RBI hikes rates… So what?

Most of us do not really consider headlines associated with monetary policies of The Reserve Bank of India (read increase or decrease in interest rates) as being of any direct consequence to us but the underlying trends of these moves can have an impact on our personal finances.

The Reserve Bank of India (RBI) recently increased its key policy rates by 25 basis points (100 basis points = 1%) almost a month ahead of its quarterly monetary review meeting scheduled for July 27, 2010 in an attempt to contain rising inflation which in May stood at 10.16%. The move came a day after the government raised fuel prices that is expected to raise inflation by another 1% over current levels.

On July 2, RBI increased its Repo and Reverse Repo rates by 25 basis points to 5.50% and 4% respectively. Repo rate is the rate at which RBI lends short term funds to banks while Reverse Repo rate is the rate at which RBI borrows short term funds from banks. An increase in these rates results in reducing the available liquidity in the economy and is often used as a measure to curb inflationary pressures.

This is the third such increase in rates this year and most analysts and economists expect RBI to further increase these rates by another 25-50 basis points as part of its quarterly review later this month. With the current levels of inflation, it is now expected that this trend will continue for the remaining part of the year with further increases expected in the last quarter or even earlier.

What can one expect in such rising interest rate scenarios?

Both deposit and lending rates of banks are likely to inch upwards, even though with a lag. Deposit rates are likely to go up if liquidity dries up as a result of the measures taken by RBI and banks have to offer more to source funds. Banks may also come under pressure from the central bank to increase their deposit rates in an attempt to support its measures to curb inflation. Lending rates on the other hand will increase only if the demand for funds picks up and if deposit rates actually rise – this is because lending rates are now linked to the base rate of each bank which in turn is linked to the cost of funds. Higher deposit rates will result in a higher cost of funds for banks thereby resulting in higher lending rates.

Rising interest rates can also adversely impact the debt portfolio of investors – debt oriented mutual fund schemes or debt securities and bonds are likely to witness a fall in prices if rates continue to rise. This is because the price of a debt security is inversely linked to its yield. A simple explanation for this behaviour would be the fact that when interest rates rise, new securities are available that pay a higher interest and so the demand for older securities or bonds reduces thereby resulting in fall of prices for these bonds or securities.

The best course of action in a potential rising interest rate scenario is to try and invest in shorter duration schemes and deposits so as to have the flexibility and time to identify and move to better opportunities as and when they emerge.