Changes In Monetary Policy Rate: Unlikely To Be Effective

Introduction
On Friday, 22^nd January 2016, the Monetary Policy Committee (MPC) commenced its meetings to review developments in the economy and to announce what the next policy rate ought to be.

The 67^th (previous) Monetary Policy Committee meeting culminated in an increase in the policy rate from 25 per cent to 26 per cent although the government had days earlier announced (via the reading of Budget and Economic policy) a tight fiscal policy stance for the 2016 financial year.

Key among the reasons for the contractionary monetary policy stance included the persistence of inflationary pressure which prevailed throughout the 2015 as well as the expectations of inflation to rise in the 2016 fiscal year since aggregate expenditure typically increases during election years according to the (recent) economic history of Ghana.

The MPC’s decision to increase the policy rate to 26 per cent in November 2015 followed previous increases from 21 per cent at the start of the same year. Nevertheless, the hikes in the policy rate have been ineffective in terms of its target of reducing the inflation rate since monetary policy in Ghana operates under an inflation-targeting framework. Specifically, the hike in the policy rate from 25 per cent to 26 per cent paradoxically led to a marginal increase in the rate of inflation from 17.6 per cent in November 2015 to 17.7 per cent in December of the same year. The ineffectiveness-argument is clearly substantiated by the graphical evidence below.

Fig 1

Source: Ghana Statistical Service
Figure 1 above shows that inflation has increased, in general, despite increases in the policy rate as asserted earlier.

This begs the question: why has inflation rate been increasing, on the average, in the face of the continual implementation of contractionary monetary policy? An investigation into the sources driving inflationary pressure in the Ghanaian economy reveals this.

As computed by the Ghana Statistical Service, the composition of the Consumer Price Index (CPI) showed that sources of inflationary pressure tended to be cost-push in nature rather than demand-pull. For example, the 17.7% inflation rate in December had major non-food inflation drivers such as transport and utility costs as well as leading food-inflation drivers including vegetables and mineral water and soft drinks.

What is the Central Bank’s MPC likely to do?

Although inflationary pressure is largely stimulated by supply-side dynamics, it is expected that the MPC will announce an increase in the policy rate due to internal and external developments.

On the domestic front, an increase in taxes under the recently passed taxed law (Act 896) coupled with the increment of electricity and water tariffs by a maximum of about 59% and 67% respectively have heightened inflationary expectations for the 2016 fiscal year. Since the anticipation of these increments was an important factor in the decision of the MPC to increase the policy rate in November 2015, how much more their actual implementation?

Moreover, the 2016 fiscal year being an election year has its attending effects in terms of increasing expenditure, money supply and hence inflation. Therefore high inflationary expectation for the year ahead is likely to encourage the MPC to take a tighter monetary policy stance especially considering the fact that the committee’s most recent stance only resulted in a less than suboptimal outcome.

Externally, pressure from the IMF as well as the decision of the FED of the United States to increase interest rate (for the first time since the 2007 Global Financial crises) and its accompanying effects on the value of the Ghana cedi could significantly factor in the MPC’s decision

What should the Central Bank’s MPC do?

Considering the fact that inflation (in recent times) is strongly driven by supply-side rather than demand-side dynamics, the impact of the policy rate on the rate of inflation is likely to be atomistic irrespective of the resultant nominal interest rate engendered by an increase in the policy rate. In essence, a further increase is likely to do more harm (in terms of increasing the cost of credit to the private sector) than good to the economy as a whole.

Further, just as expansionary monetary policy becomes ineffective as interest rate approaches zero, contractionary monetary policy has less and less marginal impact on reducing inflation rate beyond a point because , for instance, less additional people are discouraged from going for loans when interest rate is already very high. With the policy rate as high as 26 per cent, further increases may outlive its usefulness in reducing the rate of inflation which is possibly the Ghanaian case as shown by figure 1. With the growth rate of the economy generally declining in recent years, tightening monetary policy more than intended could throw the economy into a deep recessionary loop.

Reducing the policy rate (an expansionary monetary policy) may not necessarily be prudent either. This is because with 2016 being an election year, the government already has a huge incentive to embark on expansionary fiscal policy to increase growth and some of the associated increase in expenditure in may not be underpinned by economic efficiency. It may be motivated by political expediencies intended to fulfil manifesto promises. Besides, reduction in the policy rate is expected to translate into a reduction in lending rates which may also provide incentive for various politicians to go for loans, fund campaigns and ‘buy’ votes. This will further aggravate inflationary pressure.

Hence, counterintuitively, the suitable monetary policy stance is to maintain the policy rate.

Conclusion
A prospective MPC stance of increasing the policy rate is not likely to have a significant impact on reducing the rate of inflation. The policy rate being sufficiently high should be maintained.

Rather, inflationary pressure through supply-side dynamics should be given more attention (well-researched) and minimized if Ghana is to realistically achieve the targeted single-digit inflation by the end of the 2016 fiscal year.

Also, the commitment of government to its announced economic policy for the 2016 financial year is crucial since the private sector typically forms inflationary expectations based on the announcement. Thus reneging on its expenditure commitment is likely to lead to an increase in inflation making the economy worse off.