How does Inflation Affect your loan interest rate?

A small bank in one of the villages of India has been distributing monies at very low rate of interest. Seeing that money is cheap & easy, the villagers have been buying all sorts of things.

Seeing that many households’ items demand has gone up, the shop-keepers have increased the price of the items. Now some important household items are getting out of reach for few households in the village. This brings a disruption in system since the earnings is still same, however, the cost-of-living increases. These concerns travel to the head office of the big bank which lent money to this small bank. They assess the situation and tells the small bank – “Curtail your lending”.

They ask the small bank to keep a sizeable amount of money as deposit (Cash Reserve Ratio) with the big bank and secondly it increases the Rate of interest of the loan given to the small bank (Repo Rate). With no choice left, the small bank too passes the higher ROI to the client and has limited kitty to fund its client. Seeing the higher ROI, the villagers take smaller loans and spend less. Seeing that there is less spending, the shopkeeper reduces the price of the items and everyone is now able to afford the required household things. The small bank here is any Nationalised/ Private Bank. The villagers are its clients and the big bank is RBI. This is an ideal scenario where the inflation is curb but in reality, it is a complex matter to understand given the current situation globally. For sake of simplicity, we haven’t factored the Corona Virus, Ukraine Russia War, the lockdown in China, the heatwave. These are some of the reasons why prices of Cereals, Meat, fish, Oils, fats, Pulses, Clothing, footwear, Fuel, light are rising.

There is a demand for these items but their supply is constraint and hence their prices have increased. The Banks doled out money at lower ROI and hence the demand was matched with the money available but the inflation mark has been crossing the 6% mark of RBI for last 4 months and it’s a worry for RBI. Now money is expensive and hence to restrict the inflation rates, RBI has increased the Repo rate & Cash Reserve Ratio. Since your lender has also borrowed money either through deposits or financing, they will pass on the higher ROI on to the end user and hence the end user too will take a brunt of the inflation. This is the period where Interest Rates will rise leading to lower demand. Lower demand means less production. The factories will remain idle and hence there may be lay-offs.

This will further lower the demand. Seeing that there is low demand, prices will fall and hence inflation rate will come down. With lower inflation, RBI will lower the rates and banks will dole out money again and the cycle continues.