We know that when there is abundance of something, its price falls. The reverse happens in case of scarcity, when the price tends to increase.
This is simple #Economics101.
Now, think of money like any other commodity.
If you need some money now and your savings fall short, you can always borrow cash from a bank or financial institution.
However, borrowing money has a cost. We call it interest!
Now, think of a situation when money is in abundance in the economy. The price that you need to pay for it i.e the interest rate will be low.
On the other hand, when money supply is tight, the interest rates will be high.
The peril of Inflation!
Very recently, economic activities round the world were brought almost to a standstill, on account of the lockdowns induced by the deadly virus!
To help people and economies recover, Governments and Central Banks across the world undertook various measures to help ease the money supply in the economy.
Most Governments increased public expenditure to put more money in people’s hands. Some Governments like in the US also made direct cash (a.k.a stimulus) payments to their citizens to help them tide the crisis.
Central Banks, on the other other hand resorted to measures like Quantitative Easing and lowering bank rates and reserve requirements in a bid to stimulate credit growth in the economy.
However, all this (as well as the supply side issues brought about by Covid and the Russia-Ukraine War ) has led to another problem – Inflation!
What is inflation?
Inflation happens when the demand for goods and services outpaces their supply leading to an increase in price.
Over the past few months, we have seen inflation reach somewhat alarming levels across many economies. This has been brought about by the inter-play of various factors.
For one, Covid induced lockdowns had disrupted supply chains across the globe. After the economies gradually opened up, several inputs, including metals, essential for the production of goods and services were in short supply. This led to an increase in the price of inputs.
With input costs rising, the producers of goods and services had no option but to increase the prices of their output supplies.
The breakout of the Russia-Ukraine war, simply accentuated the supply side issues already plaguing the world.
For example, with several countries halting trade with Russia, Crude Oil prices; of which Russia is a major supplier, shot up.
This is bad news for a country like India which is heavily dependent on Crude Oil Imports to meet its growing energy requirements.
According to this report published in TOI, a $10 rise in Crude Oil price per barrel could lead to an increase of 40 to 60 basis points in the Consumer Price Index (CPI) in India. CPI is a measure of Inflation.
Aside from the supply side issues, there was one more critical factor at play.
As interest rates were historically low, people borrowed large sums of money to spend. While all this helped the economy recover by reviving demand, it also led to problem of excess demand.
Further, there was also a lot of pent up demand from the days when people were confined to their homes.
The coming together of all these factors, led to fears of Inflation going out of hand; prompting Central Banks to take action.
Central Bank Intervention!
Of late, Central Banks have been raising policy rates and bank reverse requirements in their fight against inflation!
All these tools are aimed at reducing the money supply in the economy; thereby increasing the cost of borrowing funds.
With interest rates increasing, the hope is that the consumers will pull back on some of the discretionary spending that they have been doing with borrowed money.
High interest rates also lead to more efficient allocation of capital by companies. When money is expensive, firms will tend to allocate capital to only the most productive projects.
The measures that central banks use to control inflation are collectively known as monetary policies.
Rate Changes & Reserve Requirements:
Central banks influence the lending rates of banks by changing the policy rates – repo and reverse-repo.
Repo rate is the rate at which banks can borrow from the central banks. Reverse repo, on the other hand, is the rate which banks earn when they deposit excess funds with the central banks.
Banks can face situations of short term liquidity mismatch because the deposits they accept and the money they lend have varying degrees of maturity. It is then, that they tap into the repo rate borrowings by selling approved securities to the central bank and then buying them back at a premium. Repo stands for Repurchase options.
So when central banks increase the repo rate, it increases the cost of funds for bank.
Moreover, as a corollary, increase in repo also mean an increase in the reverse-repo rate.
In times like this, when banks have excess liquidity, increase in reverse-repo rates assume greater significance.
This is because banks will only assume the risk of making a loan when they can make more money by making such loan than parking the funds, risk-free, with the central bank.
Central banks have also been raising the reverse requirements of banks.
Banks are required to hold a certain percentage of the deposits they accept from the public in liquid assets. The money they are left with after meeting the reserve requirements, can then be lent out.
When central banks increase these reserve requirements, banks are left with less money to lend.
This reduces money supply and increases the overall cost of funds for banks, pushing lending rates higher.
This is exactly what has been happening with lending rates showing an upward trend.
But will it be enough to control inflation?
Outlook for India:
While it is difficult to predict anything for certain, we must appreciate the fact our economy is extremely resilient.
While India’s savings rate has been coming down over the past few decades, it is still quite high as compared to some of the other large economies in the world.
With increase in policy rates, deposit rates are also expected to go up in the near future. This might increase the propensity of people to save.
Moreover, in the Indian context, presently inflation seems to be more of a supply side issue. High crude oil prices and higher cost of inputs on account of supply chain disruptions seem to be the major contributing factor.
When crude oil and input prices normalise, it is expected to have a more calming effect on the CPI numbers.
We can however expect the interest rates to move up in the short run till the time inflation levels are brought under control.