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RBI Rate Hike and Its Impact

Context:

In its bi-monthly review, the Reserve Bank of India hiked the repo rate by another 50 basis points. This move, and the RBI’s focus on the withdrawal of its accommodative policy, both in response to rising inflation, are expected to lead to a further rise in interest rates in the banking system.

Relevance:

GS III- Indian Economy

Dimensions of the Article:

  1. Why has RBI hiked the repo rate?
  2. How will it impact borrowers and depositors?
  3. What will be the impact of withdrawing the accommodative policy?
  4. Will consumer spending be impacted?
  5. Instruments of Monetary Policy
  6. About Monetary Policy Committee (MPC)

Why has RBI hiked the repo rate?

  • The 50-basis-point hike, which follows a 40-basis-point hike in May, has been done with a view to taming inflation.
  • Noting that headline inflation has risen by 170 bps between February and April 2022, the RBI has projected it at 7.5% in Q1 Of FY 22, 7.4% in Q2, 6.2% in Q3, and 5.8% in Q4, with a baseline inflation of 6.7% for 2022-23.
  • The RBI aims to bring inflation down to its targeted 4% (±2%).
    • The two hikes in repo rates over the last five weeks, totalling 90 bps, takes the rate to 4.9%.
  • Repo rate refers to the rate at which the RBI lends to commercial banks. When interest rates are raised, it makes money more expensive, thereby resulting in reduction of demand in the economy and bringing down inflation.
  • Even as it looks to support the economic recovery from the impact of the pandemic, RBI’s concerns around inflation has been the primary factor in raising the rates.

How will it impact borrowers and depositors?

  • While both borrowers and depositors are expected to see a hike in lending rates and offering on deposit rates, respectively, over the coming days and weeks, borrowers are likely to be impacted earlier.
  • Banks and housing finance companies, which have already raised their lending rates between 40 bps and 50 bps points following the 40 bps hike in repo rate in May, are now expected to raise the rates again.
  • If the 90-bps hike in repo rate raises the lending rate by 100 bps, it will have a significant impact on EMIs.
    • For example, if the rate on your home loan goes up by 100 basis points from 7% in April to 8% in the next couple of weeks, the EMI on principal outstanding of Rs 50 lakh for 15 years will go up from Rs 44,941 to Rs 47,782 — a jump of Rs 2,841 monthly if you keep the tenure unchanged.
    • Should the rates rise by 150 bps by the end of the year (which is expected given RBI’s enhanced concerns around inflation), the loan rate would go up to 9.5%, and the EMI for the the same loan to Rs 49,236 — an increase of Rs 4,295 per month.
So, more rate hikes are expected?
  • Given the RBI’s projected inflation of 6.7% for 2022-23 and enhanced concerns around it, market participants feel it may go for an additional hike of 50-100 bps over the remaining part of the year.
  • Indeed, RBI Governor has said future decision on rate hikes would be in line with developments around inflation.

What will be the impact of withdrawing the accommodative policy?

  • Interestingly, the RBI removed the word “accommodative” from the policy stance.
  • The RBI’s policy panel, chaired by the RBI Governor, has decided to remain focused on withdrawal of accommodation to ensure that inflation remains within the target.
  • The RBI had pumped huge liquidity into the system in 2020 to counter the impact of the pandemic.
  • While this did support econonic recovery, it has also been the main reason for the rise in inflation.
  • The RBI’s market operations had led to a decline in liquidity in May.
    • Still, overall system liquidity remains in large surplus, with the average daily absorption under the liquidity adjustment facility (LAF) moderating to Rs 5.5 lakh crore during May 4-31, from Rs 7.4 lakh crore during April 8-May 3, in consonance with the policy of gradual withdrawal of accommodation.
  • The withdrawal will also put upward pressure on interest rates.

Will consumer spending be impacted?

