“Economy does not lie in sparing money, but in spending it wisely”
-Thomas Henry Huxley
With just a single odd to five favors, The Monetary Policy Committee (MPC), on August 1, 2018, agreed to raise the Repo Rate* to 6.5% by 25 bps. This was the second consecutive hike within just two months, the former being raised after almost 4 years in the month of June this year.
The RBI adjusts this rate in its bi-monthly monetary policy, taking into consideration various factors that come into play. Except for the external member Mr. Ravindra Dholakia, the rest of the members in the MPC had voted FOR the hike.
*A repo rate is the rate at which central bank of a country lends money to commercial banks in the event of any shortfall of funds with the latter.
But What Prompted The MPC To Increase The Repo-rate?
“The main reason for increasing the repo rate is to maintain the 4 percent inflation target, a target from which we have been away for several months”, the RBI Governor Mr. Urjit Patel said as per Business Today.
MPC thus, maintained a neutral stance to achieve the medium-term target for inflation of 4 percent. The reason for rising in inflation is its dependence on Consumer Price Index( CPI**). Analysts have further ascertained few visible reasons for rising CPI.
- Minimum Support Prices might no longer be Minimum
Budget’18 brought with itself many inflation targeting policies. Ironically, the idea of increasing MSPs of Kharif crops to 1.5 times the cost of production was a direct hit to inflation acceleration. In the month of July, the Union cabinet approved to increase in the Minimum Support Price of paddy, thus fulfilling the promise of 150 % of the Production Cost as a return to the farmers. The cost is inclusive of all paid out costs which include the cost of material inputs, irrigation charges, hired labor, rent paid on land as well as the cost of family labor. A hike in the MSP of pulses and cotton was also observed. This is believed to be a historic move as it is the highest single year raise in MSP. However, an upward movement of inflation is expected out of this which compelled the RBI to hike the repo rate.
- OIL Price is still a concern
Even though crude oil witnessed a fall in its prices following the production increase by Russia in July and price cut by Saudi Arabia for its Asian customers, yet the market is volatile enough to generate turbulence in the Indian market. As India imports 80% of its total oil requirements from rest of the world and given the fact that oil is used as a raw material in the production of various products, a huge impact could be observed on domestic oil prices. For instance, pricing of petroleum products is now deregulated as the sector has been kept out of GST regime. The RBI had the projection of $68/barrel in April but the prices rose to $80/barrel.
Retail Prices Of Petrol And Diesel Alongwith Crude Oil
- The threat of Global Trade War
Earlier this year, the US and Europe got engaged in a trade war where the US had imposed duties and tariffs on the imports of steel and aluminum from Europe. On July 6, US President Donald Trump imposed tariffs on $34 billion worth of Chinese goods under his new tariff policy. This compelled China to respond with an introduction of similar tariffs on American products. A further increase in the import duties by the U.S is expected on 29 items such as walnuts, pulses etc in the upcoming months as well. Taking these events into consideration a situation of trade war is thus expected to emerge as many advanced economies such as China, Japan and Russia have retaliated to these protectionist measures. The threat is further escalated when we see individualism and protectionism dominating these economies.
The trade war situation will hamper the investments across borders. The threat of global trade war brings along with it an uncertainty in the markets and chances of upward inflation as the price of commodities that are circulated globally may rise.
**Consumer price index is a measure that examines the weighted average of prices of a basket of consumer goods and services. It is a measure of estimating the inflation rate at the consumer’s end.
Impact Of A Repo-rate Hike
- Deposit and lending rates
Higher repo rates will translate into higher deposit rates and loan rates. SBI had hiked its deposit rates by 5 to 10 bps. However, an anticipated macroeconomic policy always have a counteractive phenomenon ready for it beforehand. Lenders had already speculated this move, due to which lending rates have gone up manifolds. This would effectively mean higher EMI’s on Home loans, Personal loans, and car loans.
- Impact on Equity and Mutual Funds
From an investor’s point of view when interest rates rise, the risk-free returns go up as the government bond yield rises. Also, corporate bonds offer better returns when government yield increases. A risk-loving investor seeking higher returns thus choose equity in this period. As a result, the Mutual Fund AUMs grows at a tremendous pace. The investor with a risk appetite can continue to invest in equity with the expectation of above-average returns in the long-term.
- Effects on the economy
Many analysts believe that raising the repo rate was, in fact, a response to the global backdrop of FED’s rate policy and the fact that many emerging economies have already hiked their rates in order to defend their currencies. However, some believe that increased repo rates might create a vacuum in the growth story which is already struggling from the setback of demonetization and GST.
- Impact on debt funds
Yield and bond price are inversely related. Rising rate is a bad news for Debt Funds investors as net asset values of their bonds are at stake. Thus in such times, investors usually prefer short-term bonds over longer maturity bonds. Short-term debt funds are expected to deliver lower volatility and low risk in this scenario.
Categories: Story Of The Week