EspressoLogy

Why the repo rate affects share markets and the price of coffee!

What’s the connection between a change in the repo rate and the price of a cup of coffee? Why does a decrease in the repo rate make your home loan cheaper? How does the repo rate affect the stock market? What, indeed, is the repo rate? And why are we talking about this now?

Recently, the Reserve Bank of India left the repo rate unchanged on fears that it would lead to inflation. Since March 2020, the RBI has made two cuts in the repo rate – from 5.15% to 4.40% on March 27 and a further cut to 4% on May 22.

Let’s understand the repo rate and its intersection with our lives a little better.

What is the repo rate?

Repo rate or the repurchase rate is the rate at which the RBI lends funds to banks, usually for the short term. Banks use these funds to lend to people like you and me. So, when the RBI cuts the repo rate, banks can raise cheaper funds. As a result, they lend money to you at a lower rate of interest. Ergo, your loans to buy a home or a car or a TV become cheaper as the repo rate goes down.

The repo rate and inflation

RBI uses the repo rate to boost consumer demand or control inflation. It’s a fine balancing act like most such monetary policies are. Usually, when the rate of interest on loans go down, people borrow more and buy more stuff (be it coffee or computers). Demand rises. But as demand increases, prices tend to rise as well.

In March and May 2020, with India in lockdown, the RBI cut rates to spur demand and economic growth by making funds and liquidity available to consumers.

But over recent months, RBI’s priority has been to rein in inflation. Prices, as measured by the Consumer Price Index (CPI), have been steadily rising. In July, the CPI was 6.9%. It was 6.23% in June.

The government has set the RBI a target of keeping inflation at around 4% (with a ± 2% tolerance). Given that inflation is already over the tolerance of 6%, the RBI kept the repo rate unchanged, fearing it would push prices even higher.

The repo rate and stock markets

Stock markets and interest rates have a negative correlation – when interest rates go down, stocks do well, and when interest rates increase, stock prices recede. Why does this happen? For the same reason that we explained earlier. Lower interest rates boost demand. People borrow more and buy more. So, companies do well. This reflects in their stock market prices.

The opposite happens when interest rates rise. Loans are more expensive, so consumers buy fewer houses, cars and televisions. Demand falls. And so do stock prices.

It’s complicated

The interplay of interest rates and different aspects of our life and the economy are far more complex. The RBI uses a combination of policies, including the reverse repo rate (the rate at which the banks keep money with the RBI), the CRR (Cash Reserve Ratio), SLR (Statutory Liquidity Ratio) and so on, to manage the flow of money and its impact on the economy.

At the end of the day, what affects the economy impacts the share markets and, of course, the price of that cup of Espresso!