RBI hikes interest rate to fight inflation, as economy gathers steam

Prior to today’s policy review, the repo rate was 4.9 percent, jacked up from a pandemic-period low of 4 percent. Going into today’s review, the financial markets had already factored in a rate hike. What was not known was the extent; would it be a hike of 25 basis points (0.25 per cent) or 50 basis points (0.5 percent).

Another aspect was RBI’s “stance” on interest rate action. Broadly, there are three stances on future action: accommodative, which means supporting growth through lower interest rates, neutral, and hawkish, which means a preference for higher interest rates to contain inflation. In the previous policy review on 8 June 2022, the MPC changed its stance from accommodative to “withdrawal of accommodation,” because the economy has recovered from the pandemic.

Announcements

The repo rate was hiked 50 basis points (0.5 percent), from 4.9 to 5.4 per cent. The stance remains “withdrawal of accommodation”. Other variables which financial market participants look at are inflation and GDP growth. On these, RBI’s projections remain the same as earlier. Consumer Price Inflation (CPI) is projected at 6.7 percent in 2022-23, and the GDP is expected to grow at 7.2 percent.

Analysis

The fact that the 0.5 percent the rate hike is on the higher side of expectations means that the RBI is front-loading it. There is a time lag between central bank action and a change in bank lending and borrowing rates.

Front-loaded rate hikes imply that an increase later would not have been as effective. Also, the RBI seems to have moved closer to a neutral stance. Somewhere down the line, may be in the next review on 30 September 2022, they may formally embrace a neutral stance. However, another possibility is that it is a matter of nomenclature — this may be RBI’s version of neutral.

A neutral stance implies that interest rates would be balanced, high enough to contain inflation but low enough to support growth. For perspective, prior to the pandemic-period lows, the repo rate was 5.15 percent. At 5.4 percent, they have already crossed the 5.15 percent line and are focussed on fighting inflation.

Implications for your investments

The bond market had mostly priced in the interest rate action. Usually, when the RBI hikes rates, bond yields (interest rates) in the secondary market move up as a logical reaction. However, when market events are already priced in, the increase is not as much. Your debt fund investments are in bonds or other fixed income instruments. Since bond prices and yields move inversely, the immediate fallout is that the NAV takes a hit. Subsequent to today’s repo rate hike, the potential for a further drop in NAV over the remaining part of this rate hike cycle is low.

Over the past two years, while returns from debt funds have been muted, the Yield-to-Maturity (YTM) has moved up. YTM is the annualised return on the instrument if held till maturity. Higher YTM means higher accruals, which will lead to better returns over time.

For equity investments though, higher interest rates are not a positive. It shows that the RBI has the scope to hike rates as economic growth has gained traction. However, over a long holding period it should not matter.