Is India Heading towards a Rate Hike?

RBI –Reserve Bank of India is planning for next round of interest rate hike in the month of August. But there are no consensus on the size of the move given the absence of any clear guidance from the Apex Bank.

RBI and Rate Hikes

• If the RBI expects that inflation will rise beyond its tolerance limit, it hikes the rate at which banks borrow money from the central bank.
• When the repo rate increases, the cost of borrowing for banks also increases, which is passed to their account holders by increasing the interest rate on loans and deposit rates.
• This also makes borrowing money from the bank a costly affair, which in turn slows down investment and money supply in the market.
• As a result, it limits money supply and brings down the purchasing power of consumers, which helps in controlling inflation.
• The repo rate is reduced when the government intends to infuse money into the market and support economic growth, as it did during the lockdown.

How a small increase in repo rate effects?

• A small hike in repo rate makes borrowing from the commercial banks expensive. Home loan, vehicle loan, education loan, personal loan, business loan, credit cards, mortgages are all influenced by the rate hike.
• When the borrowing cost increases, the common man is discouraged from making unnecessary purchases, thereby reducing the demand for goods and services. This kicks off a chain reaction, leading to a reduction in prices and thereby, the inflation.
• This is simply a game of demand and supply, with the repo rate acting as a catalyst.
  On the other hand, people who have savings and have a fixed deposit, for example, will benefit from an increase in interest rates.
• When borrowing business loans becomes expensive, businesses either reduce or freeze hiring, leading to unemployment. Consumers also put a pause on buying all luxury items including vehicles, which affects the auto industry.
• The real estate sector, which was witnessing good pickup in sales due to the low cost of financing, could be impacted by RBI’s rate hike move. As banks increase their interest rate, it will result in a further rise in equated monthly instalments for existing borrowers and dent new homebuyer’s confidence.
• Low-interest rates are unlikely to come back as the Indian government predicts that the country’s economy will take at least 12 years to overcome the setback from Covid-19. It said that the ongoing structural changes catalyzed by the pandemic can potentially alter the growth trajectory in the medium-term.

What is Repo Rate ?

• Repo (Repurchase) rate is the rate at which the RBI lends shot-term money to the banks. When the repo rate increases borrowing from RBI becomes more expensive. 
• Therefore, we can say that in case,  RBI wants to make it more expensive for the banks to borrow money, it increases the repo rate; similarly, if it wants to make it cheaper for banks to borrow money, it reduces the repo rate.

Higher Inflation and Interest Rates Puts Common man in trouble

• The war in Ukraine significantly increased the common man’s woes. It elevated commodity prices due to geopolitical tension and affected the global supply-chain, tightening financial conditions globally.
• As a result, due to curbs on imports and high demand for essential commodities, everything from food and beverages to clothing and accessories is expensive today.
• The common people of India were already struggling to manage their daily expenses with limited purchasing power on a minimum wage.
• Due to this soaring inflation, consumers are further losing purchasing power, which is a measure of how many goods or services you can buy with a unit of currency, at a faster-than-usual rate.

Rate Hike in June 2022

• The Reserve Bank of India raised its key repo rate by 50 bps to 4.9% during its June meeting, after May’s surprise 40 bps off-cycle hike, surprising markets had forecast a 40 bps rate hike, aiming to ensure inflation remains within target going forward while supporting growth.
• The annual inflation accelerated to 7.79% in April of 2022, the highest since May of 2014, amid surging food prices. The central bank also raised both the standing deposit facility rate and the marginal standing facility (MSF) rate and the bank rate by 50 bps to 4.65% and 5.15%, respectively.

Rate Hike expected in August 2022

• The RBI acknowledged that inflationary pressures have intensified and have become more broad-based. There is a greater pass-through of input costs to product prices.
• In addition to goods inflation, services inflation is also picking up. The recent spike in tomato prices, revisions in electricity tariffs, and elevated commodity prices are also adding to the inflationary pressures. 
• Spillovers from global developments are still unfolding. The price of crude oil, after showing signs of easing, has again inched up to $120 per barrel.
• While the UN Food and Agriculture Organization’s (FAO) Food Price Index moderated in May, the cereal price index sub-component continued to escalate. The RBI noted that inflation will likely fall below the upper threshold of 6 per cent only by the end of the year.
• The RBI has projected inflation to decline from 7.4 per cent in the July-September quarter to 6.2 percent in the October-December quarter, and further to 5.8 percent in the January-March quarter. If inflationary pressures accentuate, there could be revisions to the inflation projections for the second half of the year.   
• Predictions from the 63 economists polled between July 25 and Aug. 1 ranged from a 25 basis point hike to one of 50 bps when the RBI meets on Aug. 5.
• Over 40% of economists, 26 of 63, expected the RBI to go for a hefty 50 bps hike, taking the repo rate to 5.40%. More than one-quarter of respondents, 20 of 63, forecast a smaller 35 bps hike. About 22%, 14 of 63, said 25 bps while the remaining three said 40 bps.
• A slim majority of economists, 35 of 63, saw the repo rate already reaching 5.75% or higher by end-year, up 10 bps from a July poll, while the median expectation is for at least 6% in the second quarter of next year. The RBI has raised rates twice so far in this cycle, first catching markets off guard with a 40 bps hike at an unscheduled meeting, followed by 50 bps in June.
• The RBI can always reduce the pace of rate hikes from September onwards if inflation and growth momentum softens, but we think it is a risky strategy at this stage to be an outlier in delivering less than 50 bps rate hikes.
• The outlook for next year was even less clear, with end-2023 forecasts ranging from 4.75% to 6.75%. With the RBI a relative laggard in the global tightening cycle, India has seen heavy capital outflows, which have helped drag the rupee to lifetime low close to 80 per U.S. dollar.
• With the dollar expected to remain strong in the short- to medium-term, the RBI has few options to defend the rupee without burning through foreign currency reserves. Just over half of respondents, 20 of 38, who answered an additional question said the exchange rate is playing a larger than normal role in the RBI’s interest rate deliberations.

Conclusion

• RBI only has the monetary tools to arrest demand by making money more expensive or by reducing its ssupply. So when it raises the repo rate it translates in to an increase in lending rates for borrowers.
• But, it does not have control over supply side issues that  also impact inflation. For instance, there has been a major .. disruption of supplies due to the ongoing Russia-Ukraine war, which has raised commodity prices of key items like crude .. oil and fertilizers.
• Supply shocks arising out the pandemic and the ongoing geo-political developments have been a cause of concern globally in case of India a significant part of inflation is imported and will require concerned effort to bring under control.
• While the RBI is clearly targeting inflation, on the regulatory side, there were a series of announcements that will have a positive impact on the housing sector as well as further encouraging the use of digital payments. Both the RBI and government were steadfast in their approach to support the economy through the challenging period of the pandemic.
• Due to these factors, we expect the RBI to increase the repo rate by another 75 bps this fiscal, and take it 50 bps above the pre-pandemic level. This will not, however, hit growth in the real economy with a lag in the current fiscal because as monetary policy impacts the real economy with a lag.