Rate adjustment: Right move at the wrong time?
News that the Reserve Bank of Malawi (RBM) increased the policy rate—the rate at which commercial banks borrow from the central bank as lender of last resort—from 18 percent to 22 percent eroded the hope for recovery among many businesses.
RBM justifies the option as a long-term measure to contain inflationary pressure. But it acknowledges the possible devastation it may cause, especially in the short term.
Its Monetary Policy Committee (MPC) hinted that the decision was arrived at after noting that inflation outlook had worsened due to unforeseen shocks, like the Cyclone Freddy and drought in some parts of the country.
The harsh weather conditions are poised to worsen food supply prospects, leading to adverse supply-side inflationary pressures.
“The committee also observed that the need to rehabilitate the infrastructure damaged by the cyclone has the adverse impact of amplifying aggregate demand and fueling inflation, requiring further tightening of monetary policy to dampen the demand effects,” the MPC report reads.
First things first; the central bank’s mission is to ensure price and financial stability through formulation and implementation of sound monetary and macro-prudential policies.
Thus, the policy rate is one of the tools that it uses to control inflation.
In a more normal scenario, when the central bank raises its policy rate, the market reciprocates by making borrowing more expensive thereby slowing down activities.
Simply put, the higher the interest rates, the lower the consumer spending and the lower the business outturn.
One the other end, lower interest rates are expected to encourage consumers and businesses to spend more, which traditionally leads to increased demand for goods and services.
But the relationship of the two variables ignores other factors especially in an economy such as Malawi.
For example, the fact that the government continuously borrows from commercial banks to satisfy its budget financial needs defeats the very principle of the relationship between the policy rate and inflation.
We must appreciate that the manufacturing sector in Malawi remains small. This is the industry that is expected to grow to anchor the economy as highlighted in Malawi 2063.
The sector is still nursing gashes from the Covid pandemic, persistent foreign exchange shortages, unstable supply of electricity, the Russia- Ukraine war and cyclones, among other occurrences, in recent years.
This notwithstanding the deteriorating buying power among the masses as witnessed by the rocketing of the cost of living to K405,000 in March 2023 for a family of six.
Now, the increase in the policy rate obviously means that the cost of borrowing is going to constrain business growth. The challenge comes in when commercial banks revise their rate upwards in reacting to such a decision which has already been seen on the market.
The gravity of the situation is that as commercial banks adjust their rates, it applies on what has already been borrowed and most companies operate using borrowed money which means they are going to meet huge costs in order to service their debt.
But for such companies to survive, the only way forward is to adjust prices of their goods and services that consumer’s buy. This shows that instead of controlling inflation with the policy rate, it has become a tool to fuel inflation in itself.
In recent months, causes of inflation were mainly food supply shortages. Therefore, the expectation was that having entered the harvesting season pressures from food inflation on headline inflation was to ease significantly. More so, the onset of the tobacco selling season was expected to ease foreign exchange shortages in the economy.
Banking on these factors and the somewhat stable electricity supply being enjoyed since last month it was proper for the MPC to allow the private sector to grow.
History has it that in the United States of America, the Federal Reserve implemented a contractionary monetary policy in the 1980s to control inflation. This policy led to a recession in 1981-1982.
Similarly in the United Kingdom, the Bank of England implemented a contractionary monetary policy in the early 1990s to control inflation. This policy led to a recession in 1990- 1991.
Yes, the larger economies were able to bounce back and contain inflation in the long run but the question is; could the local economy pull off such a stunt?
Containing inflation through policy rate increase may be the right move but has been implemented at a wrong time in as far as the local economy is concerned.
