As expected, RBI hikes interest rate by 50 basis points

RBI has hiked repo rate today by 50 basis points to 5.9%. Standing Deposit Facility (SDF) rate and Marginal Standing Facility (MSF) rates have also been increased by 50 basis points. SDF now stands at 5.65%. MSF now stands at 6.15%. Repo rate is the rate at which RBI lends money to banks. Standing Deposit Facility is the rate at which banks can lend to RBI without the RBI have to give government securities as collateral to banks. MSF is the rate at which banks can borrow from RBI without having to pledge government securities as collateral. In the case of borrowing on repo rate, banks need to put government securities as collateral. The purpose of increasing these rates is to slow down demand in the economy so that inflation rate goes down. Increase in these rates will increase the cost of loans that banks give to businesses and individuals. This will bring down demand for interest sensitive consumption and investment, that are financed by loans. 

While announcing the interest rate hike, the RBI also lowered its GDP forecast for FY 23 to 7% from 7.2%. Interesting thing is that in spite of the third consecutive interet rate hike this year, RBI did not lower its inflation forecast for FY23. It maintained its inflation forecast for FY23 at 6.7%. This is an implicit acceptance by the central bank that successive interest rate hikes are not going to have any downward impact on inflation rate. The best that they can do is to prevent the inflation rate from accelerating further. But that objective will also not be achieved if commodity prices such as that of oil & gas rise because of supply side constraints. The present inflation is clearly a supply side driven one. Monetary policy as a tool for controlling inflation is effective when inflation is driven by demand side factors. It is not effective when inflation is driven by supply side factors.

One reason because of which RBI has to increase interest rate today is because of continued depreciation in Rupee against the Dollar. Currencies of countries whose interest rates are higher tend to appreciate against currencies of countries whose interest rate is lower. After the Federal Reserve increased its interest rate recently, US Dollar started appreciating against other currencies, such as Rupee. To check that appreciation, RBI had to increase interest rate today.

RBI has remained silent on what is the monetary policy transmission period it expects with regard to interest rate hikes of the past few months. Monetary policy transmission period is the period in which change in interest rate starts having an impact on economic activity and inflation.