Economics Focus: Inflation and interest rate maze in Sierra Leone
The farrago over the interest rate changes may risk making the Bank of Sierra Leone look impetuous and incompetent rather than bold. So, why would small changes in the interest rate could have a greater impact on households and bondholders alike? (Photo: Idrissa Koroma)
The financial crisis was precipitated by the collapse of the banking industry in 2008, which left a major dent in the economies of the world. In which Britain and America are no exceptions. On a cue, as policy makers are beginning to come to terms with the economic grime left by the recession, they are now grappling with the task of deleveraging and fighting inflation. Both America and Britain have been assiduous in the fight to reduce their budget deficits through painful austerity measures. But it’s not just America and Britain. Some members of the European Union, PIGS – Portugal, Ireland, Greece and Spain – have received or are on the verge of receiving another bail out from the EU and the IMF to bring their sovereign debts under control, so as to avoid a government shutdown. Also China, one of the emerging nations has a wodge of bad loans to sweep under the carpet. All these economic woes facing these countries are as a result of the debilitating streak left by the financial crisis. Thus, simple economics taught us that a stagnated economy means interest rate cuts and a growing economy or an economy ravaged by inflationary spiral prompted an interest rate rise.
Winston Churchill once said that, apart from all others, democracy was the worst system of government. One could therefore transcribe this to monetary policy. Everyone knows that it’s rough around the edges, but like monetary policy, fiscal policy has ever looked capable of delivering the expected results. As the effect of monetary policy takes longer to be achieved, there are always controversies among policy makers on which right policy mix to implement. Therefore, choosing the wrong choice of macro-prudential policies would plunge the economy into the abyss.
Now, to the issue of the interest rate! It is one of the main monetary policy variables the central bank uses to control inflation. Normally, when inflation is on the run the central bank through its Monetary Policy Committee (MPC) increases its bench mark interest-rates to tackle inflation. As I was writing this piece, the Bank of Sierra Leone stated on its website that the benchmark interest rate would remain unchanged at 23%, albeit an increase in the inflation rate for the months of April to May by over 1.2%. So, why the Bank of Sierra Leone did not abide by the normal principle of increasing the interest rate to curb the inflationary spiral, as it’s the usual mantra? Well this is to everyone’s guess, but I would come to that shortly. However, the interest rate went up by 0.5 percentage point and it is expected to continue if inflation continues to wreck havoc. Not here, but in India. The governor of the Reserve Bank of India said the approach was needed to tackle inflation, which reach 9.5 per cent in June.
Unlike the Reserve Bank of India, the Bank of England though faced a huge increase in inflation, which is around 4.5 per cent as of now and more than double the targeted 2 per cent failed to follow their compatriot.
Mr Mervin King, the governor of the Bank of England, has long argued that raising interest rates would do little to curb an inflation problem that is rooted in rising global commodity prices, and that the recovery is too weak to start tightening. But Sierra Leone is not the UK. With hindsight, it seems a straight forward decision to increase interest rate when an economy is growing steadily and banks are willing to lend freely. As a slight increased in interest rates may not impact heavily on consumers spending relative to their income. However, in Sierra Leone’s scenario where there is sporadic growth of the economy, unemployment is high, taxes are increasing and inflation erodes the value of wages which is growing sluggishly. That seems unrealistic as a slight increase in interest rates in those circumstances could prompt an inexorable reduction in consumers spending. Also, there is a clear line of distinction between the rich and the poor households which is a course for concern.
Meanwhile, if each household has equal share of its debts and cash at the same time which is very much inconceivable, there would be very little to worry about. It is true for Sierra Leone that personal debt is around two times the disposable incomes of individuals. So it is true that a percentage increase in interest rates, if fully passed on by lenders, would take up 2% of borrowing cost from consumer’s income. Invariably, the income effect of changes in interest rates does not work in only one direction. Yes, there are savers who always take advantage if interest rate goes up. Apparently, savers with large deposits of cash on their bank accounts would welcome the idea of increase in interest rates, as the returns earned on them increases. But the stock of cash if any is relatively smaller than the stock of debts. So the overall effect of interest rates rise would be to crimp the meager household income. But again as long as deposit rates rise in tandem with borrowing costs, the cost of a percentage increase in interest rates would be very infinitesimal relative to incomes.
However, that thinking understates the likely impact as households typically do not have both large debts and stock of cash at the same time. Thus, since it makes sense for the latter to pay off the former. It is absolutely clear that the financial market in Sierra Leone is not wide enough to accommodate the mortgage entity. Households barely take mortgage due to the land tenure system; people prefer building their own houses rather than take a loan (mortgage) in the bank to buy a house, which will accrue higher interest. And default means repossession or foreclosure. But rather, there is a financial spectrum with debt-strewn bondholders – government, corporate and individuals. These consumers will react to any slight changes in interest rates that will impact the economy greatly.
Meanwhile, Keynes believed that in certain circumstances people would prefer holding bonds to money since interest is paid on them.
Bonds are an IOU or debt by the issuer to the bondholder. When you invest in new bonds you are lending money to the issuer, whether it is a corporate entity, government or individuals.
So if interest rates are EXPECTED to change in such a way as to cause capital losses on bonds, it is possible that these expected capital losses would outweigh the interest earnings on the bond and cause an investor to hold money instead. This is what Keynes describes as a liquidity trap and if it persists for a long time will result to inflation. But in a situation where investors believe interest rates will fall, bonds have the higher expected returns and yield a capital gain. Once rate start to rise, those with the biggest debts might be anxious to save harder to pay off the debts at a faster pace. The indebted will cut their spending to free up the extra cash to service their debts also.
Therefore, a big enough interest rate increase to tackle inflation would start a downward spiral in debtor’s finances, spending and bonds yield. Hence, rising default on the bonds as a result of rate rise would exacerbate the damage. For this reason, the Bank of Sierra Leone is likely to tread carefully at a ‘glacial pace’ when changing interest rates. Furthermore, the polarisation of individual finances that makes the impact of interest rate increases so uncertain also helps to explain why the Bank of Sierra Leone feels the need to act.
Finally, debtors are hoping that interest rates stay low; savers and bondholders need to be reassured that today’s high inflation won’t be allowed to continue. A small interest rate rise would be a victory for savers. The immediate needs of the economy mean that, overall, monetary policy favour debtors.
Idrissa Koroma (Babito)
Stay with Sierra Express Media, for your trusted place in news!
© 2011, https:. All rights reserved.
