In an unscheduled press conference on May 4, Reserve Bank of India (RBI) Governor Shaktikanta Das announced a 40 basis point hike in repo rate and 50 bp rise in cash reserve ratio (CRR). Repo is the rate at which the central bank lends short term funds to banks. CRR is the percentage of bank deposits that need to be parked with the central bank. Banks don't earn any interest on this.
Why the rate hike now? There is no clarity on why the RBI chose an off-cycle rate hike. We only know that inflation worries have returned strongly and the central bank probably believes that the inflation risk is higher than estimated earlier.
How big is the inflation problem? At 17-month high, the inflation data for March itself was a shocker. It came at close to seven percent (6.95 percent to be precise) versus 6.07 percent in February. This is the third consecutive month in which inflation has come in above the six percent upper bound of the RBI mandate, averaging 6.3 percent in January-March. As such, six percent-plus inflation in April-June and July-September will see the monetary policy committee (MPC) failing to meet its mandate. The RBI's latest forecast pegs average consumer price index (CPI) inflation at 6.3 percent in April-June and 5.8 percent in July-September.
If the MPC fails to meet its mandate, it owes an explanation to the Parliament. The only way the central bank has to fight inflation is make money costlier by hiking rates and tightening system liquidity. The idea is to bring down demand, which will in turn contain high prices.
The hurried, off-cycle rate hike shows the sense of urgency within the MPC to act against inflation. The panel probably believes that if it doesn’t act now, it will be tough to catch up. Couldn’t it have started the rate hike cycle earlier in small doses, instead of shocking markets with a sudden, major hike? Probably yes. There is a view that the MPC should have acted in April itself.
But even with this sudden move and probably a few more hikes, can the MPC tame inflation? One needs to wait and see. The efficiency of monetary policy is limited to act against supply-driven inflation or if the factors leading to inflation are beyond its control.
The 40 bp hike in repo has taken the key policy rate to 4.4 per cent. Most likely, we will see another repo rate hike in June of another 25 bps that will be followed by a few more hikes as the MPC strives to restore rates to pre-pandemic levels. Much of this will also depend on the inflation trajectory ahead. Rising prices, especially in essential items, can hurt the poor more and can drag the growth recovery even further.
Now, what does all this mean for the common man? The RBI move has started reflecting already with a host of banks increasing their lending and deposit rates a day after the announcement. Among the banks which increased lending rates are ICICI Bank which raised its external benchmark lending rate by 40 bps to 8.10 percent and Bank of Baroda also hiked the repo-linked lending rate by 40 bps to 6.90 percent.
Similarly, a clutch of banks have hiked their deposit rates as well including Bandhan Bank, Kotak Mahindra Bank, Jana Small Finance Bank, Bank of Baroda, and ICICI Bank.
To sum up, rising interest rates are both bad news and good news for customers. For borrowers, EMIs will become costlier as banks adjust rates while for depositors returns on their fixed deposits will be more, hence good news.
(Banking Central is a weekly column that keeps a close watch and connects the dots about the sector's most important events for readers.)
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