Rwanda's central bank recently increased its lending rate to 7.5 per cent up from 7 per cent, citing the need to tame inflation, stemming from rising food prices due to unfavorable weather conditions, and increasing global tensions.

Also known as the key repo rate, the lending rate is the fee at which the central bank lends to commercial banks. Adjusting it upwards or downwards allows the regulation of liquidity in the banking system with the aim to stabilise the economy.

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The decision to further tighten came at a time when the country had registered a slight decrease in headline inflation, despite food inflation remaining relatively high.

By raising the lending rates, the central bank intends to make spending more expensive in order to bring down prices.

But how exactly does this work?

The central bank makes borrowing more expensive, which can decrease spending and slow down economic growth. This in turn can decrease inflationary pressures.

By increasing borrowing costs, rising lending rates also discourage consumer and business spending, as well as reverse the wealth effect for individuals, making commercial banks more cautious in lending decisions.

In Rwanda, inflation has started to subside, but according to Central Bank Governor, John Rwangombwa, the work is far from done.

Despite the already declining trend of inflation towards the desired five per cent in 2024, Rwangombwa said vulnerabilities remain around global geopolitical tensions and climate change.

"Normally our policy rates have an impact with a lag of about three quarters or so, we started seeing inflation come down from December, we picked the curve in November and it started the downward trend from December,” Rwangombwa told the media.

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He added, "Kicking at 21.7 per cent in December, it was sticky during the first quarter of the year at around 22.1 per cent, and in May (2023) we slowed down our tightening because we saw the curve was going down and we also expected a better agricultural performance, but unfortunately it defied from our projections.”

"Though we continue to register reduction inflation, today in July we are at 11 per cent and we expect this to continue to 7.6 per cent in the fourth quarter (2023) which is within our band. But we see risks around weather conditions, also the geopolitical situation remains uncertain which might again affect the global inflation.

"But because of these uncertainties, we decided to tighten further, at least to cushion any uncertainties that could be seen going forward,” said Rwangombwa, adding, "So that's the basis, otherwise when you look at the trend it is in the right direction.”

Elsewhere

With inflation at multi-decade highs in many countries and pressures broadening beyond food and energy prices, policymakers have pivoted towards tighter policy.

According to the International Monetary Fund (IMF), central banks in many emerging markets proactively started to hike rates during the Covid-19 pandemic, followed by their counterparts in advanced economies in the final months of 2021.

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The monetary policy cycle is now increasingly synchronised around the world.

IMF noted the pace of tightening is accelerating in several countries, particularly in advanced economies, in terms of both frequency and magnitude of rate hikes. Some central banks have begun to reduce the size of their balance sheets, moving further towards the normalisation of policy.

"Stable prices are a crucial prerequisite for sustained economic growth. With risks to the inflation outlook tilted to the upside, central banks must continue normalising to prevent inflationary pressures from becoming entrenched. They need to act resolutely to bring inflation back to its target, avoiding a de-anchoring of inflation expectations that would damage the credibility built over the past decades.”