Explained: Relationship between repo rate and inflation

On September 30, the Reserve Bank of India (RBI) hiked repo rate (or the repurchase rate) by 50 basis points to 5.9%. This decision was largely priced in by the markets as inflation remained elevated. Repo rate is a pivotal tool used by the RBI to keep a tab on inflation. Let us understand how higher repo rate can help in taming inflation.
 
The primary objective of the monetary policy (announced once in two months) is to keep inflation at reasonable levels. Currently, monetary policy decisions are taken by the Monetary Policy Committee (MPC), which is headed by RBI Governor Shaktikanta Das. hashanka Bhide, Ashima Goyal, Jayanth Varma, Mridul K Saggar, and Michael Debabrata Patra are other members of the MPC.
 
After careful deliberation of trends in forex reserves, inflation, and the macro economy; the MPC decides whether to maintain the benchmark rates or change them. Some of the prominent rates are repo rate, reverse repo rate, cash reserve ratio and statutory liquidity ratio.
The repo rate is the interest rate at which the RBI lends money to commercial banks for a short term. These loans are given in exchange for government securities like bonds and treasury bills (T-bills).

Recent bouts of hike in repo rate are propelled by the spiking inflation which is way beyond RBI’s comfort zone (6%). CPI inflation or retail inflation has remained over 7% every month since April 2022.
 
Once the RBI hikes the repo rate, commercial banks have to shell out more money to borrow from the central bank. Banks, in turn, pass on this higher interest rate to its customer. This means, interest rate increases on deposits as well as loans provided by the banks. While customers get more return on parking their savings in deposits, they also pay more on existing as well as new loans. In effect, the money circulating in the economy, also known as liquidity, gets reduced. Consequently, the consumption demand (for homes, cars, etc.) goes down. This in turn, helps reign in the retail inflation.
 
In times of falling inflation, the RBI starts cutting repo rates with the aim of increasing money supply in the economy. Typically, there is a time lag between transmission of rates to the end customer. This happens because banks start adjusting their interest rates in response to RBI’s policy decisions. Usually, it takes 2-3 months for rates to trickle down to the borrower.