Ahead of inflation data, understanding how CPI is linked to RBI and markets

The Reserve Bank of India (RBI) hiked the benchmark interest rate, or repo rate, in May and then in June to control demand and liquidity in the economy, bringing CPI down

India will on Tuesday release its June data consumer price index (CPI) or retail inflation, which was at 7.04 per cent in May. The Reserve Bank of India (RBI) hiked the benchmark interest rate, or repo rate, in May and then in June to control demand and liquidity in the economy. After the hike, inflation eased to 7.04 per cent from an 8-year high of 7.79 per cent in April.

The repo rate--at which the RBI grants loans to the commercial banks against government securities--was hiked by 40 basis points in May after two years of pause. Currently it stands at 4.9 per cent. The cash reserve ratio (CRR)—the amount of money banks must keep with the RBI without getting interest--was also hiked to 4.5 per cent in May. It had remained at 4 per cent since May 2021.

Inflation in last six months, that has stayed over the RBI's upper tolerance level of 6 per cent, can be attributed to the higher food and fuel prices. Food inflation rose from 4.05 per cent in December 2021 to 7.84 per cent in May 2022. In April 2022, it touched a high of 8.10 per cent in April 2022. The oil prices rose from $77 per barrel in December 2021 to $123.66 in May 2022.

How are inflation figures and repo rates linked?

The repo rate determines the interest rate that will be given by the banks to the depositors. It also determines the interest rates banks would charge from the customers on the loans granted.

Generally, repo rates and bank interest rates are directly proportional.

When interest rates on deposits go up, investors usually pull out their money from other instruments and park it with banks. This reduces the money in hand and thus demand in the economy goes down. With the supply staying constant, a fall in demand pushes the prices downwards.

However, it also has an impact on the share markets.

How do the markets get impacted by repo rate hikes?

When the repo rate is hiked, investors usually pull out from markets and park it with banks. This leads to a fall in the benchmark indices, which for India are Sensex and Nifty50.

From 56,975 points on May 1, Sensex fell over 1,300 points to 55,669 on May 4, 2022, the day the repo rate hike was announced. Later, on June 8, when another rate hike was announced Sensex fell to 54,892 from 55,818 on June 2.

Nifty50 fell nearly 300 points from 17,096 to 16,677 on May 4. It has stayed below 17,000 since then.