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The Monetary Policy review - here is how the 2% rate cut will affect you

BY: John Kwaku Mensah Mawutor, PhD
The writer
The writer

The two per cent cut in the central bank’s key “monetary policy rate” on Monday, January 27, 2017 has been received by anxious business analyst and the general public as welcome news.

To most business connoisseurs, the decision is a clear indication of the current government’s commitment to improve output growth, price stability, job creation and currency stability though the effect of this decision has manifold implications on businesses, financial institutions and consumers.

The monetary policy rate (prime rate) is a policy tool used by the Bank of Ghana to lend money to all commercial banks in Ghana. By economic theory, there is a positive correlation between prime rate and base rate, therefore, a reduction in prime rate will spontaneously trigger a reduction in base rates, vice-versa. In summary, a lower prime rate will reduce cost of credit, increase Gross Domestic Product (GDP), lower interest on real estates and discourage savings

 

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In fact this theory holds all other economic variables constant and is, therefore, confronted by the complexities of other macroeconomic variables. In the Ghanaian economy, the monetary policy rate (MPR) is expected to influence the market interest rates and inflation rates through several channels however; it has become obvious that the MPR has been rendered a tool to guide mainly money supply with the ultimate goal of regulating inflation and the currency.

For instance, the current reduction of the MPR is a direct response to the reduction of inflation from 18.7 per cent (2016) to 13.2 per cent in February 2017. The same strategy was deployed  to strengthen the weak cedi in 2012 when the MPR was increased three times within the first half, thus 12.5 per cent in January to 13.5 per cent in February.

It further increased from 14.5 per cent in April to 15 per cent in June.  Ostensibly, the 2 per cent (200 points) cut in the policy rate will obviously affect individuals, financial institutions and businesses in divergent ways.

Effects on businesses and consumers

Holding other factors constant, a fall in the MPR will prompt a reduction in lending rates thereby making borrowing cheaper. This will encourage businesses to take more loans in order to finance greater spending and investment. Consumers will also benefit from this cut through lower prices in all commodities. For instance, a lower interest rate will influence individual taste for acquiring houses through mortgages.

In fact this will make it attractive to buy houses and make the real estate sector more profitable. The overall benefit of lower MPR is to trigger a rise in aggregate demand leading to high economic growth (GDP).

Effects on equity market

It is quite intriguing to note that lower interest rates are good news to borrowers but bad news for savers who will have their interest on fixed deposits reduced. The positive impact on consumption along with lower interest rates would also enhance the profitability and valuation for the equity market in the sense that unsatisfied savers will now shift their deposits from the money market to the more profitable but risky equity market.

The flip side of this phenomenon will mean that firms listed on the capital market will now expand their operations with cheaper funds from savers thereby expanding the private sector and providing more employment opportunities. 

Financial institutions

Within the last decade, the lethargic response by commercial banks to the reduction in MPR has become a grave concern to businesses and several stakeholders including the Bank of Ghana itself. As a virtue of fact, monetary policy rates work successfully in relatively efficient industry and market environment, however, the situation is different in our case. In the Ghanaian economy, it is evident that commercial banks fix their existing base rates independent of the changes in MPR.

According to these banks, cost of funds is the major ingredient that influences their base rate. This makes the weighted average cost of funds expensive coupled with high cost of intermediation, and loss of loans due to high non-performing loans.

These banks also carry very expensive and long term funds which may not have mature as at the time of the reduction, making it difficult for them to promptly reduce their base rate to reflect the MPR. In fact, the money market interest rates largely depends on real interest rates and inflation but not necessarily on the MPR, therefore, the base rate of commercial banks will always be at variance with the MRP until these market rigidities are eliminated.

Government

The effects of MPR cuts has manifold implications to the government. To the government, a reduction in the MPR will create more jobs through economic growth. The situation will also lead to increase in tax revenues, however, the government will find it difficult to borrow from the public for developmental projects.

Considering the primary intent of successive governments to reduce infrastructural deficits in the country, it will be difficult to ultimately depend on domestic debt thereby necessitating the need to access foreign loans.

The effect of this policy initiative will in the short term trigger an unfavourable depreciation in the cedi against major competing currencies and further interest lending rates in the country.

In conclusion, the MPR is essentially an economic tool used to achieve the ultimate goal of monetary policy i.e stabilisation of currency, reduction of inflation rate, job creation and economic growth, however; this argument is inconsistent with realities in the Ghanaian economy.

To address these challenges, the economy should operate largely on credit basis instead of the over-reliance of our existing cash system; government’s intervention to reduce banking risks by implementing the national identification system, ensure effective operations of credit bureaus, make treasury bill investments unattractive to the general public.

 

 

The writer is the Dean of the School of Graduate Studies of the University of Professional Studies, Accra