Repo Rate

The repo rate refers to the rate at which central banks lend short-term credit to commercial banks in exchange for collateral. Its purpose is to deal with the shortage of funds faced by banks in the financial market.

The repo rate is a useful instrument for central banks to regulate the money supply in a market. As a measure, authorities regulating the monetary policy adjust the repo rate per the economy. Central banks also employ it to combat price inflation in an economy.

• The repo rate is the interest rate at which commercial banks take short-term loans from central banks.
• An increase in the repo rate intends to raise lending rates, limit the money supply, and control inflation. At the same time, decreasing it can help boost economic activities, encourage borrowing, and expand the economy.
• Its opposite is the reverse repo rate at which the central bank borrows from commercial banks.
• Commercial banks transfer the repo rate to their customers by increasing or decreasing loan rates.

The repo rate is the lending rate offered by a central bank to a commercial bank for its short-term funding requirements. The commercial banks then pass on the interest rate levied by the central bank to their consumers through loan interest. Hence, the repo rate is directly proportionate to the interest rates paid on commercial loans by banks.

A central bank is responsible for monetary control, foreign reserves management, bank operations regulation, and inflation monitoring in every nation. For that, it uses different rates, such as repo and reverse repo rates, and provides economic policy advice to the government. Repo and reverse repo rates are the most crucial duties for the central bank out of all those listed above. As the name suggests, the reverse repo rate implies the lending rate offered by a commercial bank to a central bank.

The repo rate is an effective way for commercial banks to satisfy their short-term liquidity requirements. The repo rate, determined by the central bank, is the rate at which commercial banks trade securities or bonds for loans. Since commercial banks are paying a specific rate on their borrowings from the central bank, it transfers this rate to its clients by increasing/decreasing lending rates.

The repo rate history dates back to the 1970s when inflation surged and regulatory limitations prevented deposit rates from increasing. The restriction on bank interest rates led to the interbank repo market. As inflation escalated during the late 1970s and early 1980s, the size and significance of the U.S. repo market grew substantially. As a result, short-term interest rates climbed throughout the era due to rising inflation.

Banks could not boost the deposit rates provided to clients due to a Fed regulation that capped deposit rates. A widening disparity between restricted bank rates and rising market rates prompted organizations and individuals to avoid banks.

Consequently, many institutions began to route money directly to the repo market. Also, other institutions and people started to participate in mutual funds, diverting money to the repo market. This is how the repo market formed and flourished.

Repo rate is a defining factor in determining retail lending rates and regulating inflation. Suppose the government wants to control rising prices. In that case, it entrusts the central bank with taking the necessary steps to combat inflation.

As inflation occurs due to the dollar's devaluation due to a surplus of money in the economy, the central bank decides to restrict the money supply. In doing so, the central bank raises the repo rate for commercial banks, causing a chain reaction of rising lending rates for customers and the market.

Thus, individuals begin to spend less, and the money supply declines to decrease inflation. Consequently, reducing the repo rate will stimulate expenditure, demand, and consumption of commodities, resulting in economic expansion.

Below given repo rate examples will help understand the concept clearly:

Example #1

Assume that the inflation rate in nation "A" has been increasing. Hence, the government asks its central bank "ABC" to control inflation. Since ABC is aware of how it works, it increases the overall repo rate for all banks from 3% to 3.5%.

As a result, commercial banks requiring $100,000 to lend to their customers would now pay $3,700 as interest instead of $3,000. Consequently, the commercial lending interest rate will increase proportionately, making loans more expensive. As a result, it will discourage firms and individuals from borrowing loans, and less money would be infused into the market resulting in inflation control.

Example #2

According to the repo rate news on Reuters, the US dollar value declined compared to other currencies due to an increase of 75 basis points in interest rates by the Federal Reserve. It was a significant step in combating inflation. Federal Reserve anticipated a sluggish economy and growing unemployment in the future.

The rate increase was the highest by the U.S. central bank since 1994 after recent statistics indicated little headway in the fight against inflation. The dollar was 0.50 percent weaker at 104.76 after jumping to a high of 105.79, its highest level since December 2002, immediately following the Fed's announcement.

Any changes in repo rate can affect a nation's economy in the following ways:

This has been a guide to Repo Rate & its meaning. Here, we explain its history, function, and impact on the economy with examples. You may learn more about economics from the following articles –

• Bank Rate vs Repo Rate
• Repo Rate vs Reverse Repo Rate
• Fair Credit Reporting Act (FCRA)