RBI hikes repo rates for first time in Four years

(RBI 4th may 2022, monetary

policy statement,

https://rbidocs.rbi.org.in/rdocs/Pres
sRelease/PDFs/PR154MPC775AD
9D2A37141F7A6E64AC29BB8D2
C0.PDF)

The standing deposit facility (SDF)

rate is adjusted to 4.15 percent
and marginal standing facility
(MSF) rate and the Bank Rate to
4.65 percent.
● The RBI and the Monetary Policy Committee acted together in the
surprise move.
● The MPC raised the benchmark repo rate by 40 basis points for the
first time in four years. The last rate hike was in August 2018 during the
tenure of former governor Urjit Patel.
● RBI has undone about a third of the accommodation provided in
response to Covid, at least by way of lower repo rates.
● But the unscheduled action must be seen together with the scheduled
April move. Until then, the reverse repo rate of 3.35% was being seen
as the effective rate. Now the RBI has moved to the standing deposit
facility and the rate at this window is pegged at 25 basis points below
the repo rate. As such, the SDF rate is now at 4.15%.
● The RBI's off-cycle move(next meeting was actually due in June 2022)
also comes ahead of a widely-expected 50 basis points hike by the US
Federal Reserve later on Wednesday.
● In a recent research document called Report on Currency and Finance, the central bank had said that liquidity of
more than 1.5% of net demand or time liabilities, broadly bank deposits, is inflationary. At present the liquidity surplus
is a little more than 4% of NDTL.

● RBI has pulled out about Rs 87,000 crore or about 0.5% of NDTL(by CRR hike). Even after this there is a lot of
liquidity in the system and the RBI may choose to hike the CRR further at subsequent meetings.

● It’s clear the RBI wants to convey that the inflation situation is very serious. Hence the choice of a mid-cycle hike. RBI
wanted to make a point by announcing the hike mid-cycle.
● central bank is conveying its urgency of the surging inflation in several ways:

a. The timing- can’t wait till June. (seriousness)

b. The extent of the repo hike- 25 bps not enough, at least 40 bps needed bang in the first ball and (magnitude)

c. Rate hike isn’t enough, crunching the quantity of money was also needed; hence the 50 bps hike in the cash reserve ratio or
CRR to 4.5 percent. (immediate sucking up of money supply)

● The other reason for this unscheduled action by the RBI could be the central bank’s and the MPC's effort to show the Parliament that
they are doing their job, The inflation targeting Monetary Policy Framework, in vogue since 2016, requires the MPC and the RBI to
keep CPI at 4 percent, +/- 2 percent.

● That is CPI cannot go above 6 percent for three quarters in a row. By this measure, most definitely by September the MPC would
have failed this test and will have to write to Parliament explaining why it failed and what steps it has taken to remedy the failure. The
RBI and the MPC will now be able to explain to Parliament that they indeed have taken timely steps.
● CRR:

○ RBI mandates that banks store a proportion of their deposits in the form of cash so that the same can be
given to the bank’s customers if the need arises. The percentage of cash required to be kept in reserves,
vis-a-vis a bank’s total deposits, is called the Cash Reserve Ratio.
○ The cash reserve is either stored in the bank’s vault or is sent to the RBI. Banks do not get any interest on
the money that is with the RBI under the CRR requirements.
● There are two primary purposes of the Cash Reserve Ratio:

i. Since a part of the bank’s deposits is with the Reserve Bank of India, it ensures the security of the amount. It
makes it readily available when customers want their deposits back.
ii. Also, CRR helps in keeping inflation under control. At the time of high inflation in the economy, RBI increases the
CRR, so that banks need to keep more money in reserves so that they have less money to lend further.

● At the time of high inflation, the government needs to ensure that excess money is not available in the economy. To that extent,
RBI increases the Cash Reserve Ratio, and the amount of money that is available with the banks reduces. This curbs excess
flow of money in the economy. When the government needs to pump funds into the system, it lowers the CRR rate, which in turn,
helps the banks provide loans to a large number of businesses and industries for investment purposes. Lower CRR also boosts
the growth rate of the economy.

