Tafara Mtutu:Investment analyst
THE policy interest rate is the rate at which commercial banks can borrow money from their central bank. Policy rates are a widely accepted monetary policy tool to control levels of inflation and economic activity within an economy. A sustainable policy rate is the equilibrium rate that satisfies both borrowers and people with savings available for lending.
An increase in policy rates is a means of slowing down growth when the economy exceeds its sustainable growth rate. The increase in the rates incentivises more people to save instead of spending, and discourages debt funding in projects, which both leads to slower economic growth.
A reduction in policy rates, on the other hand, is a way of boosting a country’s economic activity. A decline in the policy rate often occurs as a result of an economic slowdown or a major economic shock. Lower interest rates provide commercial banks with liquidity and lower credit costs, which in theory boost investment and therefore economic growth.
The Reserve Bank of Zimbabwe (RBZ) maintained the bank policy rate of 35% per annum in its most recent monetary policy statement. Before we answer the headline question, we unpack the theories behind policy rate formulation and begin with the Taylor Rule.
The Taylor Rule, when used in the context of setting policy rates, stipulates that the policy rate is a function of (i) real short-term interest rates that balance long-term savings and borrowings in an economy, (ii) the current inflation rate, (iii) inflation rate target, (iv) the logarithmic levels of actual real GDP and (v) the logarithmic levels of potential real GDP.
The rule adds the real short-term interest rates, the current inflation rate, the different between current and targeted inflation rates, and the difference between the logarithmic levels of actual and potential GDP to come up with the appropriate policy rate. If the target inflation rate is lower than the actual inflation rate, the policy rate tends to increase. This is also the case if actual real GDP is higher than potential real GDP.
The rule intuitively adjusts the policy rate higher (lower) in order to lower (increase) inflation rate. Based on the Taylor Rule and a variety of information sources, Zimbabwe’s policy rate should be ranging between 150% and 350%. However, this theory has a number of limitations and assumptions that limit its reliability.
An additional, but loose, proxy for gauging the appropriate level of the policy is the Yardeni model. This model is an extension of the Fed model, which is a market timing tool for determining whether the US stock market is fairly-valued.
The model is based on an equation that compares the earnings yield of the S&P 500 with the yield on 10-year US Treasury bonds. The Yardeni model incorporates the earnings growth forecast in addition to the earnings yield of the S&P 500.
If we take this closer to home and reverse-engineer it to find the theoretical representative 10-year government bond yield in Zimbabwe, we get a yield of roughly 40%. Given that the longer dated Treasury bond yields are conventionally higher than the policy rate, the current policy rate of 35% set by the RBZ seems plausible.
There are also some factors that l believe the central bank also considered in its decision to maintain the 35% rate, specifically the need to balance between affordable financing for productive sectors and preventing parallel market speculation with “cheap” money. A rate that is lower than 35% will encourage parallel market-driven speculative borrowings, as was the case before the policy rate was increased from 15% to 50% in June 2019 and then to 70% in October 2019.
However, the increase also made debt financing, a critical component to local business operations, considerably unfeasible. As a result, the central bank revised the overnight rate downwards to 35% in November 2019.
There remains some level of uncertainty as to the direction of the rates in the forthcoming monetary policy statements, but independent analysis strongly suggests that a lower rate might be announced by the RBZ sooner than expected.
Firstly, the central bank and MoFED have now enacted policies that have contained inflationary pressures driven by the parallel market, such as the more liquid auction system and stringent limits on mobile money and ZIPIT. The success of these measures has seen stability in prices and also opens up an opportunity for the RBZ to lower rates and further support businesses without worrying about inflationary pressure from the parallel market.
Further, the empirically positive relationship between interest rates and economic growth also warrant a further decrease in the policy rate given the estimated 10,4% GDP contraction by IMF largely due to the Covid-19 pandemic. The lower growth prospects of the global economy since the declaration of Covid-19 as a pandemic in March 2020 were also met by lower interest rates globally, and the graph below illustrates the impact in select countries.
There is the possibility that the central bank will increase the policy, although it is highly unlikely. A higher policy rate would theoretically stymie the rampant inflation rate but a simple regression of Zimbabwe’s CPI on interest rates between January 2019 and March 2020 shows a very weak relationship that is illustrated in the graph below.
In other economies, one would observe a very strong negative relationship between the movements of the two variables. This shows that the transmission mechanism that is initiated by interest rate movements, in this particular case, does not hold and further confirms that the high inflation rates in Zimbabwe between 2019 and 2020 were not driven by local demand.
Instead, Zimbabwe’s inflation largely stems from the country’s extensive import dependence and depreciation of the local currency.
The deep-dive into policy rates in Zimbabwe arguably hints that policy rates may fall, but whether I am right or wrong, the outcome seems immaterial because of the ineffectiveness of policy rates in controlling the inflation rate. This suggests that other measures to contain inflation rates may be more relevant, such as exchange rate targeting.
Exchange rate targeting is the process through which a central bank intervenes in the market mechanism to maintain the exchange rate at a particular level that they deem as desirable.
In Zimbabwe’s case, changes in the exchange rate will directly filter to the inflation rate. This can be achieved through the use of international reserves to alter the supply of currency in order to keep its value fixed or maintain it at a particular rate with another currency.
Zimbabwe is limited in its ability to use international reserves to alter the exchange and inflation rates, but the introduction of the auction system has managed to stabilise the country’s local currency exchange rate around ZWL81,34/USD.
In its October 16, 2020, Reserve Money Update, the RBZ highlighted that there was a ZW$700 million increase in reserve money due to the purchase of foreign exchange by the central bank through banks for purposes of funding the foreign exchange auction. Currency stabilisation has resultantly been a driving factor towards inflation rate stabilisation in recent months.
The strength of the central bank’s policies will be tested in the coming months, especially in light of inflation targets below 100% before the year ends. A brief analysis on inflation rate movements over the last three months, however, point to a decline in the year-on-year inflation rates to double digits only after June 2020, assuming that monthly inflation rates continue to slow down at their steady pace and complementary policies are implemented efficiently.
Mtutu is an investment analyst with Morgan & Co. He writes in his personal capacity.