So, the mandarins in the Reserve Bank of India (RBI) met and took a decision on the interest rates. And the decision was to raise interest rates. Base interest rates are of two kinds – the Repo and the Reverse Repo.
The Repo is the interest rate charged by the RBI to banks and the Reverse repo is, as the name suggest, the rate charged by banks to lend to the RBI (YES, THAT HAPPENS TOO).
And this is the second time in three months that the interest rate has seen an upswing. The first hike was in June 2018 from 6.00% to 6.25% and now this hike of another 0.25% to 6.50%.
And that brings us to the issue of the day. The RBI said the move was to curb inflation. So how does the whole thing work?
The entire banking industry is working in the “fractional” mode, i.e. a fraction of the money received as a deposit, stays with the bank in a super safe system (CRR – Cash Reserve Ratio) and the rest is disbursed as lending to borrowers. This amount earns the money the bank uses to pay for the deposit as well as earn some profit for itself. Thus Rs 1,000 with a 10% CRR means the bank keeps a Rs 100 with them in the super safe mode and the rest 900 is given to lenders with a stated interest rate. This interest rate is popularly known as The Cost of Money.
Now when interest rate rises, the investors find that keeping money in interest bearing instruments like deposits have gotten more attractive than before. So, there is a flow of money into the banks and savings options which brings down the total liquidity in the system. Inflation is nothing but changes in prices over another period. And this is heavily influenced by the available money supply. The entire supply graph thus shifts down. Since liquidity or money supply comes down in totality, the available resources for making purchases come down. This brings down the demand. As demand shifts down, companies making and providing goods and services have little leeway to hike prices so that the consumers will be encouraged to buy. However, this further creates a vicious cycle where consumers think(hope) that prices will fall further and defer their purchases, thus depressing prices even more.
And what of the direct fallout of higher interest rates? As we all know, in today’s consumerist and credit driven world, most household purchases are bought on credit. Thus, when the benchmark interest rates are rising, forcing the hands of the banks to further increase rates, the net cost of ownership goes up. This, not only forces consumers to rethink their purchase decisions and maybe in some cases altogether cancel them. Imagine that I was on the verge of buying a house for Rs. 50 lacs, on loan. If my housing credit company hikes the cost of such borrowings (interest rate), then perhaps I will rethink on how and when to go about it.
Because of the hike in rates, the manufacturers also might defer their upgradation/increase in capacity addition. Thus, because of this, the unit costs might remain the same or perhaps might go up too. This will have an impact on the entry of goods and services into the market, thereby depressing the desire for customers to make purchases. It’s quite logical actually. Without newer things on shop shelves and store fronts, why should we go out and make any effort to buy?
Unless of course, these are of course staples that we cannot do without.
It is agreed among economists that the central bank with their monetary tools have a far superior handle to curb inflation, judiciously, then any fiscal step by the government. Thus, whenever inflation control becomes the issue at hand, the RBI comes in with their interest hike hammer to curb the demon.