How does an increase in Repo rates by the RBI help control inflation

New Delhi: As expected, the Reserve Bank of India (RBI) raised its policy rate by 25 basis points (bps) to 6.5 per cent on February 08, 2023. Since May 2022, the RBI has raised repo rates by a total of 250 basis points for the sixth consecutive year in the current fiscal year, FY23, to combat inflation. The repo rate is the interest rate charged by the RBI to commercial banks when they borrow money from the RBI.

The Central Bank of India raised interest rates on Friday, effective 10 February. The mortgage interest rate increased from 8.35-9.10 per cent to 8.60-9.35 per cent. The decision to raise the policy rates indirectly affects interest rates on mortgages, car loans, etc. The increase will also directly affect bank depositors and borrowers as banks raise interest rates on consumer loans.

Meanwhile, interest rates on deposits remain unchanged, except for his 0.25 per cent rise in five-year deposits. A one-year deposit will accrue 7.75 per cent interest, while a three- and five-year deposit will accrue 7.50 per cent and 7.25 per cent respectively.

An increase in Repo rates by the Reserve Bank of India (RBI) can help control inflation through several channels:

Reducing money supply

When the RBI increases the Repo rate, it makes borrowing more expensive for banks. This, in turn, reduces the money supply in the economy as banks have less money to lend to businesses and individuals. A decrease in the money supply can help control inflation as there is less money chasing the same amount of goods and services, which can reduce the upward pressure on prices.

Decreasing demand

An increase in Repo rates can also increase the cost of borrowing for businesses and individuals, which can reduce demand for goods and services. If demand decreases, producers may reduce prices to attract buyers, which can help control inflation.

Strengthening the rupee

An increase in Repo rates can also attract foreign investors, who may be lured by higher interest rates. This can strengthen the rupee and make imports cheaper, which can also help control inflation.

The RBI remains committed to withdrawing adjustments to keep inflation within target while supporting growth. However, the Monetary Policy Committee (MPC) said stubborn core inflation remains a concern for India’s economic outlook, leaving the door open for future rate hikes.

RBI Governor Shaktikanta Das said efforts to bring down the Consumer Price Index (CPI) must be looked into. Breaking persistent core inflation is key to improving medium-term growth prospects, he added.

The RBI has revised its growth forecast for FY23 to seven per cent (previously 6.8 per cent) and inflation forecast to 6.5 per cent (previously 6.7 per cent). With GDP growth forecast at 6.4 per cent and CPI inflation at 5.3 per cent in FY24, risks are balanced on both sides.

In his speech, the RBI Governor explained that the outlook for the global economy is not as bleak as it was a few months ago. He said, “Growth prospects in major economies have improved, while inflation is on a descent though still remains well above target in major economies. The situation remains fluid and uncertain.”

In a rapidly changing global order, data-driven policy reassessments keep markets under constant tension, and markets continue to fluctuate with the timing and magnitude of policy turning points. Global tightening is still expected, but the prospect of a slower pace of rate hikes has eased some financial conditions. This suggests that Asia's emerging central banks, including the RBI, may be able to breathe a sigh of relief.

This 25-basis point increase makes the estimated one-year real repo rate most likely to turn positive (meaning a pause, but not necessarily the end of the cycle). While we do not believe the RBI will be overly hawkish, we believe that global conditions are volatile and that the macroeconomic outlook may necessitate future policy adjustments.

Interest rate hikes may increase the EMI burden on variable-rate loans. However, the bank's net interest margin (NIM) is likely to remain stable as the proportion of EBLR-linked loans increases. Moreover, a 25-basis point rate hike is expected to protect the rupee from further depreciation, thereby curbing import-led inflation and balancing internal and external factors towards sustained growth above 6.5 per cent next year.

Many experts suggested that the RBI's forecast that the current account deficit will weaken and remain within a manageable range in the second half of 2023 will support the currency and ensure a stable trade deficit. The RBI's decision to expand the scope of the accounts receivable discounting system “TReDS”. Also, it benefits SMEs in the export sector. This encourages the buyer to fund or discount the liability regardless of creditworthiness.

Excess liquidity may decrease somewhat when the pandemic facility expires, but they ensure that this is likely to be offset through the various tools at their disposal, compared to pre-pandemic levels. Although the comment that liquidity remains accommodative in the market suggests a somewhat hawkish tone, the RBI is expected to maintain a reasonable liquidity surplus to support the country’s future growth.