Rising Interest Rates and Rising Inflation – Is the Economy Unresponsive or Just Misunderstood?
A sick person may not respond to a particular type of medicine, or doctors may have misdiagnosed what is wrong with them.
In paragraph 28 of the mid-year budget review statement, the Minister of Finance said: “Mr. President, the Bank of Ghana has increased the monetary policy rate cumulatively by 450 basis points between March and May 2022 and reserve requirements at 12% to help cope with rising inflation and currency depreciation This has led to a significant increase in interest rates and funding costs and a decline in liquidity causing refinancing pressures.
In paragraph 34, the Minister of Finance added: “Inflation jumped to 29.8% at the end of June 2022…”
Let me simplify this.
Although the Bank of Ghana raised the policy rate cumulatively by 450 basis points between March and May 2022, to help deal with rising inflation, the economy failed to respond and inflation instead jumped from 19.4% in March to 23.6% in April, 27.6% in May and 29.8% in June.
The basic economic theory behind raising the policy rate to fight inflation is that the increase in the policy rate leads to higher interest rates charged by commercial banks, the cost of finance increases and contributes to reducing borrowing and consumer spending, thereby reducing the demand for goods. and services and thereby contribute to lowering inflation.
Inflation is simply a general increase in the prices of goods and services in an economy. A general increase in prices can be caused by a demand for goods and services exceeding the available supply. It can also be caused by the rising prices of the same goods and services even though the demand remains the same.
Rising prices can be caused by supply chain bottlenecks such as Covid, or rising prices of a major factor of production and distribution such as petroleum products, caused by events like war Russian-Ukrainian. How you approach rising inflation cannot be unique.
Unfortunately, this is how it seems that many central banks around the world are currently reacting to global inflationary pressures. The common theme has been major central banks announcing “further monetary tightening,” as the IMF noted in its July 2022 G-20 Surveillance Note.
Simply put, major central banks have raised their policy rates as a tool to fight inflation, just like the Bank of Ghana has. So why has inflation in Ghana continued to rise despite the policy rate hike and higher interest rates for businesses and consumers?
The key answer is that the rising cost of borrowing only succeeds in preventing the local productive sector from having access to cheaper credit. Ghana imports so much of everything. People who import are not bothered by the rising cost of borrowing. You know why? They end up passing that cost on to the consumer as part of the new prices for the same product, when the next batch of goods arrives in the country.
And what does that do to inflation? It keeps increasing. Thus, the increase in the key rate only leads to the loop of the vicious circle of inflation. The cost of borrowing increases, the cost of imported goods increases, the prices of imported goods go up in the market, the BoG increases the cost of borrowing and the cycle continues!
The Bank of Ghana is aware that rising fuel prices resulting from the Russian-Ukrainian war are at the heart of current global inflationary pressures. There is no doubt that Ghana has enough food right now. I always find locally produced staple foods whenever I go to the market.
Yet each time, prices continue to rise. It is not because the demand for tomatoes, yams or fish is increasing, which is why the BoG needs to raise the policy rate to curb demand. The reason for the rising prices is simply a factor in rising fuel prices. Rising interest rates will only keep the economy dependent on imports, since the productive sector in Ghana cannot compete with imported products when the interest rate exceeds 30%!
On the other hand, if the BoG reverses the trend and instead makes cheaper funds available to the productive sector through quantitative easing, for example, abundant availability of locally produced goods at cheaper prices could largely offset the impact of rising fuel prices and thus combat inflation.
Resetting interest rate dynamics in Ghana
Imagine if the Bank of Ghana gave GHS 50 billion directly to the productive sector of the economy, through the Development Bank, at zero interest. These companies would produce at a much lower cost.
Ghanaians would buy. If companies exceeded local demand for their products, they would export to the rest of Africa, taking advantage of the African Continental Free Trade Area (AfCFTA).
None of these companies would be in a hurry to apply for a cedi loan from a commercial bank at the current interest rate. Practically, there would be fewer requests for loans from commercial banks. If the dynamics of supply and demand really work in Ghana, it would mean that commercial banks would be forced to cut their interest rates in order to attract lending customers.
Commercial banks would, in turn, pressure the BoG to reduce the policy rate, so that commercial banks remain profitable and viable. Any further monetary easing from the BoG to the productive sector would mean a further cut in the commercial bank interest rate and a further cut in the policy rate.
The BoG can use this kind of monetary easing in a calculated way to bring Ghana’s interest rate down to single digits, just like you did in developed countries, backed by the real productive sector that would produce for local consumption and for export!