● CRR as the percentage of a bank’s deposits cannot be lent and has to keep idle as cash. CRR hikes, hence, have higher impact
because a bank’s cost of money immediately goes up, as it has to keep more cash idle. Also it has a multiplier impact as banks
have to keep an additional 0.5 percent of deposits idle on every new loan. So the net amount drained from the system is not just
Rs 87,000 crore but 2-3 times that number depending on loan growth.
● REPO Rate
○ When commercial banks are short on funds, they borrow money from central banks. The repo rate is the rate
at which the country’s central bank – the RBI in India – lends money to commercial banks.
○ Repo rates are increased by the RBI when there’s inflation. Raising the rates makes borrowing money from
the central bank more expensive.
○ Here, the central bank purchases the security.
 How Does the Repo Rate affect the Country’s Economy/money supply?

● Repo rate acts as a powerful tool that is used by RBI to regulate the money supply, liquidity, and inflation levels of the
country. The repo rate is directly proportional to the cost of borrowing for commercial banks. Higher the repo rate, the
higher will be the borrowing cost and vice versa.
● When there is a rise in inflation, RBI increases the repo rate to bring down the money flow in the economy. An
increased repo rate makes borrowing costly, thereby slowing down the investments and reducing the money flow
in the economy. Though it brings down inflation, increased repo rate leads to decreased growth of the economy.
● On the other hand, when RBI wants to enhance the cash flow into the economy, it reduces the repo rate and
increases the supply of money, which in turn boosts economic growth.
New Rates
Why has RBI hikes repo rate?

● RBI Governor rationalised the MPC's decision to hike the policy repo rate by highlighting the current global scenario, wherein
there has been a sharp rise in inflation due to current geopolitical tensions. Inflation has risen to its highest level in the last 3-4
decades in major economies with global crude oil prices remaining volatile and above USD 100 per barrel.
● The global food prices also touched a new record in March and have been up even further since then.
● There is also a shortage of products relevant to India such as edible oils that are inflation-sensitive due to the conflict in
Europe (russia-ukraine crisis)and export bans by key producers(indonesia).
● There has also been a spike in fertiliser prices and other input costs, which has a direct impact on food prices in India.
● The COVID-19 and lockdowns in major global production hubs (china) are likely to further increase the bottlenecks in the
global supply chain while suppressing growth.
● The global growth projections have been revised downwards by up to 100 basis points for this calendar year.
○ The International Monetary Fund (IMF) has revised down its forecast of global output growth for 2022 by 0.8
percentage point to 3.6 per cent, in a span of less than three months.
○ The World Trade Organization has scaled down projection of world trade growth for 2022 by 1.7 percentage points to 3.0
per cent.
● The RBI cautioned that the economy faces global spillovers risks from geopolitical tensions, elevated commodity prices and
moderating external demand.(export sector)
○ The RBI Governor noted that food Inflation is expected to remain high as spillovers from global wheat shortages are
impacting domestic wheat prices, even though domestic supplies remain comfortable .
● India’s retail inflation (as measured by CPI) indicates that the inflationary pressures can be attributed mainly to adverse
cost-push factors, coming from supply-side shocks in food and fuel prices, even as weak aggregate demand conditions
continued to exert downward pressure on inflation. The RBI statement thus cites food inflation as a major source of discomfort.
● Supply-side or not, inflation pressures are coming from everywhere. Food prices and fuel prices, in particular, are pushing
inflation prints into ugly territory.
● policy action is aimed at containing inflation spike and re-anchoring inflation expectation,” he(governor) said, adding that "high
inflation is known as detrimental to growth".
Why Now? Why not in the last review, as high Inflation (above 5%) has been there
since Nov 19.
● In the last MPC meeting, it was decided to stick to an
accommodative stance "while focussing on
withdrawal of accommodation to ensure that inflation
remains within the target going forward while
supporting growth".
● RBI Governor Shaktikanta Das said the decision was
taken in view of rising inflation, (CPI inflation rate
6.95%, source:NSO, Ministry of statistics and
programme implementation)
● Retail inflation hit nearly 7 per cent in March and
held above the upper end of the RBI's target band of
2-4 per cent for the third month in a row
● Inflation that has remained stubbornly above the
target of 6 per cent for the last three months
● The most interesting aspect of the rate hike is the continuation of the accommodative policy stance.by pledging to
remain accommodative to spur, and reinvigorate growth, it has reaffirmed its commitment to being a trusted partner in the
growth of the country.

