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Increasing interest rate to curb Inflation?

Increasing interest rate to curb Inflation?

Wed, 4 Mar 2009 Source: Dapaa, Gyasi Kwabena

Are you serious,Mr. BoG?

On February 24, 2009, a friend of mine called me to inform me that the Bank of Ghana(Henceforth BoG) has decided to increase the prime rate by 1.5% (I mean some whole 150 basis points)! Knowing that the previous rate was already at an economically toxic level of 17%, I wildly wondered why a sound monetary authority would dare to even bump the rate by a basis point (ie 0.0001 or 0.01%). I therefore subsequently asked about the only reason that would justify an increase of interest rate in a struggling developing country: “Has BoG realized any sudden hike in default rates?” “Nope,” my friend responded, “they said they had to do it to control inflation?” After hearing this, I was saddened by the low fundamental economics knowledge of, ironically, the decision-makers of our economy.

Having been strongly criticized afterwards, however, the BoG continues to stubbornly defend its clearly misguided action as a sound economic policy. In fact, when I personally heard a whole director of Research at BoG (Dr. Ernest Addison) explain to a joy FM interviewer the really inexplicable increase of interest rates, I couldn’t help but laugh out loud at his incredibly funny and flawed justifications. To help you better appreciate the humor and also make my story more credible, I will first paste his responses before making the easier attempt to reveal the flaws in his (and for that matter BoG’s) reasoning that stand out clearly but obviously lost him:

Dr. Addison: “We’re seeing some downward adjustments to petroleum-related prices, so the question is what is it that is keeping inflation rates sort of sticky around this 17,18,19% that we’ve seen recently. And our assessment is that, yeah, 2008 was a year in which the economy did fairly well; economic activity was fairly robust; underlying that fairly strong growth rate are significant inbalances, that is the budget deficit of 15% and a very large current account deficit. Now when you have a budget deficit of that magnitude, it implies that you have very serious aggregate demand pressures . So what would be the corrective measures when you have such large inbalances which is putting pressure on prices and on exchange rates. The answer lies in trying to reduce the pressures in aggregate demand which would also lead to a correction of prices and exchange rates”

(Please feel free to personally listen to Dr. Addison’s defense at http://topics.myjoyonline.com/business/200902/26836.asp)

In his above argument, Mr. Addison makes it seem as if a budget deficit on its own could lead to his so-called “serious aggregate demand pressures”. For your information, Mr. head researcher, your allegedly serious aggregate demand pressures only result when you printed money for the government to fund its deficits. Alternatively, if the government had borrowed the money (or better still, had been fiscally disciplined), such extraordinary pressures wouldn’t have resulted. Also, if your institution could advise a government to increase an interest rate that is already at an intolerable level, then you could as well have advised the out-gone president about the consequences of printing money. After all, isn’t BoG, under the 2002 Bank Act 612 aimed at Inflation Targeting, supposed to suppress fiscal dominance?)

Also can someone please teach Dr. Addison that, given the stifling growth the Ghanaian economy has always experienced, demand pressures can never be too much (Aside: Because of the low GDP per capita level, a single-digit growth rate would never be considered as “fairly strong” by any Growth economist. I am therefore perplexed when Dr. Addison perceives it as such). In these current economic downturns, when even highly industrialized nations would kill for strong aggregate demands, it’s pretty mind-boggling why Ghana would find its demand as strong enough. Stimulating Demand and Investment , rather than stifling them with toxic interest rates increases, should rather be uncompromising agenda of your institution. This is because through these allegedly serious demands, there could be some serious extra tax revenues for the government so that the money-printing job of your institution becomes obsolete. When this happens, there would not be any future “serious demand pressures” to cause inflation to deserve your totally wrong anti-inflationary measures (ie interest rate hikes).

Paradoxically, the journalist who interviewed Dr. Addison demonstrated a much more sound understanding of economics analysis. He presented his guest with the alternative view of how the hijacking of interest rate could rather increase inflation by the following chain reaction:

high interest rates ? high cost of capital (an input of production) ? high prices of goods and services (inflation).

Surprisingly, when presented with this cogent analysis, Dr. Addison mumbled and fumbled and ultimately resorted to using technical language which presumably was an attempt to confuse his host. As a response, Dr. Addison said BoG was taking a macro- approach as if micro was the enemy of the macro. Little did he know that successfully influencing a macroeconomic variable begins with the ability to effectively affect microeconomic activities (A Macro variable by definition is an aggregate of the corresponding micro level variables).

(A personal note to Dr. Addison: I read your article about Inflation targeting (http://www.bog.gov.gh/privatecontent/File/Research/Research%20Papers/Paper%20on%20Ghana%20IT%20Experience.pdf) in which you claim interest rate has a higher influence on inflation than monetary supply. With no data but rather with liberal intuition, I boldly challenge the validity of the statistical or econometric analysis that yielded this clearly incredible result. I believe the Father of Monetary Economics, Milton Friedman, when he said, “Inflation is always and everywhere a monetary phenomenon!” And even if a high interest rate is indeed an effective anti –inflationary measure, one should exercise much precaution before using since it’s also an effective recessionary tool.).

Secondly, Dr. Addison, I was pleased that you rightly insinuated that inflation may be the cause of the devaluing GHC; however, you seemed to have totally missed the also plausible reverse causal effect that, perhaps, the devaluing currency may rather be causing inflation to soar. With limited data and just simple economic intuition, I will make my point to you. The trade deficit in Ghana continues to deteriorate, and by default, demand for foreign currency has surged; consequently, there is a downward pressure on the value of the new GHC compared with foreign currencies. Importers therefore have rationally developed expectations about future devaluing of currency, and with such expectations, price their goods accordingly to account for the higher future costs of foreign currency. Such expectations are self-fulfilling and can cause extreme upward pressures on the prices of goods and services. Such expectations could even cause a rapid devaluing of the GHC (and consequently sustained inflationary pressures) by further causing investments in foreign denominated assets to rise at the expense of GHC denominated assets. If my hypothesis is true, raising interest rate still would be a bad idea since an otherwise low interest rate could stimulate domestic output and hence reduce our dependence on some of the foreign goods, thereby alleviating our downward currency and upward inflationary pressures.

So as you can clearly discern right now, Dr. Addison, raising interest rates is never a good idea especially when it’s already a double-digit rate: Not only is it a powerless anti-inflationary measure, it is a powerful recessionary tool and can easily stifle the already low economic activity and growth of our nation. In developed nations, monetary agencies temper with the interest rates (which, by the way, are extraordinarily low in their case) only when there is a moral hazard of senseless borrowing but not as inflation extinguisher. Interest rates have long lost its appeal as being a meaningful anti-inflationary measure in modern economies. They rather use a less economically costly but highly effective monetary tool--Open Market Operations--which would surely be more expedient and savvy in our case: If you actually believed there were too many Ghanaian cedis floating around, you could have sold treasury bills to reduce the amount of money supply without increasing the cost of doing business in Ghana. By so doing, you achieve your targeted inflation rate with no sacrifice of economic growth.

May God bless you for your service to Ghana, and May God also bless our beloved country Ghana!

Author: Gyasi Kwabena Dapaa, M.A. Economics, Ph. D candidate in Economics Actuarial candidate MAA

Columnist: Dapaa, Gyasi Kwabena