RBI (Indiaâ€™s central bank) in its recently announced review of monetary policy has cautioned that it would be keeping a stern eye on inflation.
In its fight against inflation less than a fortnight after the announcement RBI has proposed an increase in the Cash Reserve Ratio (CRR) by a total of 50 basis points from 5.5 per cent to 6 per cent in two stages. The first hike of 25 basis points became effective on February 17 and the next 25 basis point hike will become effective from March 3, 2007.
Loosely speaking, the CRR dictates the percent of deposits which banks must set aside as cash and will, therefore, not have these available for lending. This hike will have the effect of drawing Rs 14,000 crore out of the banking sectorâ€™s funds available for lending.
This measure gains significance when seen against the fact that the banking sector has already been subjected to reigning in measures a fortnight ago. The combined effect of these measures drained out about Rs 13,500 crore of available bank funds.
During last one year inflation as measured by the Wholesale Price Index (WPI) has increased by almost 300 basis points from around 3.9 per cent to almost 6.6 per cent. While any economy needs some amount of inflation to keep it growing, an unduly high inflation can bring its progress crashing down. It could suddenly be faced with a situation where spending declines due to high prices and investment declines due to lack of demandâ€¦a situation that is more formally called a recession.
The RBI and the government are constantly looking out to avoid such a situation by toning inflation down whenever it starts to rise excessively. By drawing money out of the system, interest rates will increase (as they already have), people will invest more and spend less and the prices of goods will come down due to relatively subdued demand.
If you are servicing a floating rate loan or plan to take a loan in the near future, it is bad news. Interest rates on almost all types of loans are expected to go up. In the recently announced monetary policy, the RBI has already taken measures to curb loans. It increased the repo rate that is the rate at which banks borrow from the RBI by 25 basis points. Alongside, the policy focused on tightening credit to specific sectors by increasing the provisioning norms (amount of provision that must be made in the books against such loans) for select segments. These included credit card receivables, banksâ€™ stock market exposures, personal loans, loans to NBFCs and sections of real estate related loans. The net result of higher provisioning will mean that banks will be more prudent while disbursing loans to these segments and/or raise interest rates for such borrowers.
To add to that, the more recent increase in CRR will result in an increase in interest rates in segments, like auto loans, consumer good loans, etc., which were earlier spared. The up side of rising rates is that bank deposit rates will go up too.
Stock and bond prices:
Both stock and bond prices are expected to fall in the short term. This could mean a fall in the value of your overall portfolio if it comprises equity and/or mutual funds (equity or debt).
Real estate prices:
A further hike in the interest rates on home loans could ease the pressure on the near term demand for houses. So, while you may be able to get your dream house at a marginally cheaper rate, if you buy it with the help of a loan, the cost of financing it could swallow up the benefit.
The whole purpose of the CRR hike has been to curtail inflation. However, donâ€™t expect your day-to-day purchases to cost less right away. Drawing money out of the system has a roundabout effect on prices, which will be reflected in more stable prices only eventually.