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INFLATIONV/S
INTEREST RATES
GROU
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CONTENTS
SR.N
O
TITLE PG
NO
1 INTRODUCTION 3
2 INFLATION 4
3 CAUSES OF INFLATION 7
4 INTEREST RATES 12
5 RELATIONSHIP 13
6 EFFECTS 16
7 INVESTMENT STRATEGIES 18
8 ARTICLE 22
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INTRODUCTION
Interest rates and Inflation rates are very important rudiments in
current economy as whole.
Now-a-days, you might have heard lot of these terms and usage on
inflation and the bank interest rates. Here we understand the
relation between inflation and bank interest rates in India.
Bank interest rate depends on many other factors, out of that the
major one is inflation. Whenever you see an increase on inflation,
there will be an increase of interest rate also.
Well, coming to the point, we can say that there is a strong
correlation between interest rates and inflation. Interest rates reflect
the cost of money, such as the rate you pay when you borrow
money to buy a house or spend on your credit card. Inflation is the
cost of things. The world has seen a dramatic decline in inflation
rates in recent decades, but concerns about inflation are still
warranting especially in some countries. Evidence is mounting that
inflation is harmful to economic activity even at fairly modest rates
of inflation because of the way it adversely affects the banking
sector and investment. One way inflation might affect economic
growth through the banking sector is by reducing the overall
amount of credit that is available to businesses. Higher inflation can
decrease the real rate of return on assets. Lower real rates of return
discourage saving but encourage borrowing.
In order to understand the relationship between Inflation and
Interest Rates, it is essential that we understand each of the terms
in brief which will be explained below.
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INFLATION
A commonly used definition of the word inflation is simply "an
increase in the price you pay or a decline in the purchasing
power of money thats it.
Further, in two ways Inflation can be explained neither
mutually exclusive. One way to think about inflation, the
increasing cost of things, is too much money chasing too few
goods. In essence, this bids up the price of the goods, inflating
their cost. The other way for prices to go up could be that
production costs go up. A labour union negotiating a contract
for a higher wage, for example, could cause the cost of the
product the union members produce to increase, or inflate. Inflation generally means rise in prices. Inflation is an increase
in the price of basket of goods and services that is
representative of the economy as a whole. In simple words it
can be described as increase in the price you pay or a decline
in the purchasing power of money .The word 'Inflation' ,
therefore, refers to a growth or increase in money supply. As
one of the important economic concepts, the effects of inflation
exert impact both in the economic and social spheres of a
nation and on its inhabitants. Inflation is defined as an increase in the price of bunch of
Goods and services that projects the Indian economy . An
increase in inflation figures occurs when there is an increase in
the average level of prices in Goods and services. Inflation
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happens when there are lesser Goods and more buyers, this
will result in increase in the price of Goods, since there is more
demand and less supply of the goods .
Inflation has been defined as too much money chasing too few
goods. This attributes the cause of inflation to monetary
growth relative to the output of goods and services. Inflation is
a persistent rise in the general level of prices of all goods and
services taken together. A specific price in one commodity may
rise dramatically as in the case of oil or gas. But if this specific
price is nullified by declines in prices of other commodities, the
general price level may not rise at all i.e. there is no inflation.
The general level of prices depends on a series of individual
price changes and their relative importance some measure of
these factors, namely, a price index is required. Inflation is often reported as a percent change in the overall
price level between two periods as measured by a price index .
When the general price level rises, each unit of currency buys
fewer goods and services. Consequently, inflation also reflects
an erosion in the purchasing power of money a loss of real
value in the internal medium of exchange and unit of account
in the economy. A chief measure of price inflation isthe inflation rate , the annualized percentage change in a
general price index (normally the Consumer Price Index ) over
time.
But rise in some individual price index will not result
into what is generally meant by inflation, its consequences
wont be particularly serious if the change in the price index
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quickly reversed itself and price stability is maintained. To
become and remain a problem demanding concern, it should
involve a long succession of increases in a price index.
