Forget the hype, bank interest rates are not going to fall any time soon

The Central Bank of Kenya building in Nairobi on June 2, 2014. FILE PHOTO | SALATON NJAU |

What you need to know:

  • The longest we have been able to keep inflation within target is 10 months in 2010. One out of 10 is not a great score.
  • Other than this one episode, the norm is three to four months, then inflation surges to peaks between 15 and 20 per cent.

“In his presidential address to the American Economic Association (AEA), Milton Friedman (1968) warned not to expect too much from monetary policy. In particular, Friedman argued that monetary policy could not permanently influence the levels of real output, unemployment, or real rates of return on securities. However, Friedman did assert that a monetary authority could exert substantial control over the inflation rate, especially in the long run. The purpose of this paper is to argue that, even in an economy that satisfies monetarist assumptions, if monetary policy is interpreted as open market operations, then Friedman’s list of the things that monetary policy cannot permanently control may have to be expanded to include inflation.”

This is the dramatic opening of an influential 1981 paper by Thomas Sargent and Neil Wallace, professors at the University of Minnesota titled Some Unpleasant Monetarist Arithmetic.

Sargent and Wallace’s proposition was predicated on a deceptively simple proposition, which no serious economist contests, referred to as rational expectations, which postulates that people generally, and financial investors in particular, are able to make reasonably good price forecasts.

This seemingly innocuous assertion turns out to have profound implications for macroeconomic policy for it suggest that monetary policy is not fit for purpose.

Let us say you are considering some cash to invest for a year.

What interest rate would you require to ensure that your money is worth more in year than it is worth today?

The best place to look at what investors expect is what they are willing to lend the government money at, government being the lowest risk borrower in the economy.

Suppose the government is offering a bond which pays an interest of 10 per cent at the end of every year.

The investor expects to make it worthwhile to save, they must get at least 2.5 per cent return in real terms, that is, after adjusting for inflation (otherwise one might as well buy a plot).

If investors converge on the face value of the bond, say, Sh100, it means that they expect inflation over the next year to be in the order of 7.5 per cent.

If investors converge on a price of 95 shillings for 100 shilling face value, it implies that they are looking for a yield of 16 per cent, which given the required real return of 2.5 per cent, implies in turn that the market expects inflation to be 13 per cent (you can test your math on this calculation).

Where am I going with all this theorising? The chart shows the rate of inflation over the last decade or so. It is telling us that we are unable to control inflation.

INFLATION SURGES

The government’s inflation target is five per cent The longest we have been able to keep inflation within target is 10 months in 2010. One out of 10 is not a great score.

Other than this one episode, the norm is three to four months, then inflation surges to peaks between 15 and 20 per cent.

Of the 138 months in the graph, inflation was on or below target for 43 months, just about a third of the time, and above 10 per cent for 48 months. The average inflation for the period is nine per cent.

This is telling us that it is not possible to sustain interests that are below 10 per cent for any length of time.

To preserve the value of money, we should expect our risk free rates to be between 10 and 15 per cent. If the government is borrowing at 10 to 15 per cent, then the rest of us should expect to borrow at between 12 and 18 per cent at best.

Consumer advocates as well as the authorities have interpreted the large spreads between the deposit and lending rates as evidence that banks are overcharging borrowers suggesting that there is scope to bring down lending rates by reducing the spreads and increasing deposit rates as well.

Indeed, with deposit rates averaging two per cent and lending rates averaging 16 per cent, a spread of 14 percentage points does seem inordinately high.

But given the high and volatile inflation regime, it is readily apparent that it is depositors who are at the short end of the spreads, not borrowers.

This begs several questions. Why are people voluntarily keeping money in banks for interest rates below the rate of inflation? Is there a public interest case for government intervention?

What would be the means and likely consequences of intervening? And why is the government borrowing from the banks at 10 per cent, money that the banks are paying two per cent for?

Why does the government not cut out the banks and borrow directly from the public at four or five per cent? These are questions for another day.

SELLING TO REFINANCE

Back to monetarist arithmetic. What would happen if the government decided to drive down interest rates by, for instance, fixing them as has been proposed on occasion? Investors are currently holding Sh1.2 trillion of government bonds (excluding those that Central Bank uses for open market operations).

Some of these bonds are constantly maturing so the government has to keep selling new ones to refinance the maturing ones.

A significant portion of the debt is held by foreign institutional investors — the so-called hot money which whizzes round the world looking for good short term returns.

If the government sets out to drive interest rates artificially low, this money would stop coming in and that which is here would start leaving.

The government would find itself staring at a budget crisis since it would have to pay for maturing bonds from revenue as well as a run in the shilling as investors seek to repatriate their money.

The government would still borrow abroad, that is, float more Eurobonds to pay off the shilling debts. But this still leaves local investors facing the prospect of negative real returns on their government bond holdings.

Not wanting to lose their money, the bondholders would discount their bids on new bond purchases restoring the yield consistent with their inflation expectations.

The only way to bring down interest rates sustainably is to bring down inflation expectations. This requires a government policy that is credibly seen to be capable of moving the country to a low stable inflation regimes.

DEMAND AND SUPPLY

What could such a policy be like? Well, inflation has two sides. A demand and supply side. Let’s look at each in turn.

The surest way to deal with demand side is to abolish the government’s capacity to print money. The most resolute way of achieving this is to abolish the national currency. This is not as radical as it sounds. This is what Zimbabwe had to do to kill hyperinflation.

But our situation is not that desperate. The next best thing is to abolish budget deficits. 

As long as the government can issue bonds to finance a deficit and we have a national currency, the prospect remains that if the government finds itself in dire financial straits, the Central Bank would be compelled to print money to bail out the government (the politically correct term is to “monetise” the deficit).

Whenever investors see a widening budget deficit, they factor in the risk of inflationary financing into the returns they require from government bonds. The effect? High interest rates.

Since we are unlikely to do this either, the more realistic proposition is to fix the budget deficit by law.  This is already envisaged in the proposed East African common currency plan.

The Eurozone stability pact imposes a budget deficit at three per cent of GDP and public debt at 60 per cent of GDP (Greece got in by cooking the books and its current woes are the wages of sin).

The biggest potential beneficiary of a low inflation regime is the government.  A one percentage point reduction in the interest on domestic debt works out to Sh12 billion.

A credible five per cent inflation regime would reduce the government interest cost by as much as three percentage points, a saving of Sh36 billion per year. 

On the supply side, a key factor in the high inflation is a widening structural food deficit. Every year, we have more mouths to feed, but our agricultural productivity is stagnant, and in some cases, maize for instance, has been falling.

There are two effects at work. First, when there is scarcity prices go up to signal that the market needs more of the stuff. Second, we are moving production into marginal areas which means higher cost per unit produced.

The “mountains and valleys” you see in the inflation graph are explained by our using demand management (monetary policy) to try and control structural supply side inflation. The ultimate inflation buster for Kenya is to grow cheap food. So there you have it. Cheap maize, low inflation, low interest rates.

Dr Ndii is managing director of Africa Economics. [email protected]