Interest rates set by the Reserve Bank of India (RBI) have grown progressively this year, leading to higher EMIs for loans and credit costs for Indian households and businesses. This is happening as the RBI looks to tackle the stubbornly high retail inflation that has dominated the Indian economy over the last year. Understanding why interest rates are rising can help you make more informed financial decisions in the current landscape.

Decoding the RBI's Interest Rate Changes

The RBI controls key short-term interest rates like the repo rate and reverse repo rate to meet its primary objectives around managing inflation and encouraging growth. 

When the economy is expanding rapidly and inflation accelerates above the RBI's target ceiling of 6%, the central bank responds by raising interest rates. This makes borrowing more expensive across the economy, slowing lending activity, consumption, and investment spending. Rate hikes aim to cool down aggregate demand enough to align it with supply constraints in the economy. This helps tame the pace of price rises over the medium term.

Conversely, when economic growth slows sharply and inflation drops or turns into outright deflation, the RBI cuts bank interest rates to boost borrowing, spending, and business investment activity.

Key Reasons Behind RBI's Current Rate Hike Cycle 

The aftershocks of the COVID-19 pandemic and Russia's invasion of Ukraine impact the Indian economy via external channels like global supply shocks in commodities and imported inflation.

Despite these growth headwinds, the RBI initially kept rates low to support domestic demand. However, a combination of worrying factors has compelled the RBI over the last year to shift gears and raise rates aggressively to levels not seen since 2019. These include:

Elevated and Broad-Based Retail Inflation

Russia's war and pandemic-induced supply snarls sent prices of critical imports like oil, food, and fertilizers soaring globally. This imported inflation filtered through to Indian households via surging consumer prices.

As measured by the Consumer Price Index (CPI), India's retail inflation has stayed over RBI's target ceiling of 6% for nine straight months. Prices of food, fuel, housing, and services are rising rapidly.  

Bringing retail inflation sustainably within target requires dampening aggregate demand. Hence, RBI raised rates to incentivize saving over consumption.  

Rupee Depreciation Concerns

Rising US Fed rates to curb American inflation boosted the dollar and caused the rupee to weaken sharply against the greenback this year. A weaker rupee makes imports of critical items like oil more expensive in rupee terms, further feeding into domestic inflation.

Rate hikes also aim to stabilise the rupee rate by attracting foreign capital inflows seeking higher Indian debt yields. A stable rupee contains external inflation risks.

Robust Credit Growth

Bank lending has grown robustly 15-17% this year as credit demand recovered swiftly after the pandemic slowdown. However, high credit growth with rising inflation can risk overheating the economy.

The RBI is using aggressive rate hikes to slow the acceleration in credit and stabilize inflation expectations. 

Implications of Rising Interest Costs

In essence, higher interest costs make existing and new loans more expensive for individuals and businesses over the tenure of lending. This impacts budgets via:

  • Increased EMIs for home loans, vehicle loans, personal loans and business credit   
  • Potential delays or scaling back of larger business investments heavily reliant on debt financing
  • Greater incentives for consumers to save through fixed deposits than spend on discretionary purchases 

Conclusion

For the RBI, calibrating the pace of hikes to balance inflation control with durable growth will be crucial. For individuals, staying informed on RBI's evolving monetary policy stance and responding prudently is key to financial stability amid rising interest costs.