RBI keeps repo rate unchanged at 6.5%: What is repo rate and how it affects you

The Reserve Bank of India's (RBI) Monetary Policy Committee (MPC) has decided to keep the repo rate steady at 6.5%. This decision, announced by RBI Governor Shaktikanta Das early today, marks the ninth consecutive time the central bank has maintained the current rate, which was last adjusted in February 2023.

The MPC's decision was made by a majority vote of 4:2, reflecting a cautious approach to balance economic growth and inflation control. But what exactly is repo rate and how does it impact you? Read on as we explain.

Understanding the Repo Rate

The repo rate, or repurchase agreement rate, is a critical monetary policy tool used by the RBI. It is the rate at which the central bank lends money to commercial banks and financial institutions against government securities. By adjusting the repo rate, the RBI influences the money supply, which in turn affects inflation and economic activity.

How does it impact you?

Changes in the repo rate have significant implications for both borrowers and savers. When the repo rate increases, banks incur higher costs to borrow funds from the RBI. To maintain their profit margins, these institutions raise interest rates on loans, leading to higher borrowing costs for consumers. Conversely, a lower repo rate reduces borrowing costs, resulting in lower EMIs for various loans, including home, personal, and education loans.

Fixed deposit interest rates are also influenced by the repo rate. An increase in the repo rate can lead banks to offer higher interest rates on fixed deposits to attract more funds, benefiting depositors. On the other hand, a decrease in the repo rate might result in lower fixed deposit rates, affecting returns for savers.

Relationship between repo rate and inflation

As the lender of last resort, the RBI provides short-term funds to commercial banks through the repo rate mechanism. By doing so, it influences the interest rates that banks offer to their customers. This ability to control the cost of borrowing is a powerful tool for the RBI to manage economic stability.

In times of inflation, the RBI raises the repo rate to curb borrowing and encourage saving. Higher interest rates make loans more expensive, reducing consumer spending and slowing down inflation. Conversely, in a deflationary environment, the RBI lowers the repo rate to stimulate borrowing and spending, thereby boosting economic activity.

For example, there's a very popular bakery that everyone loves in a fictional town. This bakery makes the best bread and pastries, and almost everyone in town buys their daily bread from there.

During a period of low inflation, the central bank of the town (similar to the Reserve Bank of India) sets a low repo rate, meaning it's cheap for commercial banks to borrow money. As a result, banks borrow money at a low cost and are willing to lend more money to the residents at lower interest rates. The residents find it easy and cheap to get loans, so they have more money to spend. With more disposable income, people in the town buy more bread and pastries. The bakery sees a surge in demand.

With everyone having more money to spend, the demand for bread and pastries increases rapidly. The bakery struggles to keep up with the demand and starts raising prices. As the prices of bread and other goods in the town go up, inflation starts to rise.

The central bank notices that inflation is getting too high, making everyday goods more expensive for everyone. To control this inflation, the central bank decides to increase the repo rate.

During a high inflation period, with the increased repo rate, it's more expensive for commercial banks to borrow money. Consequently, banks in the town start lending less money and at higher interest rates. The residents find it harder and more expensive to get loans, so they have less extra money to spend. With less disposable income, fewer people buy bread and pastries. The demand decreases.

With lower demand, the bakery reduces its prices to attract more customers. As the prices of goods in the town start to stabilise or even decrease, inflation comes under control.