By Tafara Mtutu
THE Reserve Bank of Zimbabwe maintained the key policy rate at 80% in its latest monetary policy committee meeting shortly after releasing a worrying year-on-year inflation rate of 96,4% for the month of April.
The move to maintain the high interest rate most likely finds its rationale from lessons learned in 2019 when the country moved back to the Zimbabwean dollar (Zimdollar), and low interest rates birthed “cheap money” that fuelled speculative borrowing as well as the gross depreciation of the local currency relative to the United States dollar (USD).
Latest inflation trends and currency depreciation are reminiscent of theturmoil that played out in 2019, and policymakers have expressed their resolve to contain the country’s second bout with the volatile macro-economic environment.
One tool that policymakers often use to control the macro-economic environment is the interest rate. A very low interest rate is often at the heart of every expansionary monetary policymeasure, while high interest rates are effected when policymakers seek to slow economic growth to sustainable levels.
A low interest rate makes it cheaper to borrow money from banks and makes it less lucrative for one to keep funds in an interest-bearing account.
The result is an aggregate increase in expenditure as the allure of spending or utilising cheap money outweighs saving it. On the other hand, an increase in interest rates makes it expensive to borrow money and it increases the attractiveness of keeping funds in an interest-bearing account, which subsequently leads to a decline in aggregate expenditure and a slowdown in economic growth.
One might wonder why policymakers need to tame economic growth, and the answer to that is, any growth beyond what is sustainable often leads to inflation and anunconducive economic environment.
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A theoretical way to determine the appropriate level of interest rates is the Taylor Rule. In this context, the Taylor rule is an equation that expresses the appropriate nominal short-term interest rate asa summation of the neutral real short-term rate, an inflation target, the difference between the long-term gross domestic product (GDP) growth trend and expected GDP growth, as well as the difference between the expected inflation rate and the target inflation rate.
Given a set of reasonable assumptions, one can approximate the appropriate level of interest rates for Zimbabwe. The neutral real short-term rate is the rate at which monetary policy measures are neither restrictive nor expansionary, and 1% is common among several economies.
The finance minister alluded to an inflation rate target ranging between 25% and 35% in December 2022, although latest CPI figures point to an inflation rate expectation of c.380% by year end.
According to the finance minister, Zimbabwe’s expected GDP growth for 2022 ispegged at 5,5% and a long-term GDP growth trend, based on historical growth figures since 1999, is approximately 0,1%.
Based on these assumptions and the Taylor rule, a reasonable interest rate for the year would be just over 200%. Such a rate would theoretically improve the central bank’s odds of closing the year with a Y-o-Y inflation rate of approximately 30%.
While 200% sounds abnormal for a key policy rate, higher rates have been set by policymakers in several countries throughout history. Croatia deliberated on an interest rate of 2,647% in September 1993, Brazil’s interest rate reached 355,086% in February 1990, and Argentina’s interest rate soared to 557% in November 2001.
However, the Taylor rule makes a bold assumption that inflation is driven by strong demand for goods and services, which is not entirely the case in Zimbabwe.
Unlike countries that experience demand-driven inflation, Zimbabwe’s inflation rate is often driven by supply constraints, which largely vortex on the availability, or lack thereof, of foreign currency.
An adequate supply of foreign currency for imports of raw materials on a stable currency exchange often leads to low inflation.
A brief look at the inflation trend before and in the few months after the inception of the foreign currency interbank auction system shows that the availability of foreign currency was key in slowing down the inflation rate from 838% in July 2020 to 52% in September 2021.
We opine that the inefficiencies within the auction system, among other factors, have prompted a renewed period of currency depreciationon the parallel market.
Given Zimbabwe’s extensive reliance on foreign currency for raw materials, a simple substitution effect simply manifested as the supply of foreign currency that dried up on the interbank was replaced by supply of foreign currency on the more volatile parallel market.
The volatile parallel market rates subsequently rippled to the price of the end-product and have largely resulted in the high inflation rates.
The volatile parallel market rates have added to the burden of businesses and increasing interest rates have further punished businesses at a time when measures should be aimed at supporting local productive capacity.
This presents a catch-22 for monetary and fiscal policymakers who face opposing economic demands. On one end, lower interest rates will support local businesses but increase speculative borrowing that was instrumental in the local currency’s depreciation in 2019.
On the other, higher interest rates will curtail speculative borrowing but choke businesses that regularly require lines of credit for their working capital and long-term capital requirements. We note that Zimbabwe’s economic challenges require more than a revision of interest rate to slow inflation down. We are cognisant of the difficult and conflicting measures that policymakers have to deliberate in the short-term.
However, we maintain that these should incorporate long-term measures that can ensure a stable medium of exchange,such as resuscitating local production capacity, building foreign currency reserves, restoring confidence in local capital markets, integrating with the global community, and addressing corruption and opaque property rights, among many resolutions.
- Mtutu is a research analyst at Morgan & Co. — [email protected] or +263 774 795 854
