For its seventh consecutive meeting the Monetary Policy Committee (MPC) of the Bank of Jamaica (BOJ) has decided to increase the policy rate by a further 50 basis points; the policy rate now stands at 5.5 per cent.
This so-called fine-tuning is unsettling and undermines the BOJ’s otherwise stellar efforts to build credibility with the private sector, whose decision-making processes are placed under greater strain.
How high will the BOJ increase the policy rate? Can higher interest rates fuel higher inflation? Has the BOJ shifted emphasis to exchange rate stability?
The neutral policy rate — let us call it the Goldilocks rate — is the policy rate which is neither restrictive (reduces demand to reduce inflation) or accommodative (increases demand).
The BOJ has taken an accommodative stance from the inception of its inflation targeting regime in July 2017 until it started increasing its policy rate in September 2021.
The results of BOJ research conducted by Alexander Lee and Carey-Anne Williams in 2019 suggest that Jamaica’s neutral policy interest rate ranges between -2.6 and 2.6 per cent in real terms; adding 5 per cent to these real rates, in keeping with the midpoint of the BOJ’s inflation target, we get a nominal interest rate range of 2.4 to 7.6 per cent. The BOJ has been increasing its policy rate incrementally within this nominal range since December 2021. On the other hand, the International Monetary Fund (IMF), in its 2021 Article IV Consultation Report for Jamaica, uses a neutral rate of 4 per cent. With its recent rate hike the BOJ has gone past both the IMF’s suggested neutral rate and the midpoint (5 per cent) of the BOJ’s nominal range.
So based on the neutral rate for Jamaica used by the IMF, the BOJ is now firmly in restrictive policy mode, while the BOJ’s numbers suggest that it has about 200 basis points more to go before its policy rate becomes restrictive. To be clear, I am not suggesting that the IMF disagrees with the policy of the BOJ.
Increases in the policy rate are meant to lower demand and, by extension, economic growth. The idea is that by reducing the demand for loans and, by extension, the demand for goods and services, the inflation rate will fall within the acceptable range. Of course, the current inflationary pressures facing Jamaica are primarily driven from the supply side (cost-push inflation), which brings into question the repeated actions of the BOJ.
To be clear, and consistent with my previous comments on this issue, I understand that the BOJ is concerned with second-round price increases and so rate increases were justifiable. However, to increase rates at every meeting does not seem prudent as it takes months for the rate increase to affect the real economy; banks and firms are faced with greater uncertainty; and higher rates can lead to further increases in the rate of inflation through the cost channel.
Yes, higher interest rates can fuel higher inflation rates.
Economic research provides evidence of higher interest rates causing higher inflation rates through the cost channel. Caribbean researchers, Greenidge and DaCosta, in their study of Barbados, Guyana, Jamaica, and Trinidad and Tobago note that, “…[T]he authorities may first see a rise in inflation rates following an increase in interest rate. Without fully understanding the overall time path of the inflation rate towards its new equilibrium, policymakers may not see, in the short run, a reduction in the inflation rate following a policy action of increasing interest rates and may be tempted to push up interest rates even further, with unwelcoming effects.”
The idea is simple. For example, when interest rates go up, the cost of borrowing goes up, increasing the costs of those firms which need to borrow to ensure that they have enough working capital to keep their businesses going, especially during these trying times.
In an environment of high inflation, such firms might be inclined to increase the cost of their goods not only to cater for the increased costs of inputs, caused primarily by factors external to Jamaica, but also to cover the higher interest rates they must pay to the banks. Firms do not want to annoy their customers by increasing prices often unless of course there is some serious shortage. In periods such as we are currently experiencing, firms will find it easier to justify passing on increases to the consumer with the claim that “everything” is going up. Further, firms have been known to overcompensate. Years ago, a popular businessman made clear at a public forum that if the expectation is that the dollar will depreciate by say 3 per cent then his firm would make price adjustments based on a figure that is greater than 3 per cent.
So why does the BOJ keep increasing its policy rate? In his monetary policy briefings, Governor Richard Byles walks a tight rope between focusing on the inflation rate target and the exchange rate. He has consistently expressed that the BOJ is watching the exchange rate, even as it is legally obligated to target the inflation rate.
Concern has been raised about ensuring that domestic interest rates are sufficiently high to offset demand for US financial assets which will become more attractive as the US Federal Reserve Bank aggressively increases its policy rate. Increased purchases of US financial assets by Jamaicans create an increase in the demand for US dollars which, if left unchecked, could cause the Jamaican dollar to depreciate. Does this imply, therefore, that the BOJ is effectively now defending the Jamaican dollar with the view that doing so prevents further inflationary pressures?
The dollar has been relatively stable in recent months. Some will argue that the BOJ can achieve exchange rate stability without increasing the policy interest rate as it has enough foreign currency reserves to defend the dollar.
To its credit, the BOJ has been intervening from time to time and is quite content to continue building up its reserves of foreign currency. As of May 2022, Jamaica’s net international reserves is approximately US$ 3.7 billion and is equivalent to seven months of imports of goods and services and almost 12 months of imports of goods only. It is recommended that countries hold reserves to cover at least three months of imports. Having a healthy reserve of foreign currency reduces the probability of seeking IMF assistance as Sri Lanka has had to do recently.
In the past, Jamaica has struggled with high inflation (see diagram), but we must recognise that those excessive rates were largely the result of poor macroeconomic policy and the concomitant macroeconomic instability. In those days there was no independent central bank. Today, a minister of Government cannot instruct the governor of the BOJ to take a particular course of action. With better domestic macroeconomic management external factors will play a greater role in driving domestic inflation, reducing the need for the BOJ to frequently change policy rates while focusing on exchange rate stability. Of course, this view runs counter to the BOJ’s inflation targeting regime.
The BOJ is adamant that its efforts will not push the economy into a recession, but surely the pace of growth will be slowed, increasing the chance of a recession.
The BOJ’s next policy rate decision is scheduled for August 18, 2022.
Dr Samuel Braithwaite is a lecturer in the Department of Economics at The University of the West Indies, Mona. Send comments to the Jamaica Observer or email@example.com.