Should the Central Bank raise interest rates?

By R. Chand

Business, industry, investors and the street are expecting monetary action from the central bank to rein in inflation. It is widely expected to raise the Repo Rate by a minimum of 25 basis points.

The Bank of Mauritius is slated to announce it in its next quarterly review of the monetary policy on March 28. Earlier in its December policy, the Central Bank weighed the risks to the growth and inflation outlook and decided that the balance of risks did not warrant a change in the Key Repo Rate.

Our comments at that time were that such a monetary policy stance does not in any way signify “un alignment sur les préoccupations des exportateurs” . We were of the opinion that the lowering of the Repo Rate had provided only a temporary reprieve. In fact, it has not stimulated much borrowing either from households or cautious business. Banks held on to their excess reserves. If all the cheap money eventually had spurred much higher economic growth, these reserves would have turned into loans. There was thus very little reason for continuing with the lowering of the Repo Rate as the Central Bank would have only been “pushing on a string”. We were not saying that the CB had set the tone for monetary tightening and that it signalled an exit from an accommodative monetary stance via reversing some of the unconventional liquidity-boosting measures taken earlier. Now that we examine the figures (see Table 1), they tend to reinforce our position on the slow take-off of credit growth relative to the excess liquidity in the market.

Table 1

Also, despite strong recovery in domestic credit growth (9.6%) it is still below pre-crisis (above 20 %) level. The CB had noted at that time that credit growth was expected to remain below the pre-crisis average for several quarters. The Monetary Policy statement of 13 December 2010 did point out to the slow pace of expansion of domestic credit to the productive sectors, in particular, the export manufacturing sector. It further added that “several MPC members observed that the current bank liquidity overhang needed to be channelled in a way conducive to boosting economic activity.” Please note that from the Table 1, we can see that the growth in private sector credit (10.5%) is lower than in the past four years with the exception of 2009 and is much less than in 2008 (25.8%) when it increased twice as fast as nominal GDP growth and we can safely conclude that there is no evidence of an “inflation des credits”.

Monetary developments in January 2011 actually show a deceleration in the annual rate of growth of domestic credit. Claims on private sector decreased at the end of January 2011 by 0.4 per cent, lower than the growth of 0.3 per cent recorded in the previous month. The annual growth rate of claims on private sector fell from 10.5 per cent at the end of December 2010 to 9.8 per cent at the end of January 2011. Moreover, the excess liquidity, which prevailed in the banking system in the second half of 2010 relative to the lower credit off-take, was tackled by increasing the Cash Reserve Ratio (CRR) on two occasions in 2010 and by the introduction of new instruments of longer maturities. These measures helped to effectively bring the excess liquidity to a more appropriate level by the end of 2010.

So, has the domestic and external environment situation really changed such that the CB will have to hike interest rates to take the sting out of the inflationary pressures? Without indulging in the logomachies of monetary economics to confuse the lambda reader, we will confine ourselves to the CB’s Inflation Report-October 2010 (IR-Oct 2010). The monetary policy stance is determined by a number of fundamental economic indicators — the output gap, the level of liquidity in the banking system, the growth of credit, movements in real exchange rates, the yield curve and the external environment, among others. We wish to examine whether there has been any change in these factors, that are analysed in IR-Oct 2010 to warrant a rise in the Repo rate.

Most importantly, negative the output gap – the difference between potential gross domestic product and actual GDP – is still significant. In October last, IR-Oct 2010 had noted that “real output growth is likely to stay below potential for several quarters ahead. The negative output gap is, thus, expected to persist and exert downward pressure on inflation – measured by the difference between actual and potential output – in negative territory.”

The situation relating to credit growth is more or less the same: it “has been picking up since the beginning of 2010… but, as yet, do not constitute a threat to the maintenance of low inflation over the short to the medium term.”

The Real Effective Exchange Rate (REER), with weights based on trade distribution with countries that make up at least 80 per cent of total trade and adjusted for price differentials between the domestic economy and its trading partners, which was depreciating in the first half of 2010, has since been appreciating

Table 2

Export-led economies, of course, can’t take currency appreciation lightly – it undermines competitiveness and risks eroding the country’s share of the global market. It also invites destabilising hot-money capital inflows. Given the tenuous post-crisis climate, with uncertain demand prospects in the major markets of the developed world, we find ourselves in a classic policy trap — monetary tightening will mean risking the negative impact of stronger currencies. The changes in the yield spread, that is, the difference between the short-term and the long-term interest rate — not short-term real interest rates or long term real interest rates per se — seem to indicate a flattening of the yield curve. (The overall weighted yield of 91-Day Bills, 182-Day Bills and 364-Day stood at 3.01 per cent up from 2.89 per cent in the previous month while the weighted yields on Treasury Notes with maturities of 2, 3 and 4 years declined to 4.95 per cent, 5.32 per cent and 5.91 per cent from 5.20, 5.48 and 6.27). This tends to signal uncertainty in the economy, which is not expected to improve quickly in the future. On the external front, as anticipated by IR-Oct 2010, the soft external demand has persisted and real economic activity has stayed below potential over successive quarters.

Yes, inflation is back, but the CB should not lose its nerve and panic as we have seen the Monetary Policy Committee has the arguments for sitting tight despite inflation numbers that will continue to be well above its target for many months. The difficulty with raising rates in response to rises in oil and food prices is that it depresses your own economy, while doing little to dampen down the markets that are causing the trouble. The European Central Bank made this mistake in response to the commodity price spirals of 2008, raising interest rates just as the European economy was going into recession. So the central question for policy makers today is whether anything has changed to make this analysis faulty. Most of the time, prices go up because there’s too much money chasing too few things. That sort of inflation is relatively easy to bring to heel, by getting central banks to raise interest rates and suck out the excess cash from the system. That, alas, doesn’t seem to be working anymore for inflation today is caused more by global rather than by domestic factors.

“The Reserve Bank of India has hiked rates half a dozen times in quick succession and might hike some more, but hasn’t succeeded in cooling prices. Instead, higher rates seem to be dragging down growth: industrial production grew a measly 2.7% in November compared to more than 11% a year earlier, with growth in manufacturing, which makes up about 80% of the index, slowing dramatically. Runaway inflation and slowing growth could trigger a particularly nasty condition called stagflation. Its first recorded occurrence was in the US and Europe after the first oil shock of 1973, when the price of crude quadrupled overnight, throwing productivity in oil importing countries into an abyss. Governments pumped money into the system to pull growth back on track, but all that cash just added fuel to inflationary fires.”

Therefore, any interest rate hikes have to be very carefully calibrated, particularly if they are not going to take the sting of inflation because that is being caused by factors outside the control of the CB.

* Published in print edition on 18 March 2011