Here’s why the Reserve Bank of India hiked interest rates for the first time since January 2014

The Reserve Bank of India (RBI) raised its interest rates on Wednesday. This is the first time this has happened since the current BJP-led government came to power in May 2014.

The central bank raised the repo rate, a key interest rate, by 25 basis points to 6.25% after all six members of the monetary policy committee voted in favour of the hike. The committee did, however, opt for a neutral policy stance owing to the recovery in investment activity, indicating that the chances of another rate hike in the immediate future aren’t high unless conditions worsen.

The last time the RBI opted for monetary tightening was in January 2014, when it increased the repo rate to 8% to keep inflation in check. It has since reduced interest rates to support economic growth amid a global decline in oil prices.

This time around, the central bank was faced with a similar predicament with regards to increasing prices. Here is why it decided to raise interest rates:-

Higher-than-expected inflation

In its press release, the RBI cited the materialisation of “a major upside risk to baseline inflation”. India’s core inflation measurement has exceeded the 4% threshold for the past six months. Core inflation reached 5.92% in April while the Consumer Price Index (CPI), which includes food prices, increased to 4.58% from 4.28% in March. This was higher than the RBI’s projections, and these figures is expected to have increased further in May 2018.

A lot of this has to with oil prices. The average price of a barrel of crude oil in India has risen from $66 in April, when the last rate meeting was held, to a current level of $74. Higher fuel prices have translated into a higher prices for most commodities. Meanwhile, the declining value of the rupee has increased prices of imported goods and raw materials. This, in turn, has affected Indian households, who are clamouring for higher wages in response to higher costs of living.

In addition, the Indian government’s expected increase in house-rent allowances (HRA) for state employees and the revision of minimum support prices for kharif crops will also push inflation upwards. As a result, the RBI has raised its retail inflation forecast to a bracket of 4.8-4.9% for the first half of the fiscal year, and 4.7% for the second half. It needed to raise interest rates to reduce the supply of money, curtail demand and prevent a further spike in inflation.

Taking a cue from the US Federal Reserve and other countries

The US Federal Reserve has been gradually raising interest rates in the last few years - seven times since December 2015 to be exact - as economic growth and inflation have stayed buoyant. It is expected to hike interest rates again when it meets next week, marking the second rate hike of 2018.

As money is flowing back to developed countries like US in pursuit of higher interest earnings, leading to a stronger dollar, a number of emerging markets like Argentina, Philippines and Indonesia have also increased rates to withstand currency pressures and prevent outflows of funds. For it’s part, in just the first five months of 2018 alone, Indian experienced the highest annual exodus of foreign portfolio investment funds in 10 years.

Positive outlook on economic growth

The risk of any rate hike is a slowdown in economic growth, as borrowing costs become higher - leading to a lesser capital expenditure and lower demand for retail loans. However, India’s growth projections for this year are quite solid. After growing at a rate of 6.6%-6.7%, the economy is widely expected to grow at around 7.3%-7.4% this year amid improving capacity utilisation, high consumption, especially in rural areas, and continued investment. Hence, the central bank had sufficient leeway to increase rates without severely impacting growth estimates.

How will this impact the average Indian?

In the near term, retail loans for purchasing houses and cars will be more expensive. A number of banks such as State Bank of India, HDFC and ICICI preemptively raised their benchmark lending rates by 10 basis points a few days ago. Conversely, some banks will also increase deposit rates, which will be beneficial for people looking to save money.

Given its neutral policy stance, the RBI is keeping its options open. If inflation continues its ascent, which is a possibility given the upward trajectory of global oil prices and the government’s minimum support price scheme for farmers, another rate hike could very well happen. However, this is dependent on quarterly estimates of economic growth being achieved.

It’s going to be an interesting couple of months. The RBI’s monetary policy committee is scheduled to meet next on the 1 August.