The repo rate along with the money supply, is considered the principal instrument for controlling inflation. Measured by the Consumer Price Index (CPI) in India’s case, it is much higher than the target rate of 4% and remains above the maximum acceptable limit of 6%. Yet, RBI decided to stop the rate hikes.
More than half of the housing loans in India are currently subject to what is known as the External Benchmark Linked Interest Rates (EBLR). Repo rate is the external benchmark in a majority of retail cases. Housing loan interest rates go up accordingly as and when repo rates are revised upwards. In the last financial year, repo rates went up by as much as 2.5% (more than 40% over the repo rate of 4% prevailing at the beginning of the year).
Such a massive increase in housing loan rates raised Equated Monthly Installments (EMIs) of loanees to shoot up. Unable to afford such increases in EMI, most borrowers have opted for increasing the length of their loan repayment periods. In many cases, both the EMIs and repayment periods have gone up significantly.
More than half of the housing loans in India are currently subject to what is known as the External Benchmark Linked Interest Rates (EBLR).
Unable to afford increases in EMI, most borrowers have opted for increasing the length of their loan repayment periods.
While there is a lot of song and dance about marshalling repo rate hikes to bring down CPI in the Indian context, there is virtually no effect of rates on CPI inflation.
House loanees need relief badly which can come only if RBI first pivots to stopping beyond pausing the rate hikes.
Are repo rates really a good instrument to control CPI inflation? If yes, why the pause when inflation is still ruling above the maximum tolerance limit? Or, repo rates do not matter as far as CPI inflation is concerned?
Increases in repo rates have been causing massive collateral damage to retail loanees, especially in the case of housing loans. Will this pause help stop their worsening misery?
Should RBI pivot to stop rate hikes now? Should it consider getting on a decreasing repo rate cycle sometime soon?
Repo Rate Hikes Don’t Control CPI Inflation
In February 2022, a year ago, CPI inflation was 6.72%. CPI inflation was still quite high at 6.44% in February 2023. Despite the high base of CPI inflation in February 2022, CPI inflation in February 2023 at 6.44% was way above the target inflation of 4% and upper inflation tolerance limit of 6%.
Repo rates were 4% in February 2022, a year ago. They were raised in every MPC meeting starting with a non-scheduled MPC meeting in May 2022 when it was first raised by 40 basis points to 4.4%. Steadily, the repo rates were increased to the high of 6.5% in February 2023 MPC meeting.
While the repo rates were raised continuously ostensibly to control inflation, CPI inflation, though it had inter-period highs of 7.79% in April 2022 and lows of 5.72% in December, on the year as a whole, remained almost flat in the last one year.
CPI inflation in April-May 2022 rose on account of increasing prices of certain food items like wheat on account of lower wheat production and some exports. This spurt in CPI inflation had nothing to do with RBI repo rates.
CPI inflation went down in November-December 2022 because vegetables, fuel, and some other commodity prices declined on account of weather and the decline in international prices of crude oil. There was very little impact of credit monetary policy action on these price movements and CPI inflation in general.
RBI accepts that repo rates do not affect food and fuel prices. Therefore, the repo rates are intended to target what is called core inflation—the non-food and non-fuel inflation. From CPI, if you exclude food and beverages which has a weight of 45.86%, and fuel and light which has a weight of 6.84%, more than half of the CPI base disappears from the index. The leftover is considered the core inflation.
To understand core inflation, it is interesting to know what is left out in the non-food, non-fuel CPI index. These are 2.38% of Pan, tobacco, and intoxicants, 6.53% of clothing and footwear, 10.07% of housing, and 28.32% of six groups of primary services—household goods and services (3.8%), health (5.89%), transport and communications (8.59%), recreation and amusement (1.68%), education (4.46%) and personal care and effects (3.89%). This is what is spoken of as the 'core inflation’.
Even a cursory look at these items would suggest that there is very little credit flow to these so-called core items. The concept of core inflation in CPI has been imported from the wholesale price index which comprised industrial products, other than food and fuel. A bulk of credit had flown to these sectors. That, however, is not the case with the CPI composition. It should be simple. If there is very little credit flowing to these sectors, how can repo rate hikes, which only work through credit off-take becoming costlier, influence consumer prices in these sub-sectors?
No wonder, while there is a lot of song and dance about marshalling repo rate hikes to bring down CPI in the Indian context, there is virtually no effect of rates on CPI inflation. No one needs to worry about CPI inflation getting unleashed upon RBI stopping the repo rate hikes.
Housing Loans Are the Most Affected
The total bank credit rose by about 16% year on year until January 2023. Personal/retail loans increased at a much higher rate—by 20.4%. Most retail loans are linked to an external benchmark like repo rates or other similar moving anchors.
There is stress on retail borrowers, which is all too evident. Higher retail loan growth does not signal higher discretionary durable and housing asset investment. The IIP for these sectors has witnessed the least growth in the last two years.
However, squeezed with lower incomes, thanks to high inflation and dwindling savings, people have been desperate for loans despite increasing interest rates. Credit for consumer durables increased by 43.6% in the last one year. Advances against Fixed Deposits rose by 30.2%. Credit card outstanding loans increased by 29.6%. These loans witnessed the highest growth rates indicating more funding distress.
Housing loans, which at 18.88 lakh crore make up about 50% of total personal loans, increased by 15.4%, at about the rate of overall credit growth.
Credit in the services segment also recorded a healthy growth at 21.5% largely on account of feverish growth of 31% in the banks’ loans to non-banking financial companies, much of which also finally landed as retail loans.
On the other hand, the investment sectors of the economy witnessed much lower credit growth rates. Loan growth in the industry segment was tepid at 8.7% only.
An increase of 2.5% in repo rates has affected people’s EMIs by as much as 30-50%. Borrowers have been hit very hard. Constrained as they are having used up their deposits, these borrowers have been quite distressed, saddled with high EMI installments. Repo rate increases by RBI during the last year had taken the life out of these middle and lower-income class loanees.
The pause will bring some much-needed relief to them.
Don’t raise rates further Inflation is getting under control globally. Crude oil prices have got stabilised at sub-USD 90 per barrel with crude oil supply flows disrupted by the Russian-Ukraine war getting sorted out. Gas prices have also normalised substantially.
The domestic food inflation situation remains somewhat uncertain. There are conflicting claims about wheat production. The government claims a record production. Milk prices have gone up steadily but vegetable prices continued to be extra soft. The situation may change as there are some disconcerting reports about the El-Nino factor and less than normal rainfall. However, as noted above, none of these factors or commodities are amenable to RBI repo rates. The rest of the consumer inflation is also not affected much by RBI rate actions.
The RBI needs to look into who actually gets impacted by its rate actions.
It is the retail borrowers, it is the house loanees most clearly. They need relief badly. That can come only if RBI first pivots to stopping beyond pausing the rate hikes. Soon, within the next 2-3 months, RBI should start lowering the repo rates. That will bring real relief. Maybe, some joy as well.
(The Author is the Chief Policy Advisor, SUBHANJALI, Author: The $10 Trillion Dream and Former Finance and Economic Affairs Secretary, Government of India. This is an opinion piece and the views expressed above are the author’s own. The Quint neither endorses nor is responsible for the same.)