Dear Readers,

At the time of high inflation and increased interest rates day by day from the Central Banks worldwide let us discuss further on this in depth.

Here we discuss this story that  involves three parties: the central bank, banks (retail and otherwise), and the common people (like you and me). The economic system of any country can be dissected along many lines, but dividing it into these three cohorts can help illustrate the machinations that underpin the highs and lows of prices that we have seen over the past few months.

In light of the almost all the Central Bank’s  decision to raise the ‘repo rate’ by various basis points, let us explore more and discuss further on this.

If you’ve ever wondered what the core purpose behind a central bank is, here’s your answer: they exist to control economic growth.

Any sovereign monetary authority has two levers through which it can influence the workings of an economy: fiscal policy and monetary policy. The former is built around taxation considerations, while the latter is built around interest rates (i.e. rates at which banks can borrow funds).

Repo-rate is the term used to refer to the interest rates that the Central Bank sets, i.e. the repo rate refers to the rate at which Indian banks can borrow funds from the Central Bank.

Now you might be thinking: why do banks borrow from the Central Bank and what has that got to do with me?

Banking regulation generally stipulates specific cash requirements that each bank has to meet. Such regulations are structured to ensure that banks operate within a certain system and are beholden to the monetary authority of the geography in which they operate. Inevitably, this leads to banks ‘borrowing’ money from a central bank and the rate at which they borrow determines the boundaries within which they can act.

A low repo rate means borrowing costs are low for the bank, thereby allowing it to be more lenient when it comes to giving out credit, a high-repo rate does the opposite and constrains borrowing to both entrepreneurs and consumers.

This creates a loose coupling between the actions of the central bank and the economic activity in the country. Low inflation indicates low economic activity, which is corrected by lowering the repo rate. In contrast, high inflation means that the economy is overheating and needs to be cooled down by increasing the repo rate.

Whatever the direction of the repo rate may be, it has a direct and measurable impact on you. If you’ve been following along till now, you might already guess how and why that’s the case.

How it affects our existing loans:

To understand how the Central Bank’s worldwide recent repo hike affects you, let’s go through this sequentially. The Central Bank increasing the repo rate means that banks no longer have access to relatively affordable credit. This means that the amount of money they have to lend out loans shrinks. Consequently, they become pickier with their loan portfolios and raise rates to maintain their margins.

Simultaneously, cash-starved banks will start to incentivize account holders to park excess cash with them in the form of fixed-income instruments such as fixed deposits (FDs), recurring deposits, etc. These are usually done by guaranteeing a higher rate of return on FDs, which is sure to attract the attention of the average Indian working professional.

This cycle of higher interest rates stymies economic activity and encourages people to park their cash with banks, thereby removing the excess liquidity in the market. Liquidity and free-flowing credit are widely considered to be the main drivers of economic activity and many

These are happening around the world:

These hikes are happening all over the world: the U.S.A., England, Sweden, Norway, and New Zealand are examples of countries that have also been raising interest rates in an attempt to curb inflation. For now, the era of cheap home loans, and abundant funding rounds (especially in the startup ecosystem) are over.

As a consumer, this isn’t necessarily bad news. It means that the worst of the inflationary pressures are behind us and that future price movements are going to be more predictable, restrained, and measured.

In volatile times like these, isn’t that just what we need?