Thus inflation can be defined as a sharp increase in the rate of
change of a price index above an acceptable level that lasts
over a time period long enough to create expectations of its
future persistence.
Inflation can be recognized as a combination of 4 factors :
The Supply of money goes up The Supply of Goods goes down Demand for money goes down Demand for goods goes up
Inflation for the month of June surged to 9.44 per cent from 9.06 per
cent in May 2011.
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CAUSES OF INFLATION
Long term inflation occurs when the money supply (currency
and check writing deposits) grows at a faster rate than the
output of goods and services. When there is more money
available than is needed to accommodate normal growth in
output, consumers and businesses want to purchase more
goods and services than can be produced with current
resources (labor, materials, and manufacturing facilities)
causing upward pressure on prices. This is often described as
"too much money chasing too few goods.
Over a shorter term, inflation can result from various shocks to
the economy. Food and energy price shocks are common
examples of this in the U.S. The price of a critical commodity
such as fuel may rise suddenly and sharply relative to other
prices. Since the market does not have time to adjust other
prices downward in response, a short-term increase in overall
prices occurs. The rate of inflation is sometimes reported with
food and energy omitted so the long-term, underlying (or
"core") inflation rate is revealed.
There are a few different reasons that can account for the inflation
in our goods and services; let's review a few of them.
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Demand-pull inflation refers to the idea that the economy
actual demands more goods and services than available. This
shortage of supply enables sellers to raise prices until an
equilibrium is put in place between supply and demand.
The cost-push theory , also known as "supply shock
inflation", suggests that shortages or shocks to the available
supply of a certain good or product will cause a ripple effect
through the economy by raising prices through the supply chain
from the producer to the consumer. You can readily see this in oil
markets. When OPEC reduces oil supply, prices are artificially
driven up and result in higher prices at the pump.
Money supply plays a large role in inflationary pressure as
well. Monetarist economists believe that if the Federal
Reserve does not control the money supply adequately, itmay actually grow at a rate faster than that of the potential
output in the economy, or real GDP. The belief is that this will
drive up prices and hence, inflation. Low interest rates
correspond with a high level of money supply and allow for
more investment in big business and new ideas which
eventually leads to unsustainable levels of inflation as cheapmoney is available
Inflation can artificially be created through a circular increase in
wage earners demands and then the subsequent increase in
producer costs which will drive up the prices of their goods and
services. This will then translate back into higher prices for the wage
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earners or consumers. As demands go higher from each side,
inflation will continue to rise
Governments need to control high levels of unpredictable inflation
since it can severely disrupt the economy, cause uncertainty in
financial decisions, and redistribute wealth unevenly. The tools they
have available include:
1. Monetary policy (increase or decrease the money supply),
2. Fiscal policy (change the amount of taxes and governmental
spending),
3. Various controls on prices, tariffs, and monopolies.
Many nations (including the U.S.) choose monetary policy as their
primary tool since it has proven to be very effective, it is less
disruptive to market operations, and it is easier and quicker to
implement since adjusting the money supply does not require
legislative approval as would, for instance, changing the tax
structure
HOW DOES INFLATION AFFECT THE ORDINARY
MAN?
Inflation affects different people or economic agents differently.
Broadly, there are two economic groups in every society, the fixedincome group and the flexible income group.
During inflation, those in the first group lose while those in the
second group gain. The reason is that the price movement of
different goods and services are not uniform. During inflation, most
prices rise, but the rate of increase of individual prices differ. Prices
of some goods and services rise faster than others while some may
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even remain unchanged. The poor and the middle classes suffer
because their wages and salaries are more or less fixed but the
prices of commodities continue to rise. On the other hand, the
businessmen, industrialists, traders, real estate holders, speculators
and others with variable incomes gain during rising prices. The latter
category of persons becomes rich at the cost of the former group.
There is transfer of income and wealth from the poor to the rich.
