SIMPLY PUT: How RBI’s Repo Rate Hikes Affect Consumers

India’s central bank Reserve Bank of India raised its repo rate for the second consecutive month, from 4.4% to 4.9% on Wednesday.

After a small jump in May by 40 basis points, RBI hiked the interest rate by another 50 basis in its bid to fight inflation.

For the month of April, the consumer price inflation touched 7.8%, burning a hole in common man’s pockets.

But why exactly is the Indian central bank hiking interest rates? How does it reduce the burden of expenses on common people like you and I? Let’s find out.

What is repo rate?

Before we dive into this, let’s understand what exactly repo rate is.

Repo rate stands for ‘repurchasing option or repurchase agreement.’ It is the rate at which commercial banks and financial institutions like SBI, ICICI Bank, HDFC Bank and others borrow money from the central bank.

Why is repo rate increased?

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.

Over the past three months, retail inflation numbers have remained above the RBI’s upper tolerance limit of 6%. The last time inflation was below 4% was before the global pandemic in 2019.

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.

In fact, RBI had not increased the repo rate for nearly 4 years until last month.

How a small increase in repo rate affects you

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.

A poll run by Stocktwits shows that banking stocks might also benefit from the hike in repo rate.

Ripple effects of hike in repo rate

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 (EMIs) 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 catalysed by the pandemic can potentially alter the growth trajectory in the medium-term.

Higher interest rates and inflation put the common man in a soup

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.

While the current repo rate of 4.9% is still not as high as the pre-pandemic level of 5.15%, the common man will feel the pinch because of higher consumer inflation.

If the inflation rate continues to increase despite the recent changes in repo rate, RBI will resort to hiking it again in a few months to keep inflation in check.