The day Reshma received her salary, she went straight to Ramlal’s grocery shop to clear her monthly dues. Like many families in her neighbourhood, hers depended on the credit extended by the shopkeeper for everyday necessities. Ramlal was equally happy. After all, extending credit helped him retain loyal customers.
But this time, he had a warning. “Reshma, your monthly grocery bill will increase from next month,” he said. His distributors had raised their prices, leaving him little choice but to pass on the additional costs to his customers. Reshma understood. After all, Ramlal had a business to run.
Our banking system works somewhat similarly. In a supply chain, price changes at the top gradually reach the final consumer. Your neighbourhood bank is one of the last links in a much larger financial chain. At the top sits the mighty Reserve Bank of India (RBI).
When the RBI changes its policy interest rates, the effects gradually travel through the banking system. Sometimes the impact is immediate; sometimes it takes months, just as Ramlal adjusts his prices depending on existing stocks and fresh supplies.
Last week, the RBI increased its repo rate by 25 basis points to 5.50%. The repo rate is what banks pay when borrowing from the RBI under its repo facility. Higher borrowing costs can eventually translate into higher interest rates on home loans, car loans and personal loans. The previous repo rate increase was in February 2023, making this development particularly significant.
But why does the RBI change interest rates?
The RBI is the country’s central bank, responsible for maintaining monetary stability while balancing inflation and economic growth. Global conflicts, crude oil prices, international trade, tariffs and domestic economic conditions all influence its decisions. When inflation becomes a concern, higher interest rates can discourage excessive borrowing and spending. Conversely, lower rates can encourage economic activity when circumstances permit.
Those familiar with banking terminology may wonder about the reverse repo rate. Traditionally, this refers to the interest banks earn when parking surplus funds with the RBI. Today, the Standing Deposit Facility (SDF) performs much of this function. In the latest announcement, the SDF rate increased to 5.25%, while the fixed reverse repo rate was not separately revised.
The RBI also shifted its monetary policy stance from neutral to calibrated tightening, suggesting that further rate increases remain possible.
If this marks the beginning of another interest-rate cycle, borrowers may face higher costs. But savers could eventually benefit from better fixed deposit rates. Senior citizens and others dependent on interest income may particularly welcome such developments.
There is also renewed interest in fixed-income investments, especially bonds. However, investors should remember that rising interest rates generally reduce the market value of existing fixed-rate bonds. Higher rates do not automatically benefit every investor. Interest rates, like financial markets, move in cycles. They rise, stabilise and fall, sometimes over several years. Predicting these movements consistently is difficult. Preparing for them is far more sensible.
For ordinary people who work, earn, save and invest, maintaining a balanced portfolio of equity and debt investments is essential. Equity offers long-term growth potential, while debt instruments can provide income and relative stability. Neither is completely risk-free, but together they can help cushion economic uncertainties.
And what about Reshma?
She was not entirely unhappy. At home, she and her daughters made scented wax candles, which Ramlal and other neighbourhood shopkeepers sold. Their secret fragrance had become the talk of the town. Reshma hoped she could charge more for her candles too, provided customers continued buying them.
She understood something important: economic changes affect people differently. What raises one person’s expenses may create opportunities for another.We cannot control economic cycles. But we can certainly prepare our finances to withstand them.
Dipankar Jakharia
Guwahati
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