More generally, which income group of the society gains or losses
from inflation depends on who anticipates inflation and who does
not. Those who correctly anticipate inflation can adjust their present
earnings, buying, borrowing and lending activities against the loss of
income and wealth as a result of inflation.
To further determine the effect of inflation on individuals, it will be
necessary to discuss the effect of inflation on different groups.
a) Creditors and Debtors : When there is inflation, creditors are
generally worse off because, the real value of their future claims is
reduced to the extent of the rate of inflation. On the other hand,
when inflation occurs, debtors tend to pay less in real terms than
they had borrowed. Therefore, it could be said that inflation favours
debtors at the cost of creditors.
b) Salaried Persons : Those with white-collar jobs lose during
inflation because their salaries are slow to adjust when prices are
rising.
c) Wage Earners : Wage earners may gain or lose depending on
the speed with which their wages adjust to rising prices. If their
union is strong, they may get their wages linked to the cost of living
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index. In this way, they may be able to protect themselves from the
negative effects of inflation. Most often in real life there is a time
lag between the rise in the wages of employees and the rise in
price.
d) Fixed Income Group : These are recipients of transfer
payments such as pensions, unemployment insurance, social
security, etc. Recipients of interest and rent also live on fixed
incomes. These people lose because they receive fixed payments
while the value of money continues to fall with rising prices.
e) Equity Holders and Investors : These group of people gain
during inflation as the rising prices expand the business activities of
the companies and, consequently, increase profit. Thus, dividends
on equities also increase. However, those who invest in debentures,
bonds, etc, which carry fixed interest rates, lose during inflation
because, they receive fixed sum while purchasing power is falling.
f) Businessmen : Producers, traders, and real estate holders gain
during periods of rising prices. On the contrary, their costs do not
rise to the extent of the rise in prices of their goods. When prices
rise, the value of the producers inventories rise in the same
proportion. The same goes for traders in the short run. The holdersof real estates also make profit during inflation because the prices of
landed property increase much faster than the general price level.
However, business decisions are difficult in an environment of
unstable price. In the long-run, there could be an increase in wages
which will reduce profit thereby, having an adverse effect on future
investment.
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g) Agriculturalists : Agriculturalists are of three types, namely,
landlords, peasant proprietors and landless agricultural workers.
Landlords lose during rising prices because they get fixed rents.
Peasant proprietors who own and cultivate their farms gain. Prices
of farm products increase more than the cost of production. Prices
of inputs and land revenue do not rise to the same extent as the rise
in the prices of farm products. On the other hand, the wages of the
landless agricultural workers are not raised by the farm owners,
because trade unionism is absent among them. But the prices of
consumer goods rise rapidly. So landless agricultural workers are
losers.
h) Government : Inflation will have both positive and negative
effects on the government. The government as a debtor gains at
the expense of households who are its principal creditors. This is
because interest rates on government bonds are fixed and are not
raised to offset expected rise in prices. The government in turn
levies less tax to service and retire its debt. With inflation, even the
real value of taxes is reduced. Inflation helps the government in
financing its activities through inflationary finance. As the money
income of people increases, government collects that in the form of
taxes on incomes and commodities. So the revenue of the
government increases during rising prices.
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INTEREST RATES
A rate which is charged or paid for the use of money is called
the interest rate. An interest rate is the rate at which interest is
paid by a borrower for the use of money that they borrow from
a lender . For example, a small company borrows capital from a
bank to buy new assets for their business, and in return the
lender receives interest at a predetermined interest rate for
deferring the use of funds and instead lending it to the
borrower. Interest rates are normally expressed as
a percentage rate over the period of one year. An interest rate is often expressed as an annual percentage of
the principal. It is calculated by dividing the amount of interest
by the amount of principal.
If a business wants to borrow Rs. 1 million from a bank, the
bank will charge a specific interest rate that will usually be
expressed in terms of a percentage over a given period of
time.
