How high interest rates may make or break economy

After years of political commitment to enabling economic growth, the Kenyan government performed an about-turn on economic policy from September, to implement a monetary policy of a severity rarely seen worldwide.

As the shilling weakened this year, inflation rose exponentially, climaxing at 17.32 per cent in September.

That led to Central Bank raising the Central Bank Rate (CBR) to 7.00 per cent on September 15, 2011. The increase was aimed at stabilising domestic prices and easing the pressure on the exchange rate.

However, the Kenyan exchange rate did not react as expected and continued to depreciate rapidly.

On October 5, 2011, CBK lifted the CBR by 400 basis points to 11 per cent. The Kenya shilling started to strengthen a week after the CBR was increased. But the CBK then moved to raise the CBR a further 550 basis points on 1st November to 16.5 per cent.

With the economy now reeling from this doubling in finance costs, Kenya has struck out on a path almost unprecedented globally for the severity of its monetary tightening.

The Reserve Bank of India (RBI) is also currently trying to reduce stubbornly high inflation, which has stayed above 8 per cent for the past 18 months. This saw the bank raise rates by 0.25 per cent this week, to 8.5 per cent.

Since March last year, India’s central bank has raised interest rates by 3.75 per cent, in the fastest round of monetary tightening in its 76-year history.

But this has already seen growth slow, to 7.7 per cent in the three months to June, the slowest pace in two years. The policy has had little impact as yet on inflation.

The reluctance of certain types of inflation to ease on raising interest rates has been similarly witnessed in other economies.
In the 1970s, the US experienced several years of rising interest rates, implemented to tackle double digit inflation.

But the rate revisions had little impact on inflation, while also delivering a significant dampening in economic growth.

At their peak in 1975, US rates hit 20 per cent, but were then cut to 7.7 per cent, marking the end of a policy era that was later labelled “stop-go monetary policy”.

The 1975 reversal marked the abandonment by the Federal Reserve of extreme rate changes and a move towards managing inflation expectations instead. Since then, US rates have remained in a range from two to five per cent.

However, the parallels for Kenya, in using interest rates to support the currency and government debt are strongest in looking at the policies rolled out in Russia prior to its 1998 financial crisis, known as the “Ruble crisis”.

The crisis ultimately saw the Russian government devalue the ruble and default on its debts, but was preceded by an artificially high exchange rate aimed at avoiding public turmoil, and supported by soaring interest rates.

In effect, the interest rate rises were pushed – eventually as high as 150 per cent on government bonds – to stem the flight of capital as the overvalued currency and ballooning government deficit bit into all areas of the economy. At the time, the government had funded a war in Chechnya, and couldn’t cover its spending with tax receipts.

By the end of 1997, despite the extraordinarily high interest rates, Russia had to effect public spending cuts, across every area from pensions to public transport. It got emergency funding, devalued its currency and converted many of its government bonds, which it couldn’t repay, into Eurobonds.

But the economic struggle over ballooning public debt saw inflation rise eventually to 84 per cent and created a year of empty shelves, queuing consumers and massive economic disruption.

Some economists have even argued that the moves to keep the currency high diminished Russia as a geopolitical power.

However, even in less extreme circumstances, the impact on economic growth of rate rises has been demonstrated repeatedly.

The Philippines raised rates twice in quick succession in April and May this year, although very marginally, with the second rise being by just 0.25 per cent – as it sought to keep inflation that was moving towards 4.5 per cent at its target of 3.5 per cent.

However, even this measured intervention led quickly to a slowing in growth, down to 3.2 per cent in the third quarter of this year, compared with 7.3 per cent a year earlier.

For Kenya, the CBK’s mandate remains to formulate and implement a monetary policy with the aim of keeping overall inflation at the government target of five per cent, while maintaining adequate liquidity in the market to facilitate higher levels of domestic savings and private investment and therefore lead to improved economic growth, higher real incomes and increased employment.

The current radical departure in its implementation has removed liquidity in the market, and will deliver growth and job creation only if Kenya can now find the way to defy all global .