The new business normal The impact of a policy rate increaseSunday, October 24, 2021
Why did the Bank of Jamaica (BOJ) increase its policy rate? What will the economy look like after the rate hike in this current operating environment? Will the increase present any opportunities? How can investors prepare for what is likely to come? Accurately predicting what the macroeconomic environment will look like after the interest rate hike is next to impossible, however, we can make some assumptions about what is likely to occur through a theoretical lens.
The BOJ made the decision on September 30 to increase its policy rate from 0.50 per cent to 1.50 per cent, or by 100 basis points (bps). This is the first time that the rate has increased in almost 13 years. The rate hike decision was due to the expectation that inflation is likely to breach the upper bounds of the 4 to 6 per cent targeted range in September, largely driven by the expected increases in consumer prices.
But what does all this mean?
Inflation targeting is one of the many tools the BOJ can use to achieve price stability. Think of inflation targeting as monitoring your blood pressure. A normal systolic blood pressure is within the range of 90 to 120 mm Hg. Below 90 can be considered low and above 120, elevated. Once your readings are outside of these boundaries, your doctor may advise you to make some lifestyle changes to get your blood pressure back into the normal range. The same principle applies to inflation targeting. The BOJ has established that an inflation rate of 4 to 6 per cent can be viewed as healthy growth and any breaches of the target rate may call for monetary policy adjustments.
As the inflation rate is anticipated to breach the upper bounds of the targeted range within the short term, the BOJ made the decision to increase its policy rate, which it hopes will slow down consumer and business spending and allow inflation to return to its targeted range. Notwithstanding, the BOJ will need to pay keen attention to the key drivers of inflation, as the supply side is equally as important. Increasing global commodity prices, shipping costs and foreign exchange rates are critical factors that must also be closely monitored. Fiscal policy intervention such as a reduction in taxes may also be required to offset supply-side pressures.
The cost of borrowing is likely to increase. The policy rate is the interest rate at which deposit-taking institutions (DTIs) can borrow funds directly from the BOJ overnight. The increase in this rate is likely to have an indirect influence over longer-term interest rates such as mortgages, auto loans, small business loans and personal loans. Increases in these rates are likely to have a significant impact on broader markets. For example, an increase in mortgage rates is likely to dampen the demand for new homes as it would become more expensive to purchase. A higher cost of borrowing also means it is now more expensive to build homes, which means that the construction sector would also be negatively impacted.
Higher interest rates may lower bond prices. Bond prices and interest rates have an inverse relationship by nature. That is, if prevailing interest rates increase, bond prices fall which subsequently leads to an increase in bond yields. For example, if a certain bond has a fixed coupon rate of six per cent and a newly issued bond has a rate of eight per cent, due to a higher interest rate environment, the bond with coupon rate of six per cent suddenly becomes unattractive in the eyes of a bond investor, which leads to a lower bond price and a higher yield as the current price would now be at a greater discount relative to the bond's par value at maturity.
The banking sector may benefit
The banking sector may benefit from the interest rate hike. Banks and other financial institutions utilise their earning assets to generate interest income. Earning assets typically include cash, loans, and investment securities. Banks and financial institutions tend to have large amounts of cash on their balance sheets. An increase in interest rates would increase the yield on its cash.
Also, banks typically pay minimal interest on customer deposits and use these funds to invest in higher yielding short-term instruments. The marginal difference between the interest paid to customers and the yield generated on short-term securities is kept as profit. The higher the prevailing interest rates, the higher the spread, which means more money goes to the bank.
The increase in the BOJ's policy rate is also likely to influence other interest rates which will subsequently have a significant impact on several markets and the overarching economy. Increased interest rates may translate to an increase in the cost of borrowing for consumers and businesses, and a decline in bond prices for bond investors. It may also present an opportunity for investors to gain or increase their exposure to the banking sector, as an increase in interest rate is likely to benefit this type of business.
Sharif Small is a research analyst at Victoria Mutual Wealth Management with experience in the investment banking industry. Sharif was the first-quarter winner of the Jamaica Stock Exchange Stock Market Research Competition 2019/20 and the First Runner-up for the overall competition in 2017/18. He holds an MBA in General Management from the Mona School of Business and Management.