Inflation is a cause of concern, more so in a slow economy yet recovering from a pandemic. A sudden hike in RBI rates makes it the subject of drawing room and social media discussions everywhere.
I hear a lot of questions about repo rates, CRR and its linkage with inflation rate.
Let’s understand the basics of inflation economics and banking first.
Cash Reserve Ratio (CRR)
CRR is a percentage of total bank deposits to be placed in a current account with RBI. An increase in CRR means banks have less funds left for lending, and they do not earn any interest on CRR.
Statutory Liquidity Ratio (SLR)
SLR is the percentage of total bank deposits to be placed with RBI in the form of G-secs or gilt-edged securities. Banks earn prevailing market rates on the investment.
Why CRR & SLR?
RBI does not allow banks to lend 100% of deposits placed with them. It ensures that the depositors get their money back, even if there is a failure in repayment by borrowers.
It is an abbreviation for Repurchase Options rate.
Banks borrow money overnight from RBI at this rate, by placing securities (other than SLR requirements), and can repurchase the same on returning funds.
Banks link their loan interest rates to repo rates. It means interest rates on loans go up and down instantaneously with a change in repo rate.
Reverse Repo Rate
This is the rate at which RBI borrows money from banks.
A high reverse repo rate means banks find it attractive to place funds with RBI rather than lending in uncertain market conditions.
A low reverse repo rate means banks start lending more and it boosts the economy.
How does RBI control inflation rate?
Inflation is an increase in prices. We measure it in two ways.
1. Wholesale price inflation (WPI)
Wholesale price inflation is measured by prices of goods before they reach the retailer.
2. Consumer price inflation (CPI)
Consumer price inflation is measured by prices of food grains, commodities and fuel.
Prices increase if a lot of money is in circulation in the market and demand is high. This is what inflation is.
But what is the link between inflation and interest rates?
Sucking money out of the system leads to lower demand, and a consequent fall in prices.
RBI endeavors to contain demand-pull inflation by manipulating interest rates.
- Increase in CRR pulls money out of the banking system.
(It is an increase of 0.5% from 4% to 4.5% in the latest hike)
- Increase in repo rate will lead to increased rates of interest on bank deposits. It means people are incentivized to save more and spend less.
(Repo rate has been increased to 4.4% from 4% in the latest hike)
- Increased EMIs will lower spending.
- Banks will lend less money at a higher rate.
The multiplier effect of all the above factors lowers demand in an inflationary economy.
Does a rate hike by Fed impact inflation in India?
A hike in Fed rates in the USA causes withdrawal of foreign funds from Indian markets. We are seeing a volatility in stock market indices.
More so, it also causes the rupee to weaken against the dollar. It means that the country’s import bill and fuel bills go up causing an increase in prices.
Needless to say, that the RBI should attempt to contain the impact by managing policy rates.
How does it affect your household budget?
A drop in food and fuel prices will give some relief.
However, expenses on entertainment, eating out, travel, personal shopping and services are likely to remain the same.
Again, increased EMIs will tighten monthly budgets.
You need to make a higher provision for international travel and foreign education as the rupee depreciates.
Individuals need to manage debt better to lower the interest burden.
How does it affect your investments?
- Bank deposits will become more attractive. It is good for investors with a low to moderate risk appetite.
- Investments in large cap mutual funds will show good returns, as companies with low debt perform better.
- Returns on debt and gilt funds are likely to fall. However, it makes sense to exit only after completion of the cycle.
- Make investments in direct equity investments for the long-term. Short-term trading is not always lucrative in a fluctuating market.