Will RBI Be Able To Tame Inflation By Making Your EMIs Expensive?

The Reserve Bank of India (RBI) on Wednesday hiked its key interest rate (repo rate) by 50 basis points (bps), in a bid to tame rising inflation. The repo rate – the rate at which the RBI lends to commercial banks – now stands at 4.9 per cent. The decision taken unanimously by the RBI Governor Shaktikanta Das-led Monetary Policy Committee (MPC) is aimed at reigning in inflation that has remained stubbornly above the central bank’s tolerance limit for the past several months.

Loan EMIs set to rise

The immediate impact of the RBI’s repo rate hike is on the retail loans such as home, auto and other loans which are linked to the bank’s external benchmark. Most banks have linked their lending rates to repo rate and, thus, it impacts the borrowers immediately. When the RBI hikes the repo rate, the repo rate linked lending rate (RLLR) of banks also goes up, which means a rise in the home loan interest rate for the borrower. The cost of funds for banks increases when the repo rate is hiked, due to which, the cost of borrowing for retail and other borrowers also goes up.

Will the repo rate hike help tame inflation?  

Although the government is pulling out all the stops to bring it under control, it is a given that prices are decided by the supply and the demand for goods and services in an economy. In essence, the price rise in any particular situation may be led by either an increase in demand or paucity of supply or both.  

Talking about RBI’s measures, the central bank has only those monetary tools which check the demand by making money more expensive or by shortening its supply. Usually, the RBI raises the repo rate which leads to a rise in interest rates, both deposit and lending hinging up on the given situation. The central bank also has other monetary instruments in its hands, for instance, the cash reserve ratio (CRR), which is a portion of a bank’s overall deposits that the latter needs to park with the RBI.  

RBI’s monetary tools 

In an off-cycle decision, the central bank had raised the repo rate by 40 bps and the CRR by 50 bps in May. Both these steps help RBI bring down demand in the economy. Thus, it’s a given that a repo rate and CRR hike ought to help reign in inflation. But is it so?  

Inflation is not impacted by the money supply alone. The present high inflation has more to do with the disruption of supply, as has been widely reported, caused by the ongoing Russia-Ukraine war, which has led to a rise in commodity prices such as that of fertiliser and crude oil. This increase in turn affects food inflation. Furthermore, it has also curtailed the supply of sunflower oil as Ukraine was its biggest exporter in the world before the war. 

Moreover, there are seasonal factors as well that have led to a rise in the prices of tomatoes, lemons and wheat. MPC’s monetary measures may not be helpful in taming this kind of inflation. 

Nevertheless, part of inflation is also because of some resurgence of demand in the economy as it steadily improves. Monetary policy curtails this demand as well which will adversely affect the economic growth. RBI’s monetary tools also lower inflationary expectations in the economy.