How does the repo rate affect your finances?
Synopsis: In today’s article, we will discuss the role played by the repo rate in the monetary policy framework and its subsequent impact on your personal and business finances.
Serving as the nation’s central bank, the Reserve Bank of India (RBI) plays a pivotal role in conducting India’s monetary policy with price stability as its main objective. With several tools at its command, including the repo rate, reverse repo rate, cash reserve ratio (CRR), statutory lending ratio (SLR), and more, the RBI has been implementing policies to control inflation without adversely impacting economic growth.?
Out of all the policy measures in the RBI’s arsenal, the repo rate, also known as the policy rate, holds the most significant position. As banks take cues from the repo rate, with a majority benchmarking their interest rates to the policy rate, this rate shapes personal finances and businesses by influencing borrowing costs and investment returns.
Below, we understand what the repo rate is and its role in shaping interest rates, borrowing costs, and purchasing power, thereby impacting your finances.
Understanding the repo rate
The repurchase option, shortened to the repo rate, is the interest rate at which the RBI lends money to commercial banks over the short term against collateral, such as government bonds or Treasury bills. It functions as an effective monetary tool for liquidity and inflation control. This lending is done under the aegis of the liquidity adjustment facility (LAF).
Since June 2000, the RBI has been signaling its monetary policy stance by announcing the repo rate periodically. Currently, the six-member monetary policy committee (MPC) announces policy rates at least four times a year, per its mandate, to ensure it achieves the inflation target.
Moreover, after the RBI directed banks to link their interest rates to an external benchmark in October 2019, several financial institutions linked their interest rates to the repo rate. As a result, the policy rate directly impacts loan borrowing costs and investment returns, affecting the overall financial climate.
The MPC committee factors in the inflation dynamics of the last six months to project a near-term inflation outlook. It also accounts for the state of the economy, including the fiscal situation, financial markets and stability, the real economy, and the external sector, when forecasting inflation. The policy rates are announced in accordance with the inflation and liquidity projections.
Impact of repo rate on your finances
The RBI makes changes to the repo rate from time to time in order to reduce inflation or stimulate higher demand. Below, we explain the implications of the repo rate changes on your financial position.
1. Borrowing costs
When the RBI raises repo rates to control inflation, this higher lending cost is passed on by the banks to their customers, which makes borrowing an expensive affair. Thus, higher repo rates—as has been the trend recently—result in higher EMI installments for all floating-rate loans.
Repo rate changes impact all loan types, from business loans, personal loans, credit cards, education loans, and car loans, to mortgages. This means individuals and businesses alike must consider the potential overall impact of an increase in the interest rate on their budget and whether taking loans is still affordable.?
Moreover, another fallout of expensive credit is that it dampens demand for goods and services, which may adversely impact the firm’s operational and financial position. For instance, the recent hike in policy rates has forced real estate companies to raise their prices in tandem, slowing down their sales and negatively impacting the pace of market recovery.
Conversely, when repo rates decline, bank liquidity increases, which results in lower borrowing costs, making credit affordable, boosting consumer demand, and potentially stimulating economic growth.
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2. Savings and investments
Similar to lending rates, a rise in repo rates also results in higher deposit rates for a bank’s customers. So, savers benefit from an increase in interest income from savings and fixed deposit accounts.
However, repo rate hikes dampen investment sentiment, as higher interest rates make many capital investments unviable on a cost-benefit basis. It even worsens the dynamics of ongoing investment projects by raising debt servicing obligations.?
3. Stock market investments?
Many investors take their cues from repo rates to understand the economic outlook and market sentiment. As repo rates are raised in response to tackling inflation, it signals lower demand and higher borrowing costs that may adversely affect company profitability. This may further lead to poor stock performance.?
Additionally, when repo rates go up, fixed-income instruments, such as bonds and treasury securities, experience a rise in their yields, with their market prices decreasing (the inverse relation). This does not bode well for individuals with higher bond allocations in their portfolios.
It must be noted that stock market movements are also influenced by other factors like economic indicators, corporate earnings, and global conditions. Hence, the impact of repo rate fluctuations is not as straightforward. Having said that, investors must diversify their portfolios by adding inflation-indexed investments for better risk management.
4. Purchasing power
The impact of repo rate fluctuations on consumer spending and purchasing power can be significant. When inflationary pressures mount and repo and deposit rates are raised, consumers make lower discretionary purchases. Therefore, you must reevaluate your budgets and prioritize spending during inflationary periods to protect your purchasing power.
Another factor worth considering is that if policy rates are higher relative to other countries, it may attract foreign investment, leading to currency appreciation. This may have a favorable impact on consumers willing to make international investments or travel plans.
The repo rate evolution in India
The RBI has mostly kept repo rates high owing to India’s economic situation. But during 2001–2004, the repo rate was lowered to deal with the aftermath of the dot-com bubble. The policy rates were reduced again by 1.25% after the 2008 global financial crisis. These rates were eventually raised to 8% as the economy recovered to prevent further overheating.
However, the COVID-19 pandemic saw the RBI pursue an ultra-accommodative policy, decreasing the repo rate to record lows of 4%, which persisted for almost two years. With inflation becoming a cause for concern and global uncertainties, including recessionary fears, escalating, the RBI has been raising the policy rate in sync with other global central banks. The repo rate currently stands at 6.5%, which is close to its long-term average value.?
Bottom line
The significance of repo rates in financial planning cannot be overstated. By influencing interest rates, purchasing power, and investor sentiment, repo rates help shape personal and business finances. Investors must future-proof their budgets and portfolios by factoring in policy rate fluctuations in their investment strategies.