RBI hiked its repo rate and here's why you should care

The Reserve Bank of India (RBI) has hiked the benchmark repo rate, ie the rate at which RBI lends money to commercial banks, by 0.5% to control inflation. Now that the loan interest rates for commercial banks have gone up from 5.4% to 5.9%, banks are raising interest rates.

• The hike in repo rate is looked at as one of the most powerful ways to control inflation.
• The hike will also affect our everyday cash flow. 

First, the rate hike: Keeping in sync with international banks' trend of hiking interest rates, India's RBI has hiked its repo rate for the fourth time in a row. After consistent interest rate hikes in May, June and August, RBI hiked repo rates by 0.5%, making it 5.9%. 

Why hike interest rates?

• Citizens are facing record food inflation given the Russia-Ukraine war and supply disruptions. 
• The Rupee has depreciated to an all-time low, where US$ 1 now equals Rs 81.46.
• International banks like US' Federal Reserves and Bank of England are raising interest rates, which is driving foreign investors to withdraw funds from domestic or emerging economies and invest them in developed economies. An interest rate hike ensures that foreign investors do not lose out when they invest money in India, and hence continue investing here. 

How exactly does RBI (or any other bank in the world) control inflation by hiking the repo rate? To put it plainly, RBI's plan is to control the money in the economy by sucking it out of the system (ie. banks, organisations, and individuals).

• When RBI hikes interest rates, commercial banks (like ICICI, HDFC, Kotak Bank) find it costlier to borrow money from RBI (since they now have to pay 5.9% instead of 5.4%). Usually, commercial banks use this borrowed money and loan it to common people like us. 

When RBI hikes its interest rates, commercial banks automatically hike their interest rates to maintain their profit margins.

• This indirectly makes floating rate loans (like home loans, auto loans, business loans, credit cards, and personal loans) expensive for loan takers who now have to pay this new additional expense out of their savings. 
• Thus when interest rates are hiked, money is sucked out of commercial banks and indirectly from our own savings.
• This also means that bank deposit interest rates are hiked since banks value you saving more money than spending it. 

How does this stop inflation then? When people end up paying more for normal items, it causes a break in the common man's drive to splurge on goods and services. People hold back from buying new cars or taking that extra Rs 5 lakh of home loan to save money or to reduce spending so much on interest payments.

• Over a period of time, as people hold back from spending on a lot of things, the overall demand in the economy reduces.
• This causes prices of goods to fall, as manufacturers cannot hike prices anymore since they need to match the slow demand.
• This breaks the cycle of rising inflation rates. 

Bottomline: At least that's what the world's central banks like RBI and Federal Reserve are hoping for: that the textbook economic solution works.