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SURGING INTEREST RATES

28/09/2022 14:52:00 Sanele Sibiya

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In the September meeting of the Monetary Policy Committee of the Central Bank of Eswatini we saw yet another increase in the discount rate by 100 basis point or a one per cent increase.

The discount rate increased from five per cent to six per cent. We noted that the post COVID-19 recovery will be accompanied by central banks shrinking their balance sheets and rigorous open market operations to try and contain inflation, which is at a historical all-time high. The US has not seen these levels of inflation in over four decades. Global inflation is also on an all-time high. To combat the high levels of inflation, central banks across the world are forced to tighten their monetary policy stance to slow the money creation abilities of the commercial banks and ultimately slow down inflation. Today I am going to give a background of how this mechanism works and how to somehow absorb the shocks.

Money creation

The art of monetary policy is utilising the right policy tools to control money creation; and note that by money creation we do not mean the printing of additional paper money into the economy. The money that the central bank prints is called base currency or base money. Money creation in the economy is predominantly through the commercial banks’ loan ledgers. When a bank offers a loan, they are in essence creating new money, the interest is an asset to the bank and the deposits which we have with the banks are liabilities to the bank. The banks hold our deposits, which for simplicity we can assume they are backed by base money. When a loan is created, the interest earned on that loan is new money that is created as it requires the central bank to print more base money. In essence, without the loan the amount of money within the banks would still be our deposits, but with the loans and the interests the bank increases its balance by the amount of the interest.

The central bank needs to stand ready to supply this amount of money and therefore, the actions of the commercial banks would force the central bank’s hand in increasing the base money that is required not that it would have independently sought to do so. Now that I have given a primer on how money is created, let me give an indication of how the central bank can, through monetary policy, slow this process or surge it depending on the policy stance of the day.

Controlling money creation

The discount rate is a rate at which the commercial banks borrow money from the central bank. Through increasing and reducing the discount rate, the central bank can actually control the money creation abilities of the commercial banks. In order for the banks to give out new loans, they have to be able to at least borrow from the central bank to finance the new loan portfolios while keeping up with required reserve requirements from the central bank and they have to borrow this money from the central bank. If the rate at which commercial banks are borrowing from government is high, then they would have to charge higher interests (prime lending rate) to their clients on loans and the effect of this is to reduce the amount of new loans created as it will make loans unaffordable to a number of people. Also, prime linked existing loans will also be affected by this adjustment.

It will increase the interest payments on these obligations, taking away some disposable income from those who hold the obligations. This will reduce our spending power and deflate demand while slowing inflation, as there won’t be much money to spend on commodities. We expect this trend to continue until global inflation starts to respond, though our inflation problem is not that bad, but we are part of the global community and we import a lot of our inflation, hence we will have to bear it.

Surviving interest rate surge

Caution should always be taken to have a good mix of loans and investments in one’s portfolio. Those who have investments are benefitting from this surge in interest rates, while those with liabilities are being hit hard. The long-term goal should be to have a balanced portfolio of income producing assets so that our gains and losses are always balanced in times like these. We need to learn to avoid unsecured lending or taking loans to finance leisure such as holidays and frivolous expenses. We need to learn to borrow to invest so we must always balance our gains and losses from those transactions. Also, let me urge those affected by this current interest rate surge not to err and endeavour to borrow their way out of the disposable income decline. Try to absorb the shock, and try to lower expenditures to fit within the remaining disposable income. Now would also be the time to restructure one’s debt and try to negotiate for a non-variable interest rate on the loans or restructure by securitising some of the non-secured debt. Also, pay off short-term debt where possible, but no new debt if one is over committed.