  • The policy withdrawal and the rate hike are expected to impact consumption and demand in the economy.
  • The impact is likely to be more pronounced in non-discretionary spending by consumers.
  • According to the RBI policy panel, the forecast of a normal monsoon should boost kharif sowing and agricultural output. This will support rural consumption.
  • The rebound in contact-intensive services is expected to sustain urban consumption.
  • RBI’s surveys suggest further improvement in consumer confidence and households’ optimism for the outlook a year ahead.

Instruments of Monetary Policy

There are several direct and indirect instruments that are used for implementing monetary policy.

  1. Repo Rate: The (fixed) interest rate at which the Reserve Bank provides overnight liquidity to banks against the collateral of government and other approved securities under the liquidity adjustment facility (LAF).
  2. Reverse Repo Rate: The (fixed) interest rate at which the Reserve Bank absorbs liquidity, on an overnight basis, from banks against the collateral of eligible government securities under the LAF.
  3. Liquidity Adjustment Facility (LAF): The LAF consists of overnight as well as term repo auctions. Progressively, the Reserve Bank has increased the proportion of liquidity injected under fine-tuning variable rate repo auctions of range of tenors. The aim of term repo is to help develop the inter-bank term money market, which in turn can set market based benchmarks for pricing of loans and deposits, and hence improve transmission of monetary policy. The Reserve Bank also conducts variable interest rate reverse repo auctions, as necessitated under the market conditions.
  4. Marginal Standing Facility (MSF): A facility under which scheduled commercial banks can borrow additional amount of overnight money from the Reserve Bank by dipping into their Statutory Liquidity Ratio (SLR) portfolio up to a limit at a penal rate of interest. This provides a safety valve against unanticipated liquidity shocks to the banking system.
  5. Corridor: The MSF rate and reverse repo rate determine the corridor for the daily movement in the weighted average call money rate.
  6. Bank Rate: It is the rate at which the Reserve Bank is ready to buy or rediscount bills of exchange or other commercial papers. The Bank Rate is published under Section 49 of the Reserve Bank of India Act, 1934. This rate has been aligned to the MSF rate and, therefore, changes automatically as and when the MSF rate changes alongside policy repo rate changes.
  7. Cash Reserve Ratio (CRR): The average daily balance that a bank is required to maintain with the Reserve Bank as a share of such per cent of its Net demand and time liabilities (NDTL) that the Reserve Bank may notify from time to time in the Gazette of India.
  8. Statutory Liquidity Ratio (SLR): The share of NDTL that a bank is required to maintain in safe and liquid assets, such as, unencumbered government securities, cash and gold. Changes in SLR often influence the availability of resources in the banking system for lending to the private sector.
  9. Open Market Operations (OMOs): These include both, outright purchase and sale of government securities, for injection and absorption of durable liquidity, respectively.
  10. Market Stabilisation Scheme (MSS): This instrument for monetary management was introduced in 2004. Surplus liquidity of a more enduring nature arising from large capital inflows is absorbed through sale of short-dated government securities and treasury bills. The cash so mobilised is held in a separate government account with the Reserve Bank.

About Monetary Policy Committee (MPC)

  • The Monetary Policy Committee (MPC) is the body of the RBI, headed by the Governor, responsible for taking the important monetary policy decisions about setting the repo rate.
  • Repo rate is ‘the policy instrument’ in monetary policy that helps to realize the set inflation target by the RBI (at present 4%).
Membership of the MPC
  • The Monetary Policy Committee (MPC) is formed under the RBI with six members.
  • Three of the members are from the RBI while the other three members are appointed by the government.
  • Members from the RBI are the Governor who is the chairman of the MPC, a Deputy Governor and one officer of the RBI.
  • The government members are appointed by the Centre on the recommendations of a search-cum-selection committee which is to be headed by the Cabinet Secretary.

Objectives of the MPC

Monetary Policy was implemented with an initiative to provide reasonable price stability, high employment, and a faster economic growth rate.

The major four objectives of the Monetary Policy are mentioned below:

  • To stabilize the business cycle.
  • To provide reasonable price stability.
  • To provide faster economic growth.
  • Exchange Rate Stability.

-Source: The Hindu, Indian Express


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