Inflation, profits, EMIs — what gets really impacted?

The Reserve Bank of India (RBI), in its monetary policy on August 10, kept the repo rate (which sets interest rates in the economy) unchanged at 6.5 per cent. It also kept the liquidity or money supply stance ‘withdrawal of accommodation’ unchanged, indicating that the RBI would continue to reduce excess money supply in the system.

In a surprising move to reduce excess money supply, the RBI prescribed 10 per cent incremental cash reserve ratio (CRR) requiring banks to keep 10 per cent of their incremental deposits with the RBI which will not earn any interest.

The RBI has raised repo rates by 2.5 per cent in the last 18 months. Extra money supply has also been brought down from approximately Rs 8 lakh-crore to Rs 1.5 lakh-crore in this period.

In its monetary policy, the RBI increased the inflation forecast by 1 per cent (to 6.2 per cent). Yet, the RBI did not raise the repo rate. Is there a direct connection between monetary policy and inflation in India? Do monetary policy actions impact bond prices, banks’ profits, and borrowers’ EMIs more than inflation?

Inflation

The Consumer Price Index (CPI) inflation, which the RBI targets, was higher than the 6 per cent upper limit set by the government in 2021-22 (6.95 per cent) and continued to be so until September 2022. Thereafter, it moderated ending 2022-23 with inflation of 5.66 per cent. In the Q1 2024, the CPI inflation has been 5.4 per cent.

Food inflation (weight ~39 per cent) was much higher at 7.68 per cent in 2021-22 but was lower at 4.79 per cent in 2022-2023. Food inflation and fuel inflation (weight ~7 per cent), which the RBI also considers non-core, are not impacted by monetary policy. The remaining CPI constituents — prepared meals, pan and tobacco, clothing and footwear, and services like health, education, transport and communication, among others — mostly essential and predominantly provided by the government, are also not amenable to the monetary policy action.

The wholesale price index (WPI) inflation, which is more directly related to monetary policy action, has been collapsing for sometime. The WPI recorded deflation (not inflation) of 4.12 per cent in June. All the WPI constituents — including manufactured goods — have been experiencing deflation in Q1 2024. Should the repo rate be so high at 6.5 per cent when the WPI is encountering deflation?

The RBI is targeting a wrong inflation index.

Bond prices

The effective interest rates or yield on financial assets such as bonds are more closely linked to the RBI determined repo rates. As yields go up when the RBI raises repo rates, the prices of bonds with lower interest rates go down. Banks and other holders of the bonds record mark to market losses.

While there is no direct one-on-one relationship between bond yields and repo rates as many other factors also work — like investment and government demand — it is far stronger than the relationship between the repo rate action and inflation.

As financial markets have become very large — a multiple of India’s GDP — investment bankers and bond market players watch the RBI rate action with bated breath. Their commentary is often motivated by their gains and losses rather than the policy’s inflation impact.

Banks’ profitability and consumers’ EMI

The most direct impact of the RBI monetary policy action India is on two sets of players — banks and retail borrowers, people who take housing and other consumer loans or run their credit card bills.

As the housing and other consumer loan interest rates have been mostly linked to repo-rates as benchmark, the banks immediately pass on the increase in repo rates to their loanees. To lull these loanees into inaction, the banks, instead of increasing their equated monthly instalments (EMIs), elongate the loan repayment period.

The current account balances do not earn any interest. The savings bank interest rates have not been increased in the last 15 months when repo-rates have gone up by 2.5 per cent. The difference between the loan interest rates and the current account and savings account (CASA) deposits, which all banks love, has widened by this margin. Old fixed deposits (FDs) continue to earn only the old low interest rates and the new FDs see increases lower than the increase in loan rates. Banks’ interest margin on fixed deposits also goes up.

Consequently, the banks’ net interest margin has risen quite sharply. This, accompanied by lower provisions on non-performing loans, explain the banks’ soaring profits in 2022-23 and Q1 2024.

The banks have been quick to raise interest rates on loans to pass on the impact of increased cash reserve ratio (CRR). While the increased CRR will transfer about Rs 5,000 crore of interest income from banks to the RBI, the banks will not lose any profits as they increase the loan rates.

Conclusion

The CPI Inflation is more impacted by non-monetary factors such as weather (irregular monsoon, heat in winters, floods, drought, etc.) and government policy action (ban on exports, reduction in import duties, etc.).

The people most impacted by the RBI monetary policy action in India are the retail borrowers who avail housing and other consumer loans. While they suffer, ironically, the banks make a lot of money at their cost.

The RBI, while deciding the monetary policy, should take into consideration the impact its action will have on the financial health of banks’ loanees. It is time the loanee-consumers also organise themselves to make their voice heard.

(Subhash Chandra Garg is former Finance & Economic Affairs Secretary, and author of ‘The Ten Trillion Dream’ and ‘Explanation and Commentary on Budget 2023-24’.)

Disclaimer: The views expressed here are the author's own. They do not necessarily reflect the views of DH.