Raising interest rates is not the best antidote to inflation

The National Bank of Rwanda defines interest rate as “the rate at which interest is paid by borrowers for the use of money they borrow from a lender. Specifically, the interest rate is a percentage of the principal paid to a certain rate For example, a small business borrows capital from a bank to purchase new assets for its business, and in return the lender receives interest at a predetermined interest rate to defer the use of the funds and lend them out instead to the borrower.” Interest rates are normally expressed as a percentage of principal for a period of one year.

Recently, the national bank increased the lending rate (rate at which the national bank loans to commercial banks) from 6 to 6.5% with the aim of curbing inflation and preserving consumers’ purchasing power. Consumer purchasing power roughly refers to the ability of consumers to buy goods and services given their income. The National Bank increasing the rate at which it lends to commercial banks means that commercial banks will also increase the rate at which they lend to individual borrowers and businesses by shifting the burden onto consumers. The implication of an increase in lending rates is an increase in the cost of borrowing and, therefore, of investing. Lending rates are usually adjusted to reduce or increase the money supply within an economy.

Although raising the lending rate is a common monetary policy intervention to help ease inflationary pressures, it is not the most appropriate in the current situation and here are a number of reasons;

For starters, the global shutdowns that followed the outbreak of the coronavirus disease have severely disrupted the production of goods and also strained global supply chains.

As the world recovered from production and supply constraints caused by the Covid-19 pandemic, the RussiaUkraine war in Eastern Europe erupted and Western sanctions against Russia that followed the war, further aggravated production and supply chain constraints. Given the production and supply disruptions resulting from the lockdowns as well as the sanctions against Russia, commodities – mainly grain, oil and gas – have become very scarce. It is this lack of supply of goods that puts upward pressure on prices. The shortfalls in supply coupled with the high borrowing costs to produce (primarily and secondarily) raise the prices of already scarce consumer goods even further, which also lowers the purchasing power of consumers.

Second, the increase in lending rates increases the cost of investment, which reduces the possibilities for expanding the productive potential of the economy. Since there is already a limitation on the import of certain goods used in the production of other goods (secondary production), the increase in the interest rate stifles the ability of investors to invest in labor, equipment and all necessary infrastructure. Denying the economy, the ability to expand production in a supply-constrained global economy will eventually drive prices up even further in the long to medium term, as the already unmet demand for goods continues to rise.

High interest rates, while increasing investment costs, also increase the cost of labor, which exposes the economy to employment contractions. In the long run, as the economy becomes unable to expand its productive capacities, job opportunities diminish. A decline in employment will push the government to subsidize the consumption of an unproductive population (unemployed labor force).

Since the upward pressure on prices is the result of a huge balance between demand and supply, an attempt to lower demand without a large increase in supply will not cause significant changes in the price. purchasing power of consumers.

How best to deal with the problem?

Since rising prices are the result of supply shortages, which also result from global supply chain constraints, any policy intervention should aim to ensure adequate supply of goods that are in high demand.

Efforts that ensure domestic production, in sufficient quantities, of currently imported goods will protect the economy from any global developments that disrupt supply chains. Instead of increasing lending rates and discouraging investment accordingly, mechanisms should be put in place to allow willing investors to invest in the production of food products, machinery and equipment, building materials and fertilizers which represent the country’s highest import expenditure.

At the same time, the government would benefit from setting the lowest minimum or completely removing import duties on products with very high demand and those for which insufficient supply triggers price increases in other goods as a derived factor. Removing import duties will not only bridge the gap between supply and demand, but also prevent the government from spending heavily on consumer subsidies.

The government should, now more than ever, increase the national buffer stock. Increasing the country’s buffer stock capacity will give the government a strong position in situations where supply is severely constrained as is currently the case. A buffer stock is a reserve of one or more commodities that can be used to offset price fluctuations. With sufficient reserves, the government can release certain quantities of products in high demand to help control rising prices for those same products, thereby managing the situation without necessarily creating problems in adjacent areas of the economy.

In short, rather than monetary policy, current inflationary pressures require more fiscal policy interventions.

The writer is a final year law student with a passion for tech entrepreneurship and governance.

Copyright New Times. Distributed by AllAfrica Global Media (allAfrica.com)., source English press service

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