Increasing interest rate not the best antidote to inflation

The National Bank of Rwanda defines Interest Rate as, “the rate at which interest is paid by borrowers for the use of money that they borrow from a lender. Specifically, the interest rate is a percent of principal paid at some rate. For example, a small company borrows capital from a bank to buy new assets for its business, and in return the lender receives interest at a predetermined interest rate for deferring the use of funds and instead lending it to the borrower.” Interest rates are normally expressed as a percentage of the principal for a period of one year. Recently, the National Bank increased the lending rate (the rate at which the National Bank lends to commercial banks) from 6 to 6.5 percent in a bid to curb inflation and preserve consumer purchasing power. Consumer purchasing power roughly means the consumers’ ability to buy goods and services given their incomes. The National Bank increasing the rate at which it lends to commercial banks means that commercial banks will also increase the rate at which they lend to individual borrowers and businesses as they shift the burden to consumers. The implication of an increase in lending rates is an increased cost of borrowing and, consequently, investing. Lending rates are usually adjusted to either reduce or increase money supply within an economy. While increasing the lending rate is one common monetary policy intervention to help alleviate inflationary pressures, it is not the most appropriate in the current situation and below is a number of reasons why; For a start, global lockdowns that followed the outbreak of the Corona-Virus Disease gravely disrupted production of goods and equally constrained global supply chains. As the World was recovering from production and supply constraints caused by the Covid-19 pandemic, the Russia-Ukraine war in Eastern Europe broke out and Western sanctions on Russia that followed the war, further worsened production and supply chain constraints. Given disruptions to production and supply resulting from lockdowns as well as sanctions on Russia, goods- mostly grain and oil and gas- became very scarce. It is this insufficiency in supply of goods that exerts upward pressure on prices. Supply deficiencies coupled with high costs of borrowing to produce (primarily and secondarily) increases the prices of already scarce consumer goods even further which also diminishes consumer purchasing power. Secondly, the increase in lending rates raises the cost of investment which lowers opportunities for expanding the economy’s production potential. Since there is already a limitation to importation of certain good used in the production of other goods (secondary production), increasing the interest rate stifles investors’ ability to invest in labor, equipment and all necessary infrastructure. Denying the economy, the ability for expansion of production in a supply constrained global economy will ultimately drive prices even further in the long and medium term as the already unaddressed demand for goods keeps rising. High interest rates, while increasing costs of investment, also increase the cost of labor which exposes the economy to employment contractions. In the long run, as the economy becomes unable to expand its production capabilities, employment opportunities decline. A decline in employment will push the government to subsidize consumption by an unproductive population (unemployed labor force). Since the upward pressure on prices is a result of a huge imbalance between demand and supply, an attempt at driving demand lower without sharp supply increases will cause no significant changes in consumer purchasing power. How best should the issue be addressed instead? Given the fact that rising prices are a result of supply shortages, which also result from global supply chain constraints, any policy intervention should be geared towards ensuring adequate supply of goods which are in high demand. Efforts which ensure domestic production, in sufficient amounts, of goods currently being imported will shield the economy from any global developments that disrupt supply chains. Instead of increasing lending rates and discouraging investment as a result, mechanisms should be put in place which enable willing investors to invest in production of food products, machinery and equipment, construction materials and fertilizers which take up the country’s highest import spend. Alongside that, the government would benefit from setting to the lowest minimum or altogether scrapping import duties on commodities whose demand is very high and those whose supply deficiency triggers increase in prices of other goods as a derived factor. Scrapping import duties will not only help to bridge the supply-demand gap, it will also prevent government from spending high on consumption subsidies. The government should, now more than ever, scale-up the national Buffer Stock. Increasing the capacity of the country’s buffer stock will give government a position of strength when dealing with situations where supply is highly constrained as it is currently. A Buffer Stock is a reserve of a commodity or commodities that can be used to counterbalance price fluctuations. With sufficient reserves, government can release some amounts of commodities in high demand to help tame increasing prices for those very commodities thereby managing the situation without necessarily creating problems in adjacent areas of the economy. In brief, rather than monetary policy, current inflationary pressures require more fiscal policy interventions. The writer is a final year student of law, passionate about tech entrepreneurship and governance.

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Increasing interest rate not the best antidote to inflation