In the previous post we discussed about inflation and how it can be tamed by central banks. One of the ways to reduce inflation is by reducing the amount of money people spend. This can be done by increasing the rate of interests on loans or by making safe investments so attractive that people will save money in banks instead of spending on things. Think of it this way – if your home loan EMI increases, you will have less to spend on other things right? Alternatively, suppose you don’t have any loans, but you are a saver. Then if the FD interest rate went up from 5% to 6%, you might save more instead of spending and causing inflation. That was a very simplified explanation of course, but lets just go with it.

If somehow one can force the banks to increase their loan interest rate and thus the EMI, people will have less money to spend. And the way banks can be forced to do it is by increasing the repo rate. Which is precisely what the US Fed and RBI (Reserve Bank of India) did a few days ago. Repo rate is the rate at which RBI lends money to banks. There are a few ways banks get money to lend out to you for all kinds of loans. One is from deposits and another is from RBI.

When I say deposits, I mean all the savings in your bank and any fixed deposits you have with a bank. While some people take loans, some have fixed deposits. Some might have both. So banks get money from some people via FD and lend the same money to others for their loans. But why will the savers given money to the bank in the form of fixed deposits for free? They won’t. Hence banks will offer some interest on your FDs which encourages people to save. However banks can’t get enough money from FDs alone, so they also borrow from RBI and pay interest to RBI which is the repo rate.

Now if RBI increases repo rate, then banks have to pay more interest to RBI for any amount borrowed from them. So they will pass on the higher interest rate to its customers by increasing the loan interest rate. Which means your EMI will increase. When EMI increases, you will have less money in your pocket, and will spend less and hence reduce demand which in turn reduces inflation. That is how RBI controls inflation using repo rate. Of course, this is a very simplified explanation.

In this situation another interesting event can take place. Because lending from RBI is becoming expensive for banks, they can try and attract people to give them more money by increasing FD interest rates. This also reduces the money supply in the market because people might choose to invest in FDs instead of keeping in their pocket. Which also helps reduce inflation. So repo rate has this double affect.

Of course repo rate is not the only tool that RBI has in its arsenal. There is also the reverse repo rate, cash reserve ratio (CRR), statutory liquidity ratio (SLR), marginal cost of funds based lending rate (MCLR) etc at their disposal. Explaining them will require me to write a post for each one of them. If you want me to explain, do leave a comment, but I am sure you can find various articles explaining much better than me.

Impact on EMIs and Fixed Deposits

Anyway, hopefully you now understand how RBI uses repo rate to control inflation in an indirect manner. What does this mean to the consumer though? It means that some banks may start increasing your loan interest rates, which means you will either have to be prepared to increase your EMI payments or increase the loan duration keeping the same EMI. Either way, it is more cost to you. It is also possible that banks might increase FD rates and you stand to gain if you invest in FDs after the rate hike. Remember that your current FDs are already locked to the old interest rate and they are not affected in any way. The new rate applies only to new FDs. However, this is not how it works in the case of debt mutual funds.

Impact on Debt Mutual Funds

If you are already invested in some debt mutual funds, the affects of repo rate hike works differently for different kinds of funds. For example, if you are invested in very short duration debt mutual funds like liquid funds or ultra short term funds, you will not be affected much now, but in the future, you will stand to gain. Those who have invested in medium to long duration funds will see their investments drop now and in the future as more rate hikes happen. But if you stay long enough, and as old papers are replaced with new ones, the value will go up. Unless you know what you are doing, I don’t usually recommend the longer duration funds. So if you have them, I presume you know how to handle the turbulence. For the rest, I only recommend ultra short and short term funds. If you want to understand how repo rates affect debt mutual funds, let me know in the comments and I might write a post on that.

Impact on Equity Mutual Funds

Finally, when repo rates go up, stock market should go down. It may not always happen depending on how much the stock markets have already baked in that information. Why does the stock market go down when repo rates go up? Well, companies too borrow money from banks. Now if the banks have increased the loan rate, then companies will also have to pay more EMI which means they will have less profit. Less profits means the stock market will not like it and the stock price will come down. Again, that was a simplistic way of explaining things and there is quite a bit more to it.

Impact on Government spending

Another way this repo rate hike might affects inflation is in the form of reduced government spending. You see, even government has to borrow money to spend on infrastructure development and various other programs. When it borrows money, it will have to repay at higher interest rates going forward. This may mean a decrease in government spending. When it spends less, there is less going into the pockets or various workers and government contractors. As a result the inflation will come down because people have less coming into their pocket because of less work as government reduces spending.

What should you do?

What should investors do during the period of rate hikes? Nothing as usual. Just keep on investing as before and if the asset allocation is drifting, bring it back to where it should be. Beyond that, there is absolutely nothing that one should change in their financial plan. People who are invested in longer duration debt mutual funds and equity mutual funds will feel a little pain until the whole rate hike scenario settles. But the good news is that from what I understand, RBI is front loading rate hikes, which means the hikes will be lower in the future.