Can high interest rates tame inflation?

By Victor Bhoroma

In a desperate effort to tame runaway inflation, the Reserve Bank of Zimbabwe (RBZ) recently doubled interest rates from 80% to 200% through a raft of resolutions adopted by the Monetary Policy Committee (MPC). In the same press statement, the central bank also maintained the Statutory Reserve Requirements at 10% for demand and call deposits and 2.5% for savings and time deposits.

Reserve requirements are the amount of money banks are legally required to keep on hand to cover for withdrawals and overdrafts. Low interest levels had resulted in a surge in money creation with total banking sector loans and advances increasing from ZW$142.79 billion as of 30 June 2021 to ZW$287.02 billion as of 30 April 2022.

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Runaway inflation

Consumer price inflation jumped to 191.6% in June 2022, from 60.6% in January 2022. Month on month (MoM) inflation increased from 5.3% recorded in January to 31% in June 2022. The mean MoM inflation rate for 2022 (January to June) was 14.3%, up from 4% recorded from January to December 2021. Annual inflation skyrocketed due unabated growth in electronic money supply, deteriorating confidence in the central bank and government policy, and external shocks emanating from mainly the Ukraine-Russia War.

Inflation is largely expected to stay in triple digit figures in the next 12 months due to increases in money supply growth as the government is aiming to hand out agriculture inputs to over 3 million farmers for the 2022/23 agricultural season which coincides with the general elections.

To achieve this, the government requires at least US$300 million or ZW$240 billion if current market rates are used.

These agriculture subsidies, infrastructure projects and other off-budget financing programs will play a key role in the election campaign season. Similarly, quasi fiscal operations to incentivise exports and credit exporters’ accounts will continue to increase money supply levels in the economy as export receipts surge.

In the SADC region, Zimbabwe’s month on month inflation rate is more than the average annual inflation rate of the region which falls below 12%. This means that Zimbabweans experienced unprecedented levels of price increases that are unmatched in the whole region.

In Africa, Zimbabwe’s annual inflation (191.7%) is at par with war torn Sudan which recorded 192.2% in June. Zimbabwe is largely expected to lead the continent come July with inflation rates of at least 240%.

Violation of In-Duplum rule

The in-duplum rule is a common law rule in Zimbabwe that specifies that interest on a debt will cease to run when the total amount of arrear interest has accrued to an amount equal to the outstanding principal debt.

In other words, the rule prevents the interest accumulating on a loan from exceeding the principal amount of the loan borrowed. With interest rates of 200%, it means the rule will largely be violated and there will be several court cases for existing loans. For future loans, increase in inflation will likely exceed the interest rates set by the apex bank.

Role of adjusting Interests rates

In contractionary monetary policy aimed at controlling inflation, money creation within an economy can be curtailed through increasing interest rates. The downside is that this slows economic growth by making credit more expensive, thereby reducing consumer and business spending.

Interest rates play a key role to businesses in any economy (Zimbabwe not an exception) as loans are used to finance business operations, hence the adjustment may result in a shock or depressed spending on capital projects or reduction in forward payments to contractors for raw materials, inputs, and other services.

In effect, companies will seek to preserve a huge chunk of their revenues in hard currency for operational needs to plug the loan hole. This may temporarily increase pressure on foreign currency.

Africa, Global trends

Facing the highest annual inflation in over 40 years (8.6% In May 2022), the United States Federal Reserve raised interest rates by 75 basis points to 1.75%. The fed expects inflation to close the year at 5.2%. In the United Kingdom (UK), The Bank of England raised interest rates to 1.25%, their highest level in 13 years in a bid to tackle soaring inflation.

Annual UK inflation hit a 30-year high of 7% in March as food and energy prices continue to surge. Closer to home in South Africa, The South African Reserve Bank (SARB) increased base interest rates from 4.25% to 4.75% (highest level in 6 years) after signs pointed to increase in annual inflation from 5.9% recorded in March and April 2022. Zambia bucked the global inflation trend as inflation fell below 10% for first time in three years.

In response to the positive development, the central bank left the lending rate unchanged at 9%. The Bank of Zambia expects inflation to average 12.5% in 2022 and then ease to 8.9% in 2023.

Inflation a monetary phenomenon

Milton Friedman (US economist and 1976 Nobel prize winner) famously said inflation is always and everywhere a monetary phenomenon, in the sense that it is produced only by a more rapid increase in the quantity of money than in economic output.

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