Key issues as BOJ meets this week: When to slow rate hikes?
ECONOMIST Dr Adrian Stokes is warning that the economy is at risk of a hard landing if the Bank of Jamaica’s (BOJ) interest rate hikes over the last year start taking full effect at the same time the US economy is expected to slow substantially or even enter a recession.
His warning comes as the monetary policy committee (MPC) engages in a fraught debate over whether it may soon be time to slow its rate hikes, which are intended to cool the worst inflation in a decade but are also raising the risk of a recession.
“The big question is what impact interest rate increases will have on the real economy when the monetary transmission mechanism runs its course,” Stokes told the Jamaica Observer in response to questions about the key issues the BOJ must consider in deciding when it is time to slow rate hikes.
The monetary transmission mechanism is the process through which monetary policy decisions by the central bank, such as interest rate hikes, affect the economy, in general, and changes in the prices of goods and services, in particular.
“There is also the real risk that the effects of the past interest rate hikes will start impacting the local economy at the same time that headwinds from the US economy are being felt locally. This is the proverbial double whammy and the BOJ must be very careful how it manages this risk,” he continued.
But so far, there is little evidence that the rate hikes are having the desired impact as fast as the central bank would have liked, or as implied by Stokes, not having any impact because local interest rates cannot impact international price increases.
The minutes of the last MPC meeting held in September explicitly outlined that unlike in the past — between 1994 and 2022 — when every one percentage point increase in the central bank policy rate led to lending rates increasing in the range from 0.28 percentage point and 0.97 percentage point and also pushed up deposit rates by between 0.40 percentage point and 0.87 percentage point, the impact of BOJ policy rate increases and commercial banks lending and deposit rates is much lower now.
“For the current tightening cycle [between end September 2021 and end July 2022], the pass-through appeared weaker than that in the empirical review,” the MPC was told in its last meeting by Carey-Anne Williams, the division chief for the BOJ’s research and economic programming division.
“The pass-through of policy rate increases to [commercial] bank’s weighted average deposit rates [demand, savings and time] was just 0.07 percentage point. This response was primarily related to time deposit rates, which reflected a pass-through of 0.32 percentage point. Banks’ prime lending rates were higher on average by 1.099 [percentage point] at end July 2022, relative to the rates at end September 2021. In a context where the policy rate increased by five percentage points between end September 2021 and end July 2022, this implied a pass-through of 0.22 percentage point, again lower than that suggested by the literature on Jamaica’s recent experience,” the minutes continued.
The hope is also that with higher policy rates, commercial banks would be increasing deposit rates enough to encourage people to save instead of spend, which can also tamper down inflation, but that is not happening as expected.
With that data, what does the central bank do? Central bank officials have stressed that they need to raise rates significantly to tame inflation, which has caused hardships for thousands of households. What we have seen so far is the fastest pace of rate increases since 2008. It is designed to cause much costlier borrowing rates, ranging from mortgages to auto and business loans, to cut into disposable income and slow demand and ultimately the economy. With this, the BOJ aims to curtail inflation, which in September was 9.3 per cent, the lowest it had been since December, but still significantly above the 5 per cent the central bank has promised to maintain.
“The truth is, you cannot fight inflation without affecting growth; in one way or another, you are either going to slow growth or stop growth,” Richard Byles, governor of the BOJ, told an audience at a Stocks on the Rock event on October 28.
“What is important, though, is that you don’t overstep, you don’t kill growth more than you have to, and it’s a delicate process. It’s part science and it’s part art, and it takes patience and it takes data to make good decisions,” Byles continued.
But though the central bank signalled in August that it is prepared to halt its interest rate hikes if the incoming data are encouraging, a dip in the headline inflation alone will not influence that decision.
Core inflation at August 2022 (the measure that excludes fuel and food prices) increased marginally to 8.3 per cent from 8.2 per cent in July 2022, and though the BOJ said it still expects this figure to fall over the next two years, the higher rate is seeming to suggest that what started as imported inflation is seeping into other areas of the economy with no import content, such as the price for rent. Also worrying the central bank are the rate hikes in the United States, which it has repeatedly said “could cause capital outflows, prompting a faster pace of exchange rate depreciation and, consequently, a derailment of [it’s] efforts to manage inflation”.
Those two pieces of data alone suggest that even though the central bank key policy rate at 6.5 per cent is close to the top of its neutral rate of 7.6 per cent, the inflation fight is truly on.
But Stokes maintains that the central bank is going the wrong way.
“It is clear that the interest rate increases have had little effect on inflation so far. This is an important nuance that some persons fail to understand. Unlike the US, Jamaica’s inflation isn’t driven by an overheating economy. And so the usual…benefits that are normally derived from a rising interest rate environment aren’t available to Jamaica,” he told Sunday Finance, as he added, “Inflation isn’t the real risk to the Jamaican economy. As we stated from day one, Jamaica’s inflation is driven by global supply factors and will be corrected by same. The big risk and more relevant issue to deal with in Jamaica is ensuring that the unemployment rate doesn’t rise materially.”
His argument has been bearing out as well as some early signs suggest that inflation could start declining in 2023. Supply chain snarls are easing — ocean freight costs have plunged two-thirds in the past year — which means fewer shortages. For August 2022, oil prices which average US$91.50 per barrel during the month, were lower than the BOJ’s forecast of US$102.20. Grain prices were falling, too, from growing concerns about the slowing global economy, an appreciation of the US dollar, a resumption of grain shipment from Ukraine, and improved weather conditions in key growing areas in the US.
But those developments were not convincing enough for the MPC which expressed the view that the central bank’s communication efforts should inform the public that the key drivers of inflation and other economic indicators were trending in the right direction but that conditions had not sufficiently solidified to ensure that inflation was sustainably on a downward path.
Though LNG prices trended above projections over the same period was a worry, of greater concern is wage growth which could fuel further inflation.
For Stokes, the key for the BOJ is to be forward looking, ensuring that it has a good forecast of economic conditions over the next three to four quarters.
There are a number of factors to be taken into consideration:
1) The world and US economies will slow going into 2023. The only question we are struggling with is how much or how deep the slowdown will be.
2) The risk to commodity prices is skewed to the downside given the expected slowdown in global output.
3) The Jamaican economy will slow given the expected slowdown in global output.
4) Inflation in Jamaica, as predicted, has started to fall in line with international commodity prices and will continue to trend in this direction.