● Why haven't the MPC members moved the stance to ‘neutral’?

○ An accommodative stance means the central bank is prepared to expand the money supply to boost economic
growth. The central bank, during an accommodative policy period, is willing to cut the interest rates. A rate hike is
ruled out (but here rate is hiked so it necessary highlight commitment to policy support to growth). The Reserve
Bank of India (RBI) has been on an accommodative stance for the last two years to support the economy
during the COVID-19 crisis.
○ The central bank typically adopts an accommodative policy when growth needs policy support and inflation is not
the immediate concern. So this tells that till now inflation targeting which is the main function of the RBI was
underplayed by RBI.
○ Accommodative meant that rates would only move down; neutral meant rates would stay unchanged or move
higher; a tightening stance would mean that rates would only move higher.
○ So a rate hike with an accommodative stance, is unusual.
● The only way to explain this is to speculate that the RBI and the MPC now see the stance as a reflection of the nature of
monetary policy relative to the economy,
○ In the current situation, despite the rate hike, real rates are negative and liquidity in ample surplus.
○ policy environment remains ‘accommodative while focusing on withdrawal of accommodation’ seems to be
message communicated with the stance.(slow withdrawal)
● The reality is that the tightening to fight inflation is coming against a weak economy. The RBI will need to keep an eye on
growth as well.
● The U.S. Federal Reserve’s expected tightening and the fear that India will be seen as behind the curve would have
played an equally large part.
○ The RBI has so far managed to keep the rupee stable by selling from its reserves.
○ Outflows could accelerate if interest rate differentials widen (between Fed and RBI) and if investors start viewing
emerging markets that are soft on inflation negatively.
○ For Indian companies, the fed rate hike and fund reduction are likely to impact the availability and cost of
overseas finance. Foreign portfolio flows into the Indian equity and bond markets could slow.it could also lead to
global funds pulling out money from Indian government securities.US rate hikes could propel other central banks
to take similar measures, which could hurt Indian market sentiments.
○ FPIs pulling money out of the equity and bond markets could weaken the rupee even as the dollar gets stronger
with the rate hikes.
Accommodative’ stance

An accommodative stance means the central bank is prepared to expand the money supply to boost economic growth. The central bank,
during an accommodative policy period, is willing to cut the interest rates. A rate hike is ruled out. The Reserve Bank of India (RBI) has
been on an accommodative stance for the last two years to support the economy during the COVID-19 crisis. The central bank typically
adopts an accommodative policy when growth needs policy support and inflation is not the immediate concern

‘Neutral’ stance

A ‘neutral stance’ suggests that the central bank can either cut rate or increase rate. This stance is typically adopted when the policy priority
is equal on both inflation and growth. During neutral policy, the central bank doesn’t commit to hike rates or cut. The interest rate can move
to either sides depending on incoming data. The guidance indicates that the market can expect a rate action on either way at any point.

‘Hawkish’ stance

A hawkish stance indicates that the central bank’s top priority is to keep the inflation low. During such a phase, the central bank is willing to
hike interest rates to curb money supply and thus reduce the demand. A hawkish policy also indicates tight monetary policy. A rate cut is
nearly certain during such a period. When the central bank increases rates or 'tighten' the monetary policy, banks too increase their rate of
interest on loans to end borrowers which, in turn, curbs demand in the financial system.

