RBI monetary policy preview

8 Jun 2022 , 08:21 AM

RBI will announce a hike in repo rate today. According to most analysts and economists, the increase in repo rate is likely to be between 25 basis points and 50 basis points. One basis point equals .01%. Repo rate is the rate at which RBI gives short term loans to banks. The repo rate serves as the benchmark interest rate in India. 

It is a certainty that RBI will announce an interest rate hike today because of rising inflation rate in India. Retail inflation rate was 7.79% in April 2022. Wholesale inflation rate was 15.08% in April. Increase in interest rate makes interest sensitive consumption and investment more expensive. This reduces their demand. Reduction in demand tends to bring down prices. That is why central banks increase interest rates in order to bring down inflation.

The current high inflation in India is caused by two factors. The first factor is numerous supply chain disruptions caused by two years of Covid lockdowns and restrictions. The second reason is the ongoing war in Ukraine. The war in Ukraine has caused increase in crude oil prices and prices of some other commodities. The inflation that India is currently seeing is therefore a supply side driven one rather than a demand side driven one. It is caused by supply chain disruptions rather than by overheating of demand or excess demand. Therefore, central bank intervention of increasing interest rate for controlling it is unlikely to be very effective.

There is a trade-off between increase in interest rate and economic growth. A higher interest rate slows down the economy by reducing interest sensitive investment and demand. India is also currently facing the problem of weak economic growth and high unemployment rate.  According to Center for Monitoring of Indian Economy (CMIE), unemployment rate in April 2022 was 7.83%. It will therefore not be prudent for  RBI to increase interest rate by too much. An increase of 25 basis points will be more prudent than one of 50 basis points or more. Equity markets are likely to react positively if the hike announced today is at the lower end of their expectations. They will react negatively if the hike announed is at the higher end of their expectations or exceeds their expectations. 

RBI may also announce an increase in cash reserve ratio (CRR). CRR is the percentage of their deposits that banks have to keep with RBI. The intent behind increasing CRR is to reduce lending by banks. Reduction in lending by banks reduces money supply in the system.  Reduction is money supply in the economy brings down demand and inflation. In May the RBI increased CRR by 50 basis points, to 4.5%. Given the urgent need of economic recovery and reduction in unemployment rate, it will be prudent for RBI to not increase the CRR by too much today. Or the best course will be to leave it unchanged.