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RELATIONSHIP
Interest rates are the rate of interest you receive or pay depending
whether you save or borrow money respectively. The higher the interest rate the more expensive it becomes to
borrow money and the more attractive saving becomes.If your
bank decided to double the interest rates on your savings
account you will be more likely to put more in it, thus the
higher the interest rate the more money is restricted from the
money supply having an adverse effect on inflation.
e.g. If numerous people can purchase the same house, theprice of the house is likely to increase because there are
several prospective buyers.
In other words, the cheaper cost of money drives up (inflates)
the price of the home. Historically, you can plot the correlation
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between interest rates and inflation and see that there is a
strong positive correlation between the two.
Interest and Inflation are key to investing decisions, since they
have a direct impact on the investment yield. When prices rise,
the same unit of a currency is able to buy less. Investors aim
to preserve the value of their money by opting for investments
that generate yields higher than the rate of inflation. In most
developed economies, banks try to keep the interest rates on
savings accounts equal to the inflation rate. However, when
the inflation rate rises, companies or governments issuing debt
instruments would need to lure investors with a higher interest
rate.
Inflation is the rate of increase in the general price level, so a
10% inflation rate means prices overall are 10% higher than a
year ago. Interest rates are the cost of borrowing, or the price
of money. A 10% interest rate is the return a saver will get, or
the amount a borrwer will have to pay, over a year. There are
many ways of thinking about the link between interest rates
and inflation. The easiest is the one used by the Bank of
England.
When economic growth is strong, and in particular when spare
capacity has been used up - economists say the output gap
has been closed - there will be pressure for higher inflation.
One example would be that when unemployment is low,
additional demand for labour will tend to push up the growth in
wages.
Interest rates are therefore used to keep growth broadly in line
with its long-run trend of 2.5% or so each year. Higher interest
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rates discourage borrowing and encourage saving and will
tend to slow the economy. Lower rates encourage borrowing
and have the opposite effect
Inflation is an autonomous occurrence that is impacted by money
supply in an economy. Central governments use the interest rate to
control money supply and, consequently, the inflation rate. When
interest rates are high, it becomes more expensive to borrow money
and savings become attractive. When interest rates are low, banks
are able to lend more, resulting in an increased supply of money.
Alteration in the rate of interest can be used to control inflation by
controlling the supply of money in the following ways:
A high interest rate influences spending patterns and shifts
consumers and businesses from borrowing to saving mode. This
influences money supply. A rise in interest rates boosts the return on savings in building
societies and banks. Low interest rates encourage investments in
shares. Thus, the rate of interest can impact the holding of
particular assets.
A rise in the interest rate in a particular country fuels the inflow
of funds. Investors with funds in other countries now seeinvestment in this country as a more profitable option than before.
DRAWBACKS OF HIGHER INTEREST RATES:
Business activity in the market slows down. The threat of high
interest rates makes individuals and companies defer taking out
loans which could have been used to finance a new business orbuild a house. Less economic activity translates to slower economic
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growth. Slower growth means reduced company investments, less
job opportunities for people, or worse, lay-offs of employees.
INVERSE RELATIONSHIP
Of course , there is typically an inverse relationship, high interest
rates equals low inflation, low interest rates equals high inflation.
If there is more money in an economy, people tend to spend more.
If there is less money in an economy, there is less to spend and low
demand equals lower prices.
If interest rates are low, money is easier and cheaper to borrow,
hence more money in an economy. If rates are high, it is more
expensive to borrow, hence less money in an economy.
STAGFLATION:
There is also a concept know as stagflation, when interest rates and
inflation both increase, such was the case in the Carter
Administration. External market factors or market manipulation may
cause stagflation.
EFFECTS
Inflation affects both the economy of a country and its social
conditions, as well as the political and moral lives of its inhabitants.
However, the economic effects of Inflation are stated and described
below:
Price inflation has immense effect on the Time Value of Money
(TVM). This acts as a principal component of the rates of interest,
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which forms the basis of all TVM calculations. The real or estimated
changes occurring in the rates of inflation lead to changes in the
rates of interest as well.