‘Calibrated tightening’

Yet another term, the central bank uses often is calibrated tightening. Calibrated tightening means during the current rate cycle, a cut in the
repo rate is off the table. But, the rate hike will happen in a calibrated manner. This means the central bank may not go for a rate increase in
every policy meeting but the overall policy stance is tilted towards a rate hike. This can happen outside the policy meetings as well if the
situation warrants.
So what’s the impact of the RBI hike?

● Firstly it won’t bring down inflation anytime soon, since much of the price rise in fuel and edible oils and dairy
products and wheat is supply driven. What the RBI's dramatic hike can do is to push up the cost of money and bring
down secondary price hikes caused by inflation expectations, though this will take a while to take effect.
● While the interest rates on term loans such as houses, cars, and personal among others - are seen to get higher
during a rate hike. This is the opposite for deposits as they seem to become attractive with interest rates getting
higher during rate hikes - giving hefty returns to depositors on their investments in traditional schemes, especially in
fixed deposits which are less riskier than compared to market instruments and also offer guaranteed returns.
● Any change in RBI's policy repo rate will have an impact on the lending and deposit rates of the bank. However, the
quantum and timing of passing on the policy repo changes depend upon the bank.
○ Short-term deposits – short and mid-term rates always rise quickest in response to any change in the interest
rate cycle.
○ Retail borrowing: Interest rates are likely to be higher for new borrowers. Existing borrowers with floating
interest rates will also be affected.
● By raising the repo rate, RBI hopes to incentivise the people to spend less and save more, thus cooling down demand in
the economy and by extension, prices.The latest surprise hike completely reverses the Covid-support off-cycle rate cut in
May 2020.

● move will raise borrowing costs for corporates and individuals, The increase in repo rate will push banks and non-banking
financial companies (NBFCs) to hike lending and deposit rates. This means the interest rates on loans will go up. Equated
monthly installments (EMIs) on home, vehicle, and other personal and corporate loans are likely to rise.

● As retail loans have increasingly been benchmarked to the external rate (mostly to RBI’s repo rate) with quarterly reset
clause, the loans benchmarked to the repo rate may increase in the range of 35-40 bps, passing on the hike in full, as
banks don’t keep a wider spread in retail loans to remain competitive in the market. As of December 2021, around 39.2 per
cent of the loans are benchmarked to external benchmarks, so the increase in repo rate will increase interest costs on
consumers and may impact them from the next quarter onwards.

● The MCLR (Marginal Cost of Funds based Lending Rate) linked loans have a share of around 53 per cent in the overall
loan kitty. With the rise in CRR and expected future hikes in the benchmark rates, there would be an increase in MCLR
due to a negative carry. Furthermore, if banks raise the deposit rates then the cost of funds will also increase and
subsequently the MCLR will increase too
● Markets crashed after the RBI hiked the repo rate. The Sensex slipped 1,307 points to close at 55,669 and Nifty settled at
16,678. Investors reportedly lost Rs 6.27 lakh crore because of the crash, reports The Times of India. All the sectoral indices
ended with sharp cuts especially the rate sensitive sectors – banks, realty and automobiles.
● But the crash is combination of reasons (global) such as
○ Russia-Ukraine war,(due to ongoing war, more EU embargo on russian gas and crude)
○ China's economic growth, (concern over rising Covid-19 cases in China, and the slower than expected pace of growth
of the Chinese economy.)
○ Experts feel the restrictions in China are likely to hurt global supply chains and that could further lead to rise in inflation,
which has already been impacted by the Russia-Ukraine war.
● US Federal Reserve rate hike.

○ expectations in the market that the US Fed may increase the pace of rate hike; instead of a 25 basis point hike, it
could even go for a 50-75 basis point hike, experts believe.

○ While the rate hikes were expected, a sharp increase could result in faster outflow of funds by foreign portfolio
investors, and could keep the emerging economy markets and the domestic equity markets under pressure.

○ To this extent, the decision by the RBI to frontload the rate hikes ahead of the Fed decision is again an
attempt to stem capital outflows.

