Business cycles · India · 2022
Why the RBI Raised Rates Off Cycle in May 2022
Why the RBI raised the repo rate between scheduled meetings in May 2022, how its cash reserve move worked, and what followed for Indian borrowers.
By Vimista EditorialPublished 5 min read
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On 4 May 2022, the Reserve Bank of India (RBI) raised the interest rate at which it lends to banks. It acted between its regular policy meetings instead of waiting for the next one. This is what “off cycle” means.
The RBI had kept borrowing cheap to support the economy during the pandemic. Now food and fuel were becoming more expensive, and it was worried that prices would keep rising. Why would making borrowing more expensive help?
Why waiting became harder
During the pandemic, the RBI had lowered its main lending rate to 4 percent and kept it there through April 2022. The idea was to make borrowing cheaper so people and businesses could keep spending.
By May 2022, rising prices had become a bigger concern. The war in Europe had pushed up global food and raw-material prices. The RBI’s Monetary Policy Committee (MPC), which decides its main lending rate, was worried that these increases would spread to more goods and services.
Imagine a business paying more for fuel and raw materials. It may bear the extra cost for a while, but eventually it may charge customers more. If many businesses do this, people start paying more for a wider range of purchases. Households and businesses may also begin to expect prices to keep rising. The MPC was concerned that inflation would spread and last longer.
A rise in the prices of the goods and services households buy is called consumer-price inflation. The RBI’s target was 4 percent, with a tolerance band of 2 to 6 percent.
Raising interest rates could not bring more oil or grain into the market. It could, however, slow some spending. A family might delay a purchase if the loan became too expensive, while a business might put off opening another shop. When spending grows more slowly, there can be less pressure on prices. The difficulty is that this can also slow the economy, so the RBI had to consider both inflation and growth.
The MPC met on 2 and 4 May and raised the rate from 4.00 to 4.40 percent with immediate effect. This was an increase of 40 basis points, or 0.40 percentage points. One basis point is 0.01 percentage points. The increase reversed a cut of the same size made in May 2020.
Two decisions, two routes into the banking system
Banks sometimes borrow short-term funds from the RBI, using eligible securities such as government bonds as security. The interest rate on this borrowing is the Repo rateThe repo rate is the rate at which the RBI lends short-term funds to banks against eligible securities. Changing it signals policy and influences other rates.View topic and related stories. When it rises, borrowing from the RBI costs banks more.
This can lead banks to raise the interest they charge on loans and offer on deposits. It also affects other short-term interest rates. But every loan and FD does not change on the day the RBI acts. The timing and size of the change depend on the bank, the product and the rate a loan is linked to.
The RBI also asked banks to keep more cash with it. Banks must keep a set share of their deposit-related obligations with the RBI rather than use that money elsewhere. This share is called the Cash reserve ratioThe cash reserve ratio is the share of a bank's net demand and time liabilities it must keep as cash with the RBI. Raising it reduces cash available elsewhere in the banking system.View topic and related stories. The formal calculation uses net demand and time liabilities, which include amounts payable on demand and those due later.
The RBI raised the CRR from 4 to 4.5 percent, starting with the fortnight beginning 21 May. It estimated that banks would have to keep about ₹87,000 crore more with it. Banks would therefore have less cash available for lending or other uses; the change did not take money out of customers’ account balances.
Suppose, in a simplified example, a bank has ₹100 crore of liabilities on which CRR is calculated. At 4 percent, it keeps ₹4 crore with the RBI. At 4.5 percent, it keeps ₹4.5 crore. With everything else unchanged, that leaves ₹50 lakh less for other uses.
The two changes worked in different ways: the repo increase made borrowing from the RBI more expensive, while the CRR increase required banks to keep more cash with it. The RBI was taking back some of the support it had provided during the pandemic, while saying it would keep enough cash available in the banking system for productive lending.
What followed after May
The RBI continued raising rates after May. It made six increases during the 2022–23 financial year, taking the repo rate from 4 percent before the May decision to 6.50 percent by February 2023.
Banks had already started passing on the changes. In June 2022, the RBI reported that banks were raising the lending rates used to price loans and the rates offered on term deposits. This is how an RBI decision begins to reach a household: through the interest it pays on a loan or earns on savings. The process is called monetary policy transmission.
What it meant for an Indian borrower or saver
Suppose you have a floating-rate home loan linked to the repo rate. “Floating” means the interest rate can change. When the repo rate rises, your loan rate can rise at its next reset, when the bank updates it under your agreement. Depending on the terms, your monthly instalment may increase, you may need longer to repay, or both. A fixed-rate loan follows its contract instead.
For someone opening a new Fixed deposit versus bondAn FD pays the agreed rate under its terms. An existing bond can change in market price when new bonds offer different yields.View topic and related stories, rising rates may mean earning more interest. An existing FD, however, keeps the rate agreed when it was opened for its term. It does not automatically pay more after an RBI hike. The RBI reported increases in term-deposit rates after May, but the rate a saver received depended on the bank and the deposit.
An existing fixed-rate bond works differently because it can be bought and sold. Imagine you own a bond that pays ₹5 a year on ₹100. A similar new bond now offers ₹7 a year. Why would a buyer pay the same price for your bond when it pays less? You may have to accept a lower price to attract a buyer.
This is why higher market interest rates can lower the Bond price and yieldWhen comparable new bonds offer a higher return, an older bond with fixed payments usually sells for less. Price and yield move in opposite directions.View topic and related stories. The size of the fall depends on its payments, how long remains until repayment and the return buyers want. This is a hypothetical example, not a measure of how a particular bond moved on 4 May.
What to remember
The RBI could not fix the supply of food or fuel by raising rates. It could make borrowing more expensive and slow some spending, helping to limit further price rises. That came with a cost: households and businesses could find it harder to afford purchases made with loans.
For a borrower or saver, the useful questions are simple: can my interest rate change, what is it linked to, and when will it change? The answers explain why the same RBI decision can raise the cost of a home loan while improving the rate offered on a new FD.
Sources
Show 5 sources
- Reserve Bank of India, “Monetary Policy Statement, 2022-23: Resolution of the Monetary Policy Committee (MPC), May 2 and 4, 2022”, 4 May 2022
- Reserve Bank of India, “Governor’s Statement”, 4 May 2022
- Reserve Bank of India, “Maintenance of Cash Reserve Ratio (CRR)”, circular RBI/2022-23/46, 4 May 2022
- Reserve Bank of India, “Annual Report 2022–23”, monetary-policy chronology, 30 May 2023
- Reserve Bank of India, “Governor’s Statement”, 8 June 2022