Inflation exerts impact on the treasury of a nation as well. In
United States of America, Treasury Inflation-protected Securities
(TIPS) ensures safety to the American government, assuring the
public that they will get back their money. However, the rates of
interest charged by TIPS are less compared to the standard
Treasury notes.
The most immediate effect of inflation is the decrease in the
purchasing power of dollar and its depreciation. Inflation influences
the investments of a country. The Inflation-protected Securities
(IPSs) may act as a guard against the loss in the purchasing power
of the fixed-income investments (like fixed allowances and bonds),
which may occur during inflation.
Inflation changes the allocation of income. This exerts
maximum effect on the lenders than the borrowers at the time of
persisting inflation, because the loans sanctioned previously are
paid back later in the form of inflated dollars. Inflation leads to a
handful of the consumers in making extensive speculation, to
derive advantage of the high price levels. Since some of the
purchases are high-risk investments, they result in diversion of the
expenditures from regular channels, giving birth to a few structural
unemployments.
EFFECTS ON TIME VALUE OF MONEY:19
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As we all know, the simple meaning of TVM is The idea that money
available at the present time is worth more than the same amount
in the future due to its potential earning capacity. Price Inflation
greatly effects time value of money (TVM). It is a major component
of interest rates which are at the heart of all TVM calculations.
Actual or anticipated changes in the inflation rate cause
corresponding changes in interest rates. Lenders know that inflation
will erode the value of their money over the term of the loan so they
increase the interest rate to compensate for that loss.
Changes in the inflation rate (whether anticipated or actual) result in
changes in the rates of interest. Banks and companies anticipate the
erosion of the value of money due to inflation over the term of the
debt instruments they offer. To compensate for this loss, they
increase the interest rates. The central bank of a country alters
interest rates with the broader purpose of stabilizing the national
economy. Investors need to keep a close watch on interest and
inflation to ensure that the value of their money increases over
time.
INVESTMENT STRATEGIES DURING HIGH
INFLATION AND HIGH INTEREST RATES
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As interest rates fluctuate, investors start exploring new investment
opportunities to diversify their portfolio. They usually do so to hedge
against the risk associated with their existing investment.
Short-term interest rates have been at historic highs for quite
sometime and it's expected that rates may go up soon again to curb
ongoing inflation. That may worry investors about the value of their
investments. Some financial instruments are very much sensitive to
the interest rates.
When it comes to a rising interest rate environment there
are several things to consider. Below are few strategies you
can adopt during rising interest rates scenario:
There is an inverse relationship between the interest rates and
the price (face value) of the bond. When interest rates go up,
the value of the bond go down. The bonds with long-term
maturity are more sensitive to rate changes. Historically, rising
interest rates have caused the prices of existing bonds to
decline because newly issued bonds carry higher rates, which
pushes down the value of previously issued securities. Bonds
with shorter maturity generate good returns so you can
switch your investments in high-duration bond funds into funds
with a lower duration and average maturity i.e. short-term
bonds.
Floating rate funds can be a good option in rising rate
scenario. Floating rate funds vary from conventional fixed rate
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is revised at regular intervals with respect to change in the
benchmark rate. Consequently, if there is a rise in the interest
rate, the coupon rate usually reflects this change, thereby
securing the interests of investors during rising interest rates.
Some of the floating rate funds available in the market are
Birla Sun Life Floating Rate Fund, HDFC Floating Rate Income
Fund, Canara Robeco Floating Rate Fund, etc.
Investing in defensive stocks is also a bull strategy during
rising rate scenario. You can buy stocks of the companies that
make or sell products that people have to buy no matter what:
medicine, for instance, or groceries. Defensive industries such
as health care, consumer staples, and agriculture wouldn't
affect much during such time in-fact they are dominant players
in the market and they usually maintain earnings growth in
most economic conditions. So you can buy stocks of suchcompanies.
Commodities offer real protection and hedge against high
inflation and high interest rate environment. That's because
when inflation is surging, price of natural resources like oil,
food, and raw materials soar too. And, metals like gold andsilver are considered to be as safe haven during such times.