● The amount of deposits banks are required to maintain a cash reserve by 50 bps to 4.5 per cent to suck out Rs 87,000 crore
of liquidity from the banking system.The CRR hike will be effective from May 21.

● Impounding bank reserves through the CRR (Rs 87,000 crore) could give some space to the central bank to conduct open
market purchases of bonds from banks and thus inject concomitant liquidity some time in the future if the need so arises.
Views of the some market experts

● Indranil Pan - Chief Economist, Yes Bank said, "The logical underpinning of RBI hike today and away from the regular policy
date is the rising concern on inflation – especially with regards to food. Food inflation, more than non-food inflation, can change
inflation expectations in India drastically. The governor pointed out that even as domestic supplies are healthy, global high wheat
prices are affecting domestic prices while edible oil prices have increased due to the ban on exports from Indonesia. Manufacturers
may also pass on higher input costs to end-users sooner than later. Thus, the crucial backing for the 40 bps hike came from an
understanding that inflation is here to stay. The timing of the hike is important too as it seems to just precede a likely 50-75 bps
increase in the policy rate by the US Fed. This is possibly to ensure that the INR is safe from any speculative attacks,
notwithstanding the LIC IPO, and especially as the FX reserves are down by around US30 bn from their peak levels. In this
financial year alone, India’s FOREX reserves are down by about $6.9 billion."

● Anjana Potti, Partner, J Sagar Associates (JSA) said, "The geopolitical situation caused by Russia's invasion of Ukraine is
weighing on all markets. Market watchers across the world have their eye on the US Federal Reserve which likely to announce a
decision to increase rates later tonight. Central banks in many countries are raising rates to counter the effects of inflation. These
costs of borrowing had fallen to record lows during the pandemic to bolster growth."
● Pradeep Multani, President at PHD Chamber of Commerce and Industry said, “Though RBI’s step is considered to address the
inflationary pressure, 40 bps hike in the repo rate and 50 bps hike in Cash Reserve Ratio (CRR) will hurt the consumer and business
sentiments. The economy is still recovering from the pandemic impact of Coronavirus, yet there are worries from geopolitical
developments, such as likely contagious impact on trade and finance.”

● VK Vijayakumar, Chief Investment Strategist at Geojit Financial Services said, “The MPC’s decision, in an unscheduled meeting,
to raise the repo rate by 40 bp and CRR by 50 bp is a surprise since it came on the LIC IPO opening date. MPC’s proactive move is
justified from the perspective of inflation management, but the timing leaves a lot to be desired. The above 1000-point crash in Sensex
has soured the sentiments on the opening day of India’s largest IPO. The 10-year bond yield has spiked to above 7.39% indicating an
imminent rise in the cost of funds”.

● Prasenjit Basu – Chief Economist, ICICI Securities said, "The persistence of high crude oil prices, and uncertainty over the length
of the Russia-Ukraine war, have resulted in sustained inflationary pressure globally. With the Chinese and Japanese currencies
depreciating 4% and 6% respectively last month, emerging market currencies are under pressure. Although the rupee has depreciated
only 1.1% in the past month, any further downward pressure on the rupee would spark greater worries about imported inflation, so a
timely rate hike was needed ahead of the inevitable US rate hike expected this week."
● Adhil Shetty, CEO at BankBazaar.com said, “The latest RBI’s move to increase the repo rate may come across as hard but not
unexpected as the inflation numbers were rising due to the third wave of the pandemic as well as the Russia-Ukraine war. The
impact of the rate hike would be felt across all categories of loans, both secured and unsecured. A 40 bps will pinch the borrowers
who will shell out more now for the equated monthly installments (EMIs). According to experts, close to 40% of loans are linked to
the external benchmark, and this increase will translate into a more expensive loan for new and existing borrowers alike in a very
short time. The existing borrowers will see their tenor go up. A home loan borrower with an outstanding principal of Rs.50L and
tenor of 20 years at 7% interest could see their tenor extend by approximately 18 months when interest moves up to 7.4%.
Borrowers who have taken MCLR-linked loans will also feel the pressure, though it may take a little longer until the borrowers’
loan reset before the new rates come into play for individual borrowers.”

