability to import other goods that we need. As we’re an import-oriented country, this leads to fewer and costlier foreign goods, and a further weakening of the Rupee. If you shop, you spend more.

If you hold back spending, this causes demand for goods and services to go down -- activities like construction, manufacturing and imports slow. Companies can hire fewer employees. The overall economy takes a hit. You feel the pinch of the Rupee's slide.

In other words, less workforce and machinery will be needed. The government will have a reduced capacity to spend on infrastructure building and other welfare projects. If the government borrows too heavily to compensate for all this, international agencies may give the country bad ratings. This makes further borrowing trickier. And investment goes down. This deepens the jobs crisis. And we know that it’s the common citizens who are hit the most.

The wholesale price-based inflation has also remained in double digits for 13 months and touched a record high of 15.08 per cent in April.

FINALLY, GROWTH NUMBERS

On Wednesday, the RBI expected India’s GDP (Gross Domestic Product) to grow at 7.2 per cent this fiscal year, the same as previously forecast. In April, the RBI had cut its economic growth forecast to 7.2 per cent for 2022-23 from 7.8 per cent earlier. In 2021-22, India’s GDP growth was estimated at 8.7 per cent.

GDP is nothing but a monetary measure of the market value of all the final goods and services produced in a specific time period. That’s the entire economy.

A downward revision of growth projections, which often happens, means core sectors, including agriculture, services and manufacturing, won’t do as well as projected.

In that scenario, we're back to the economy's slowing down. It's a vicious cycle but it can be broken by, say, a good spell of monsoon. And bumper crops.