With a small stake in commodities -- say, 8% to 10% -- you can
lower your portfolio's risk regardless of the economy.
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WHY MUST THE CENTRAL BANK FIGHT
INFLATION?
Central banks the worlds over are obsessed about inflation and,
therefore, devote a significant amount of resources at their disposal
to fight inflation. Hence, the primary objective of monetary policy is
to ensure price stability. The focus on price stability derives from
the overwhelming empirical evidence that it is only in the midst of price stability that sustainable growth can be achieved. Price
stability does not connote constant (or unchanging) price level, but
it simply means that the rate of change of the general price level is
such that economic agents do not worry about it. Inflationary
conditions imply that the general price level keeps increasing over
time. To appreciate the need to fight inflation, it is imperative tounderstand the implications of frequent price increases in the
system. Some of these implications include:
Discouragement of long term planning;
Reduction of savings and capital accumulation;
Reduction of investment;
Shift in the distribution of real income and consequent
misallocation of resources;
Creating uncertainty and distortions in the economy.
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To avoid any of the situations above, central banks ensure that the
price level remains stable. This is achieved by implementing
policies that guard against inflation. Indeed, instability in the
general price level undermines the function of money as a store of
value and discourages investment and growth
Highlights of RBI Monetary Policy Review for first quarter of
the financial year FY2010-11:
The Bank Rate has been retained at 6.0%
Repo rate increased by 25 bps from 5.5% to 5.75% with
immediate effect
Reverse repo rate increased by 50 bps from 4.0% to 4.50%
with immediate effect
Cash Reserve Ratio (CRR) of scheduled banks has been
retained at 6.0% of their net demand and time liabilities (NDTL)
The projection for WPI inflation for March 2011 has been raised
to 6.0% from 5.5%
Baseline projection of real GDP growth for FY2010-11 is revised
to 8.5%, up from 8.0% with an upside bias
M3 and non-food credit growth projections for FY2010-11 have
been retained at 17% and 20% respectively
Mid-quarter review of Monetary Policy to be a regular event
beginning from 16 September 2010
In essence the RBI announced no hike in CRR and a 25 bps
(bps) increase in Repo rate but a 50 bps hike in Reverse Repo
rate was not expected by many.
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The RBI said that the Monetary Policy actions are expected
to:
Moderate inflation by reining in demand pressures andinflationary expectations.
Maintain financial conditions conducive to sustaining growth.
Generate liquidity conditions consistent with more effective
transmission of policy actions.
Reduce the volatility of short-term rates in a narrower corridor.
ARTICLE
Faced with slowdown in credit demand, Indian bankers on Monday urged the
Reserve Bank of India to hold the policy rates at the current levels, and sought
a clearer picture on the future interest rates. Lenders have suggested to the
central bank to pause its rate hike cycle and also urged for a clear forward
looking statement on interest rates at the policy review next week, said K Ramakrishnan, chief executive officer, Indian Banks Associations (IBA).
He was talking to the media after the customary pre-policy meeting with deputy
governor Subir Gokarn, where leading bankers shared views on the interest
rates, credit and deposit growth, overall economic growth, stressed assets and
other macroeconomic data. The first quarter policy review is scheduled on July
26.
New projects are not coming in, and therefore, there could be a sort of slowdown going forward as far as the overall credit demand and credit offtake
is concerned, said MD Mallya, IBA chairman and CMD, Bank of Baroda.
Since March 2010, the central bank has hiked repo rate (the rate at which the
RBI lends funds to banks) 10 times by a total of 275 basis points or 2.75
percentage points, in order to tame inflation. Repo rate currently stands at
7.5%.
Bankers said they have not yet decided to revise credit growth target. It is tooearly to revise credit growth target, said Alok Mishra, chairman, Bank of India.
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The bankers also urged RBI to delay the deregulation of interest rates on saving
bank accounts. It is not the appropriate time, said Mallaya.
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