● Ramani Sastri, Chairman & MD at Sterling Developers said, “The increase in repo rate will likely have an impact on the
industry as residential demand has been positively revived in the post-pandemic context and needs to be fostered. It also goes
without saying that the real estate industry’s perennial hope is fixed on lower interest rates as it improves affordability and also
provides the required fuel for the growth of the economy along with the real estate sector, which is allied with several other
industries.(real estate sector is linked cement, metal, heavy automobile sector growth) We remain positive and hope that the
government continues to provide the required support that the industry requires.”
What about growth?

● Economists worry that all rate hikes will dampen consumption and investment, albeit marginally. But this may not be the case in
the initial stages of the rate hiking cycle. In fact senior bankers point out that salaries are all set to rise at least 10 percent on an
average and much more for infotech jobs.
● As long as the rate of rise in EMI (equated monthly instalments) is less than the rate of salary hikes, loan demand is not
dampened.
● So chances are the growth in realty sales and home loan demand may continue.The infotech sector may likewise continue its
hiring spree given that the demand for digitalisation will be unaffected by the rate hikes.
Has RBI fallen behind the curve?(is the step taken too late?)

● Critics pointed out that this move came late and RBI has been underestimating inflation and repeatedly choose to ignore
the prices.

● There will be arguments that rates cut can do little to bring down food or fuel prices. Yet, higher rates, as the RBI has
argued in document after document over the years, can help reduce the second-round impact of these higher prices by
keeping inflation expectations in check.

● Inflation has been rising for over two years.:

○ By law RBI is supposed to target retail inflation at 4%, it allows RBI to vary by 2% points on either side so in a
particular month , the RBi could allow inflation to be 2% or 6%.

○ However the central point is that on the whole inflation should be around 4%. The leeway of 2% to 6% doesn't
mean that the RBI should allow inflation to stay at 6% all through. This is central to understanding how RBI has
been failing in its mandate.
● Since october 2019, there is only one month (feb 2021), where
retail inflation has been close to 4%. In all the other months,
even those of the nation wide covid lockdown in 2020, saw
inflation staying well above 4% and often above 6% mark.

● For the most part since october 2019, the RBI has very openly
given first preference to boosting the growth- by keeping interest
rates low- instead of controlling inflation. Choosing to prioritize
growth meant that inflation to stay high and hurt the poorest the
most, robbing poor and even middle class of their earnings and
even their savings.

● In its statement RBI has pointed to high crude oil prices in the
wake of the Ukraine war as one of the key reasons for high
inflation in India. But as eviden the high crude prices were
known to RBI in last two reviews but didn't choose to act upon.
● High core inflation:

○ Over the past year, as the headline retail inflation moderated a bit, the core inflation (inflation rate minus fuel and
food prices) had started going up.

○ Core inflation going up is more worrisome because it takes more time to both rise and fall. The prices of food and fuel
tend to fluctuate a lot, while core inflation moves up or down slowly. As such, if core inflation is at 6%. It should have,
perhaps, prompted policy action.

Headline and core Inflation

● Headline inflation refers to the change in value of all goods in the basket.
● Core inflation excludes food and fuel items from headline inflation.
● Since the prices of fuel and food items tend to fluctuate and create ‘noise’ in inflation computation, core inflation is
less volatile than headline inflation.
● In a developed economy, food & fuel account for 10-15% of the household consumption basket and in developing
economies it forms 30-40% of the basket.
● Headline inflation is more relevant for developing economies than developed economies.
● It is thought that as soon as RBI raises or reduces interest rates, the economy will respond immediately. But that
does not happen. While such monetary policy transmission has improved over the time yet it can take weeks to
have full effect.

● In other words if the RBI wanted to contain the inflation in may, it should have acted in February or at least in April.

● Raising rates now may not bring down the inflation rate immediately