The hikes in the interest rates will be done gradually as per changes in RBI’s priorities.
Every two months, the Monetary Policy Committee of the Reserve Bank of India (RBI) meets to debate on whether interest rates prevailing in the country are appropriate or require any upward or downward tweaks.
Currently, interest rates prevailing in the country are much on the lower side. The rates were brought down about two years ago when we were grappling with pandemic. Low interest rates support the growth of the economy: Money is then available at cheaper rates and people are willing to avail of loans, which in turn moves the wheels of the economy a little faster.
As of today, things have normalized in the country—economic growth is coming back and there is a need to normalize (read hike) interest rates. With inflation being somewhat on the higher side, real returns net of inflation for your deposits are now in negative territory. The RBI has a mandate to balance inflation with growth. Now, when we say “interest rates prevailing in the country”, it does not imply that the RBI will decide on each and every interest rate. Instead, the central bank sends out some signals.
The main signal is the repo rate, the rate at which the RBI would fund banks, if they require money, one day at a time—currently maintained at 4%. The committee met on Friday last, and decided that the repo rate will remain at 4%, at least till the next review on 8 June . However, there were enough hints that rate normalization is coming. What are those hints?
First is a projection on inflation, on the basis of which the RBI decides on interest rates. In the previous policy review on 10 February, the RBI projected consumer price index (CPI) inflation for 2022-23 at 4.5%. This was much lower than the forecast of economists and analysts, who were north of 5%. Thereafter, we had high prices of crude oil, metal and fertilizer prices due to the Russia-Ukraine war. RBI revisited these issues and revised the projection upwards to 5.7% for 2022-23. It is a steep revision, from 4.5% to 5.7%, which implies the RBI will look to rate hikes to contain inflation.
On the signal for interest rates, which is the repo rate currently at 4%, there is another leg, called reverse repo. When banks have surplus money, they park these funds with the RBI, one day at a time, at the reverse repo rate, currently at 3.35%.
In the latest policy review, the RBI has done away with reverse repo and instead started a system called standing deposit facility (SDF). This SDF is at 3.75%, hence, the other leg has effectively been hiked from 3.35% to 3.75%.
The technical difference between reverse repo and SDF is that in the reverse repo, the RBI gives collateral government securities to banks, whereas in SDF there is no collateral security.
In the media conference post policy announcement, the RBI governor clarified that in the sequence of priorities, inflation will come first and then economic growth. For quite some time, particularly during pandemic-induced growth slowdown, growth was a priority. The implication is, even if real deposit rates were negative, interest rates would be low. Now, with inflation being priority, the RBI will look to achieve real positive interest rates, over a period of time.
Another aspect of signal on interest rates, apart from repo rate, is the amount of liquidity floating around in the banking system. High liquidity is conducive to lower interest rates, as banks have that much more to give out as loans. As of now, banking system has huge surplus liquidity, which would be inimical to rate hikes, as and when that happens. The RBI governor has clarified that surplus liquidity would be withdrawn over multiple years, in a non-disruptive manner.
What does all this mean for you and your investments? The change of priorities by the RBI is not a game changer, it had to happen sometime, given inflation concerns and normalization of economic activities. The hikes would be done gradually, which the economy will take in its stride.