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How rising inflation is forcing interest rates ever higher

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On Monday, as widely expected, the Bank of Ghana increased its Monetary Policy Rate by 200 basis points taking it to 19 percent, from its former level of 17 percent. This is the second increase in as many Monetary Policy Committee meetings. In March, the MPC increased the benchmark MPR by 250 bps from 14.5 percent. The latest hike thus brings the cumulative increase since March this year to a huge 450 bps.

But the extent of the inflationary challenge facing the BoG is illustrated by the fact that even these recent increases may not be enough. Immediately prior to the latest increase government was unable to sell most of the cedi denominated domestic debt securities it was offering because even the longest tenured bonds offered recently – five year bonds – offered a coupon rate of 22 percent which was only marginally larger than the April inflation rate of 19.4 percent and the shortest tenured securities – 91 day treasury bills – were offered at a little over 18 percent, which is below that inflation rate. Since then inflation has risen further to 23.6 percent which means even the shortest tenured 91 day bills need to go up by over 500 bps just to catch up with the current inflation rate.

However, BoG Governor, Dr. Ernest Addison insists that the central bank does not intend to “chase inflation” by trying to match the rising consumer inflation rate with commensurate increases in its benchmark interest rate. Rather the MPC expects its interest rate hikes to pull inflation down towards the MPR.

But this will not happen soon. The BoG now projects that inflation will not fall back to within its target band of between 6 percent and 10 percent until sometime in 2023. In turn this means that the elevated interest rate regime now imposed on the Ghanaian economy will have to be navigated for quite some time to come.

However Dr. Addison – who also serves as the Chairman of the MPC – believes that the rate of growth of inflation has peaked. He expects that although inflation is bound to keep increasing over the next few months it would be at a slower pace than the 4.2 percent increase recorded for April from 19.4 percent to 23.6 percent.

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But even this is not certain. The latest sharp rise in inflation for April does not take into the consideration the officially unauthorized 20 percent increase in commercial road transport fares (in actual fact fares have been increased by close to 30 percent along many routes) implemented in May. Furthermore imminent sharp increases in both electricity and water tariffs are impending, with the two public utility providers asking for a combined 148 percent hike in the tariffs they charge. Even one third of this, combined with the effects of the latest commercial transport fare hike can be expected to push inflation considerably higher,

But the refusal of the MPC to tighten monetary policy even faster than it is doing is a relief for the school of thought who argue that because Ghana is heavily credit driven, higher interest rates would fuel cost push inflation which would nullify the reduction in demand pull inflation it set out to do. An example: if a real estate developer builds a house for sale using a loan taken at 30 percent per annum (which is the likely rate for some medium term  commercial house construction loans under the interest rate regime which will result from the latest MPR) and it takes two years from the time of taking the money top when it is built and sold and fully paid for, then interest charges alone would increase its sales price by 60 percent this translating into an average price increase (inflation) of 30 percent per annum.

Conversely though   Dr. Addison points to empirical evidence to support the MPC’s stance; indeed interest rate hikes in Ghana have tended to curb consumer inflation, even if belatedly due to policy transmission lags. Besides, points out the BoG Governor, commercial banks have not been lending much lately anyway, what with risk free government debt securities available in abundance.

The other universal concern is the effect of sharply higher on the macro-economy.  Monetary tightening in the form of higher interest rates tends to curb demand pull inflation by dampening economic activity, but this also tends to curtail economic growth. Indeed, Dr. Addison agrees that the latest hike will adversely affect economic growth. However he points out that no economy can grow sustainably in a high inflation environment.   Therefore, by strangling inflation, through higher interest rates the BoG is actually supporting economic growth by providing the right environment for sustained growth over the long term, albeit at the expense of short term growth.

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While most economists agree that this makes sense they also warn that the new interest rate regime will most likely derail government’s target of achieving 5.4 percent growth in Gross Domestic Product this year.

 Actually this is a genuine worry which economists who argue that growth as important as inflation emphasize. Indeed while the BoG claims to be an inflation targeting institution its MPR deliberations weight the economic growth consideration and curbing of inflation consideration equally which at a cursory level makes an interest hike that stifles growth along with inflation appear dubious. However Dr. Addison points out that over the long term economic growth is simply not possible within an environment of high inflation. Therefore, the curbing of inflation over the short term is supportive of sustainable economic growth over the medium to long term.

But while sustainable economic growth will benefit over the medium to .long term there may be immediate losers

Government will suffer the biggest negative impact in the form of significantly higher fiscal deficit financing costs. Having budgeted its interest payments on rates ranging between 13percent and 20 percent, it now faces rates of between 20 percent and 26 percent and this are likely to climb even higher before they start coming down, hopefully before the end of the third quarter of the year.

Indeed some policy analysts suspect that this is why the MPC has refused to raise the MPR in consonance with the rise in inflation – in order to constrain the increase in government’s debt servicing costs. But another school of thought suggests that the BoG is deliberately raising its benchmark interest rate more slowly than inflation to keep coupon rates on government’s debt securities below inflation to keep it from getting as much subscription as it wants. Effectively this is forcing the faster fiscal consolidation – which the central bank has been lobbying for over the past year and a half – on government.

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Dr. Addison however simply asserts that the central bank’s job is to curb inflation which is far more important for it than to minimize government’s debt servicing costs which is the Ministry of Finance’s responsibility. He suggests that government applies strategies such as debt profiling and restructuring to lower its debt servicing costs under the current circumstances.

For the private sector, the situation is clearer, but just as dire. Prior to the latest MPR hike the benchmark interest rate was 104 basis points below the Ghana Reference Rate of 18.04 percent, which is a rate, computed by the BoG and the commercial banks – represented by the Ghana Association of Bankers – using the MPR and treasury bill rates, and used by all the banks as their base lending rate.  If that spread does not change, the base lending rate would therefore climb to 20.04 percent.

In turn, the banks average lending rate, as stated by the banks themselves had risen to 23 percent  (although many analysts believe they are understating their lending rates to look empathic to the needs of their borrowing customers) which amounted to a 500 bps spread above the GRR. If this spread is maintained, post MPR increase, this would take the average lending rate applied by banks to 25 percent. With banks, in truth, charging a risk premium of up to 10 percent over and above the base rate, this would effectively take actual lending rates to as high as 35 percent per annum.

Ultimately, all this means things will have to get worse first, for them to get better later. For businesses and households alike, with regards to major expenditure decisions that require debt financing the prudent thing to do will be to batten down the hatches and ride out the storm.

Source:Toma Imirhe

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