With consumer inflation close to 7 %, the reserve bank increased the rate at which it lends to banks from 4% to 4.4%. Why was this done and what are the implications for us? A simple explanation.
When inflation increases it typically means, the demand for goods is higher than the supply. For absolute newbies, we recommend reading this FAQ on how inflation affects our ability to manage money first and then come back here. As explained here, inflation should neither be too high nor too low.
Our inflation has increased well above the 2% to 6% target band of the RBI. To curb this, the rate at which banks borrow money from the RBI has been increased. This rate is known as the REPO rate. See Understanding Repo Rate and Reverse Repo rate. Also see RBI Repo Rate History.
To offset this cost, banks will increase the rate of interest on their loan products. Consumers will then borrow less. They would rather save rather than spend. Product suppliers will also not be enticed to borrow more and increase supply.
The demand for goods will gradually fall (with one or more rate hikes) and inflation will start to decrease.
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The cash reserve ratio is the percentage of depositor’s money banks will have to hold with the RBI. This has increased from 4% to 4.5%. So banks will have lesser money to lend to further curb demand.
If the bank management sees fit, they can incentivise people to save further by hiking deposit rates. Since the interest need not be paid immediately, it may turn out less expensive than the higher REPO rate even if the deposit rate is higher. This will provide them with more cash to work with and may also further reduce demand for goods as savings go up.
How will debt mutual funds be affected?
The NAV of a debt fund is linked to the current market price of bonds. If the repo rate increases (due to inflation), bond market participants will demand a higher interest rate on new bonds. This is because inflation is eroding the value of the principal and they must be compensated better.
So the demand for existing bonds will fall and so will their price. So the debt fund NAV will fall. Since bond buyers will not want to buy long term bonds and lock in on lower rates, funds holding long term bonds will fall more.
Overnight funds will be the first to see a slightly higher return. Then liquid funds and then money market funds and ultra short term funds will also see higher returns gradually. Medium-term and long term funds will take longer to recover.
In the next article, we shall consider how debt mutual funds reacted to the REPO rate hike and then consider what investors should do in the current scenario.
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