Why BoN raises rates

THE Bank of Namibia has raised the bank rate seven times since June 2006, from 7,5 per cent to 10,5 per cent with a 50 basis points upward adjustment every time.

The reasons given by the BoN for the increases vary, but the core of the story was to curb inflation and manage inflation expectations. The key drivers of inflation during the period have been mainly food and fuel inflation.Inflation erodes the purchasing power of the consumer, rich and poor, albeit not equally.The current inflation surge should have a higher impact on the lower-income groups because it is mainly the food component that is pushing up inflation.Whereas higher-income categories spend only 15 per cent of their income on food, the lower income groups use up to 50 per cent of their income on this item.The situation is also compounded by the high interest-rate environment.But what is an interest rate? Money, like any other commodity, is scarce and is therefore paid for.An interest rate is the rate paid by borrowers to lenders for money loaned, i.e.the price of money.The higher the interest rate, the more expensive it becomes to borrow money.Consequently, consumers who need to borrow money in order to carry out a given economic activity become more constrained as the money becomes more expensive.Those consumers that already have borrowed money in a lower interest rate environment are also negatively affected because the debt servicing becomes more strenuous, as the compensation they have to pay gets adjusted upwards (unless it had been fixed at a certain level).Most mortgage rates, for example, are linked to the prime rate, which in turn moves in tandem with the policy rate.Therefore, unless the mortgage rate is fixed, it is adjusted upward with every policy rate increase.There are some businesses that are interest-rate sensitive in the sense that they are more susceptible to interest-rate changes.Examples of those are banks and retail businesses.Commodities are not interest-rate sensitive as such because their prices are not determined by the interest-rate environment and are more governed by the demand.Because of its purchasing power dilution effect, whenever interest rates go up labour unions tend to ask for concomitant salary increases.The reason for this is that if the workers do not get an increase that is at least equal to the inflation increase, they will no longer be able to afford the same basket of goods they were previously able to.Our being in the Common Monetary Area doesn’t have a direct bearing on our policy rate, or the bank rate, as it is called in Namibia.However, because of the fact that money drifts to where interest rates are higher, Namibia will be disadvantaged by keeping our rates lower than those of South Africa.Another reason that Namibia’s monetary policy is aligned with that of South Africa is due to the fact that the Namibian dollar is pegged on a one-to-one basis to the South African rand.South Africa has set an inflation target band of between three per cent and six per cent, which it believes is appropriate for the country to achieve its targeted financial stability.The South African Reserve Bank (SARB) uses interest rates as a policy tool for managing the inflation regime.Namibia, on the other hand, has not set any explicit inflation band.However, because of the fact the bulk of Namibia’s trade is with South Africa, Namibia actually benefits from the inflation target set by the SARB.In addition to that, the efforts made by the SARB are also intended to ensure price stability, which is positive for the economy in the long run and enables consumers to plan better.Despite South Africa’s ‘shock’ inflation number on Wednesday of 6,75 per cent (which was, in fact, in line with Investec Asset Management’s forecast) we believe SA Reserve Bank Governor Tito Mboweni has done enough.We foresee that inflation in SA will continue to worsen for the remainder of the year and peak in February next year, after which it will start falling back into the band around the third quarter of 2008.There are several signs of a general slowdown in the SA economy, which should give the Governor sufficient comfort that he has done enough to manage inflation expectations.Having said this, we do expect him to continue being vigilant and hawkish in his statements until inflation is firmly under control.* This article was contributed by Dr Alfred Kamupingene, Director of Research, Investec Asset Management Namibia, in response to The Namibian’s questions on the economic impact of the increasing bank rate.The key drivers of inflation during the period have been mainly food and fuel inflation.Inflation erodes the purchasing power of the consumer, rich and poor, albeit not equally.The current inflation surge should have a higher impact on the lower-income groups because it is mainly the food component that is pushing up inflation.Whereas higher-income categories spend only 15 per cent of their income on food, the lower income groups use up to 50 per cent of their income on this item.The situation is also compounded by the high interest-rate environment.But what is an interest rate? Money, like any other commodity, is scarce and is therefore paid for.An interest rate is the rate paid by borrowers to lenders for money loaned, i.e.the price of money.The higher the interest rate, the more expensive it becomes to borrow money.Consequently, consumers who need to borrow money in order to carry out a given economic activity become more constrained as the money becomes more expensive.Those consumers that already have borrowed money in a lower interest rate environment are also negatively affected because the debt servicing becomes more strenuous, as the compensation they have to pay gets adjusted upwards (unless it had been fixed at a certain level).Most mortgage rates, for example, are linked to the prime rate, which in turn moves in tandem with the policy rate.Therefore, unless the mortgage rate is fixed, it is adjusted upward with every policy rate increase.There are some businesses that are interest-rate sensitive in the sense that they are more susceptible to interest-rate changes.Examples of those are banks and retail businesses.Commodities are not interest-rate sensitive as such because their prices are not determined by the interest-rate environment and are more governed by the demand.Because of its purchasing power dilution effect, whenever interest rates go up labour unions tend to ask for concomitant salary increases.The reason for this is that if the workers do not get an increase that is at least equal to the inflation increase, they will no longer be able to afford the same basket of goods they were previously able to.Our being in the Common Monetary Area doesn’t have a direct bearing on our policy rate, or the bank rate, as it is called in Namibia.However, because of the fact that money drifts to where interest rates are higher, Namibia will be disadvantaged by keeping our rates lower than those of South Africa.Another reason that Namibia’s monetary policy is aligned with that of South Africa is due to the fact that the Namibian dollar is pegged on a one-to-one basis to the South African rand.South Africa has set an inflation target band of between three per cent and six per cent, which it believes is appropriate for the country to achieve its targeted financial stability.The South African Reserve Bank (SARB) uses interest rates as a policy tool for managing the inflation regime.Namibia, on the other hand, has not set any explicit inflation band.However, because of the fact the bulk of Namibia’s trade is with South Africa, Namibia actually benefits from the inflation target set by the SARB.In addition to that, the efforts made by the SARB are also intended to ensure price stability, which is positive for the economy in the long run and enables consumers to plan better.Despite South Africa’s ‘shock’ inflation number on Wednesday of 6,75 per cent (which was, in fact, in line with Investec Asset Management’s forecast) we believe SA Reserve Bank Governor Tito Mboweni has done enough.We foresee that inflation in SA will continue to worsen for the remainder of the year and peak in February next year, after which it will start falling back into the band around the third quarter of 2008.There are several signs of a general slowdown in the SA economy, which should give the Governor sufficient comfort that he has done enough to manage inflation expectations.Having said this, we do expect him to continue being vigilant and hawkish in his statements until inflation is firmly under control.* This article was contributed by Dr Alfred Kamupingene, Director of Research, Investec Asset Management Namibia, in response to The Namibian’s questions on the economic impact of the increasing bank rate.