A lower interest rate doesn’t make a debt go away
In its second bi-monthly meet of the Monetary Policy Committee of The Reserve Bank of India (RBI), after four long years, increased the Repo Rate by 25 bps to 6.25%. Along with this, the reverse repo rate also increased to 6%.
Repo Rate is the rate at which the central bank lends money to the banks.
Reserve repo rate is the rate at which banks lend money to RBI.
The last hike in the rates happened in January 2014, when the rates went up from 7.75% to 8%. The increase in the rates officially marks the turn in the interest rate cycle, though the banks have been increasing the rate on deposits and loans since a few months now. Interest rates started decreasing since 2015 and the last cut in the interest rate was made in August 2017.
Changing the interest rate is a common monetary policy tool which is used by Central banks to curb inflation in the economy.
Whenever the central bank raises the rates, this hike gets transferred to the entire banking system as well. The Banks raise their interest rates both for lending and deposits making loans expensive for borrowers and deposits lucrative for the people who have excess cash. This discourages the lending process and helps to reduce the excess money supply in the economy.
Thus, the main objective of this hike is to keep Inflation in check.
Inflation is measured using the Consumer Price Index(CPI) in India which is the weighted average prices of a basket of goods and services. The changes in CPI over a period of time is used to calculate the level of inflation in the economy.
Consumer Price Index (CPI) has reached to 137.1 index points this April, and an increase in crude oil prices added to the inflationary pressures. Retail inflation observed a peak rise in the month of April to 4.6% as compared to 4.3% in the month of March. Core inflation, which includes essentials such as food and crude oil, was at a consistent high of 5.8% in April rising from a 5.23% in March.
The crude oil prices globally have also experienced volatility, which creates considerable uncertainty in relation to inflation increasing or decreasing.
Other factors that have contributed to this rise in the Repo Rate are exchange rate depreciation, uncertainty relating to the global financial markets and an increase in HRA by the state governments
The increase in the interest rate neutralizes a currency attack that could have taken place, which would have had negative consequences for the country that imports up to 80% of its crude oil requirements.
Also, higher policy rates could have a positive impact on fixed deposits. Interest rate of FDs with long-term tenure may reach in the range of 7.25%-7.5% within next 3-6 months.
The yield of a 10-year bond, a good indicator of the direction of long-term interest rate in the economy, went up from 7.834% on June 5 to 7.917% on June 6 after the RBI announcement.
The immediate increase in the Repo Rates would lead the banks to firm up on the interest rates. The banks have previously been increasing the lending as well as the borrowing rate, a very proactive behavior of the banks has been witnessed in the past in passing on rate hikes to the borrowers.
As an effect of the decision, some banks have recently increased the Marginal Cost of Fund Based lending (MCLR), which will result in the increase in the cost of borrowing.
For the fiscal year of 2018-19, the projections of CPI-based inflation for the first half is projected at 4.6% and GDP growth for 2018-19 is projected at 7.4%
The Indian banks are moving in the direction of other central banks that have raised their rates in preparation for accommodative policies of major central banks.
Indonesia and Philippines as an example have also increased their rates, so as to save the local currency and to be prepared against the outflow of foreign investments. This is a similar direction in which India is moving.
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