Will the bank rate hike help or hurt?

The Reserve Bank of Malawi (RBM) has recently raised the bank rate—the bank’s policy tool which when changed leads to subsequent changes in many other market interest rates like lending and mortgage rates—to 27 percent from 25 percent.

The bank says it has done this to address the persistently high inflation rate, exchange rate instability, and uncertainties in food prices and wage demands.

With the bank rate hike commercial banks will most likely respond by increasing their lending rates after reducing them following the Liquidity Reserve Requirement cut to 7.5 percent from 15.5 percent a few months ago. Well, this will be the intended and expected outcome of the policy.

In principle raising interest rates has the effect of stabilising prices and exchange rates. High interest rates make borrowing expensive hence not much money will be available with which to demand goods and services. With the demand for goods and services controlled this way, prices become more stable, all else remaining constant.

On the exchange rate front, just as high interest rates will reduce the demand for goods and services, they will also reduce the demand for foreign exchange. There will not be much money available with which to demand foreign exchange. This, all else remaining constant, will restore stability in the kwacha.

Additionally, high interest rates will make Malawi’s financial market more attractive to foreigners so much that there will be short term capital inflows into our country. This, all else remaining constant, has the effect of restoring stability in the kwacha.

Stabilising the kwacha through interest rates will most likely stabilise inflation too since many studies conclude that exchange rate is a very important variable among the determinants of inflation in Malawi.

But the question is: While there are theoretical and empirical justifications to the bank’s policy move, is the bank rate hike, on the whole, desirable?

Our economy is in a puzzling state. The output is depressed, inflation is high and the exchange rate is weak. The contractionary monetary policy which the bank has engaged tends to slow economic growth. And output is already low. In as far as growing the economy is concerned, pulling the contractionary monetary policy lever is undesirable.

Nevertheless, we need to understand the position RBM is in. The economy’s puzzling state has made the bank’s pursuit of stable prices and exchange rate more conflicting with other broad goals of unemployment and economic growth. To serve one goal means sacrificing the other. While the bank rate hike is inconsistent with the goal of economic growth, hence its being undesirable, it is acceptable in as far as dealing with the important and more urgent problems is concerned. The bank’s policy stance is at best provisional, ad hoc and short-term.

The fear becomes that if we keep applying temporary short term measures in order to just keep head above water, we will keep doing this for a long time to come. To break out of this cycle, policies should focus more on economic growth. Most economists agree that economic growth is the single most important factor in improving the living standards of citizens. Another good thing is that when an economy is growing strongly other economic problems such as exchange rate volatility, indebtedness, job unavailability, inflation, corruption become less frequent and less severe. They also become easier to deal with.

An example of economic growth policy would be the Green Belt Initiative (GBI). The GBI is a great way to increase productivity by growing crops throughout the year. Again the basic conditions for a productive economy such as electricity, education, technology, transparency and accountability should be provided.

The bank rate hike will be viewed differently. Behind this difference of opinion is the distinction between the short run and long run. Those with the short term view will feel the bank was right to do something about the emerging problems. Those with the long run view will see the increasing interest rates as undesirable and retrogressive. The important point to remember, however, is that it would be a higher goal to focus more on the long run while not necessarily giving a blind eye to the current situations.n