How RBI rate hike will tame inflation? Explained

RBI Rate Hike: Treating inflation is like treating cancer! Therefore, it is important to remember that the war against price hikes can never be over. In such a scenario, it becomes prudent to take steps to check the rising prices of services and goods and also maintain a balance between the demand and supply chain. The Reserve Bank of India (RBI) in a surprise move on Wednesday (May 4, 2022) announced to hike the repo rate by 40 basis points to 4.40 per cent, the first hike since August 2018. The decision was taken amid inflationary pressures and calls for policy tightening.

The repo rate is the rate at which the central bank lends funds to commercial banks to do business. The RBI has cut the repo rate by 250 basis points since February 2019 to help revive the demand. The six-member Monetary Policy Committee led by RBI Governor Shaktikanta Das during an unscheduled review meeting on Wednesday also hiked the cash reserve ratio by 50 basis points to 4.5 per cent which will suck out Rs 87,000 crore of liquidity from the banking system.

Das said that the decision was taken in order to contain inflation that has remained stubbornly above the central bank's target of 6 per cent for the last three months. India's retail inflation jumped to a 17-month high of 6.9 per cent in March from 6.7 per cent in February. The retail inflation in January 2022 was 6.1 per cent.

Russia-Ukraine War Effect

Here, it is important to understand that the present inflationary pressure is because of the global phenomena due to the Russia-Ukraine conflict that has affected the whole world. Das in his briefing too said that geopolitical tensions are pushing inflation higher in major economies besides the crude oil price also being volatile and above USD 100 per barrel, adding that the "global economic recovery is losing momentum". "Shortages, volatility in commodities and financial markets are becoming more acute," he said.

According to Das, the inflation print in April is also likely to be high. Experts say that it may touch 7.5 per cent in April, prompting the RBI to further tighten the policy rates. The next meeting of the MPC is scheduled during June 6-8.

Why Inflation Occurs 

In a progressive economy, a balance between demand and supply of essential goods and services is very much essential to control prices. When demand exceeds supply, people willfully pay extra for goods and services they can't delay, ignore, or don't have an easy substitute. On the other hand, inflation between 3 to 4 per cent (YoY) is considered ideal, but when inflation goes beyond 4.5 per cent, it affects the masses and people with low purchasing power suffer the most. 

Due to the rise in inflation, the government’s key focus shifts to controlling the price rise and it becomes inevitable to increase the repo rate and reduce the money supply in the market. In other words, inflation in an economy occurs due to increased spending by individuals and businesses and not a substantial increase in production or supply. When this happens, prices of goods and services are bound to rise. 

"Inflation can be increased in several ways which are mainly divided into two parts: demand pull and cash push. Demand factors arise from an increase in the demand for goods and services, whereas a price increase factor apparently arises from an increase in the price or a decrease in the supply of goods and services," Ravi Singh, vice president and head of Research, Share India, said. 

How Will Rate Hike Stabilize Inflation

People hit with higher prices might wonder how rate hikes will tame inflation. But increasing the repo rate is one of the most effective tools to battle inflation. Central banks increase the short-term borrowing rate for commercial banks and then these banks pass it to consumers and institutions. 

Notably, rate hike influences everything from interest on all types of loans (home, car, personal), credit cards, mortgages, thus making borrowing more expensive. The motto behind the rate hike is exactly this. When borrowing becomes expensive, eventually, consumers and businesses hold off their demands. This ultimately helps in cooling off the demand and bringing the prices of goods and services under control.

Ravi Singh said that post-pandemic, the government announced several fiscal reforms and kept the interest rate lower for the revival of the economy. This led to an increase in the liquidity and the purchasing power of the consumer. "Implementing the rate hikes is an effort to stabilize inflation. By increasing borrowing costs, rising interest rates discourage consumer and business spending and help in curbing inflation."

"Repo rate is an instrument to check and control the liquidity of the money in the economy. The Repo rate is indirectly proportional to liquidity. When the repo rate increases, liquidity decreases and vice-versa. On the other hand, high liquidity sometimes leads to an increase in retail inflation, especially when the demand for essential goods exceeds more than their supply," Rachit Chawla, founder and CEO of Finway FSC, said. "This influences or solves the supply chain problems that are pushing the prices up."

Impact on equity market 

But there is another aspect as well, he said, adding that this boosts rates on high-yield savings. "An increased repo rate makes business loans costlier for companies and they take a back step in their expansion strategies. This discouraging behaviour sometimes compels companies to postpone their growth plans, which negatively affects the prices of their shares in the stock market," he said.

"The surprise mid-cycle rate hike by the RBI is driven by factors such as inflation concern. The impact on the equity market is likely to be negative in the short term," Sujan Hajra, Chief Economist and Executive Director, Anand Rathi Shares and Stock Brokers, said.

"Investors are likely to feel the heat in the short term as central banks across the globe try to curb inflation by hiking interest rates," Prashanth Tapse, Vice President (Research), Mehta Equities, said.

Manoj Dalmia, founder and director, Proficient Equities, said that an increase in interest rate leads to a higher exchange rate. This helps in checking the inflationary pressure as imports become cheap and exports demand declines.

"Inflation can have a major impact on the value of a country’s currency and the rates of foreign exchanges. Lower interest rates increase consumer spending and economic growth having a positive effect on the rupee, but they do not attract foreign investment. A higher interest environment increases the value of a country's currency. A rising level of imports and a growing trade deficit can affect the country's currency. Usually, a weaker rupee will promote exports raising the demand and a stronger rupee will promote imports reducing the demand thus helping in controlling inflation," he explained.

Impact on real estate 

CREDAI's president Harsh Vardhan Patodia said that the low repo rates had given a boost to the real estate sector during the course of the pandemic.

"Raising of repo rate by RBI is a surprise for real estate industry given the inflationary trends. We are witnessing trends of growth momentum in the realty sector and developers have largely stayed resilient in the midst of challenges from the pandemic. Though this escalation will impact the buying power of consumers, we feel the impact will be taken in stride by the home buyers," he said.

LC Mittal, Director, Motia Group, said that the RBI's surprise rate hike suggests that the central bank wants to act quickly before inflation derails the growth recovery. He said there is no denying that the decision will impact the growth of the real estate industry. "But it will soon be balanced as the market is strong and resilient."

Anarock's Chairman Anuj Puri said this hike signals an imminent end to the all-time low interest regime. "Rising interest rates and inflationary trends in basic raw materials in construction including cement, steel, labour cost etc will add to the burden of the residential sector," he said, adding that this will ultimately impact overall acquisition cost for homebuyers and may dampen residential sales to some extent.

Amit Goyal, CEO, India Sotheby's International Realty, said this signals an end to the historical-low interest rates regime, as lending institutions will soon follow with increase in rates on deposits and loans.

"A rate hike of 25-50 bps may not make a dent in the demand, but over a period if rates move from 5% to 9%, it will definitely have an adverse impact on overall demand and hence inflation. Central bankers do not increase rates at one go, as it does not allow economic agents to adjust their expectations and actions," Sandeep Bagla, CEO, TRUST Mutual Fund, said.

Will Rate Hike Result in Economic Slowdown? 

But there could be a secondary effect of this. A sudden hike in the rates could create an imbalance between demand and supply and could quickly dampen the demand, therefore slowing down the economy. This could even lead to unemployment as businesses will stop hiring to keep themselves running. If the rate hike is overshoot, it could even make the situation worse and put the economy back into recession.

READ MORE: Home, auto loans EMIs set to go up after RBI's unscheduled interest rate hike | Details