The logic of monetary policy encourages the central bank to raise its rates in order to fight a galloping inflation. By increasing interest rates the central bank indirectly also fights against a loss of value of its exchange rate. When, however, a central bank adopts a policy of targeting a certain rate of inflation, it can choose to reduce its interest rate.
The central bank of Ghana decided last month to cut rates from 25.5 to 23.5, a decline of 2 points when inflation rate reaches 13.2%, well above the target value of 8%. This is an illustration of the flexibility of monetary policy aimed at targeting the inflation rate. The purpose of this article is to elucidate this monetary practice. Before going further we will define the concept of targeting interest rate
Targeting the inflation rate. In order to control the rate of inflation, the central bank can manipulate its nominal interest rate. To lower inflation (induced by demand), the central bank will increase its nominal rate. This increase will affect the components of aggregate demand (Consumption-Investment – and Net Export) thereby reducing overall demand. If the central bank want to raise demand, it will reduce the nominal interest rate. The fall in interest rate will increase the aggregate demand (Consumption-Investment – and the commercial balance). Some central banks do not have in view a given level of inflation. They acts in real time. On the other hand, other are targeting a certain rate of inflation which they consider “acceptable” for growth. This practice is called “Inflation targeting”.
Below is a list of some African countries targeting inflation:
GHANA: 8,00% +/- 2,0%
BOTSWANA: 3,00% – 6,00%
KENYA: 5,00% +/- 2,50%
NIGERIA: 6,00% – 9,00%
SOUTH AFRICA: 3,00% – 6,0%
Ghana and Kenya have a target rate of 8% and 5% respectively, with an acceptable variation of +/- 2 and 2.5%. South Africa and Nigeria do not have a fixed rate but rather a band of variation that gives their central banks more leeway.
Why lowering interest rate when the inflation rate remains high?
In 2011, Ghana’s central bank reduced nominal interest rates as the inflation rate was out of its range of variation. Since March 2017, for the second time the central bank decided to reduce its key rate from 25.5 to 23.5, a decline of 2 points. One of my former economics professor at the Faculty of Economics in Vienna has always pointed out: ” Economic Theory yes but context and reality first”. So there are 4 practical reasons why a central bank momentarily abandons inflation the targeting.
a. Falling inflation rate
The further decline in interest rates is in a response to a falling inflation. In Ghana, inflation has been falling nearly over five consecutive months. The most recent rate (March 2017) is around 13.5%. Since December 2016, there has been a substantial decline in prices in the country’s goods market. This is a proof that the monetary policy put in place by the Ghanaian authorities is bearing fruit. By choosing to reduce the interest rate in spite of its 8% inflation target policy, the central bank of Ghana indirectly shows its flexibility. The Ghanaian authorities no longer seem to stick to the famous 8%, which according to them is the target rate of the medium term. In the short term, however, the target of 11.5% is deemed to be achieved before the end of the year.
b. Reinvigorating growth through a return of private investment
Another reason for the central bank to reduce its rate, comes from a business community. According to the latter, the interest rate of 25.5% would be too high and would discourage investments. Althoug the economic cycle may push the central banks away from the targeted inflation rate, most of them have their eyes on economic growth.
c. Accomodating to fiscal policy
The central bank decided to reduce the nominal rate to accommodate the effects of fiscal policy. The Ghanaian government is supposed to engage in a broad program of public spending that will raise real interest rates. By lowering its nominal rates the central bank central bank gives more room to fiscal policy.
d. Improving currency exchange rate
The other good news comes from the foreign exchange market. Recently the Cedi has stopped bleeding. It has indeed gained 8.5 points. When the Bank of Ghana adopted the inflation target it was facing a depreciation of its currency. The increase in interest rates was also aimed at raising the exchange rate. The fairly good posture of the Cedi vis-à-vis of other mains currency(Dollars and Euro), if continues, will allow more cuts.
Mounou Konan Global Economic Consulting