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How rate hikes by central banks impact economies

Repo rate and reverse repo rate are two important tools utilised by central banks to spur or slow down growth, control inflation and attract investment

‘Tis the season of rate hikes. First it was our own apex bank the Reserve Bank of India (RBI) that increased it by 25 basis points, or 0.25 percentage points to 6.25 percent. And then close on the heels came the US Federal Reserve Bank’s announcement of a similar hike of 25 basis points.

While the RBI made the move to contain inflation, the Feds motive was somewhat different. Having kept the rates at record low levels for years to enable the US economy to rebound after the recession which started in 2008, it now thinks time is ripe to increase the borrowing costs.

And just in case you are wondering how a rate hike can affect inflation or borrowing costs, we present you a comprehensive explanation of what it is and how it can prove to be an important monetary tool for the central banks.

What is a rate hike?

The “rate” here refers to the interest rate charged by the RBI or any other central bank to public and private commercial banks borrowing money from it. It is commonly referred to as the repo rate in most nations and discount rate in the US. Banks borrow from the central bank whenever they are faced with fund shortage. A reduction in repo rates helps banks get money at a cheaper rate and vice versa.

There is also a separate interest rate which central banks fix for borrowing money from commercial banks. It is called the reverse repo rate. A reduction in reverse repo rate dissuades banks from parking their money in central banks and an increase does the opposite.

What purpose does a rate hike serve?

With a rate hike, the cost of borrowing from the central bank rises for commercial banks. To offset any potential loss arising from it, the latter tend to pass it on to their customers by charging them higher interest rates on home and consumer loans. This in turn can bring about two changes in an economy – lowering inflation and slowing growth.

For the first, with lending interest rise, borrowing by the people automatically goes down. Instead, they tend to deposit money with the banks lured by the higher interest on it. As a result, demand for goods and services automatically lessens and currency circulating reduces too. Liquidity gets sucked out. This enables to stem any inflationary trend. In India, this is exactly what the RBI just did to bring down the inflation resulting from the rise in petroleum prices.

When it comes to growth, reduced demand for goods and services also hampers production and hence expansion. Sectors that take maximum blow are consumer durables, real estate and automobiles. Their earnings and subsequently expansion strategies get affected majorly.

When the rate decreases, on the other hand, money supply in the economy increases. This happens because people have less incentive to store their money in banks now since they offer lower interest rates on deposits. Consumption increases alongside since interest rates on consumer loans come down as well. Overall, this stokes growth in the economy besides increasing prices. This is exactly what the US and other European nations did (many of them had kept the interest rate at sub-zero levels) to prop up their economies after the housing sector meltdown circa 2008 rattled their markets and clipped growth severely.

Thus, this is how the repo rate or discount rate is an important tool in the hands of central banks. The reverse repo rate also plays a key role in it for an increase in it eggs commercial banks to park their excess money with the apex bank and this in turn reduces the supply of money in the economy.

Does increase of rates in other countries affect a nation’s finances?

It does for sure. The hike in rate in the US, for example, is expected to dampen appetite in Indian bonds by foreign investors. Already they have sold over four-billion-dollar worth of bonds in 2018. This is because of a shift in focus towards the US markets. And with the rise in treasury yields in tandem with the rate hike announcement in the US, the focus will likely remain intact in the near term.

Investors worldwide had turned their gaze on the emerging markets when interest rates were hovering near zero in most of the west because of the recession. At that point in time, rates were more appealing in the developing economies which were not affected that bad by it. But with the rate hike by the RBI coinciding with that of the Fed, the Indian market is set to become less attractive.