Thu | Sep 29, 2022

Delroy Hunter | BOJ’s tightening dilemma

Published:Friday | July 8, 2022 | 12:09 AM
Delroy Hunter
Delroy Hunter

The Bank of Jamaica, BOJ, has been increasing its policy interest rate in a bid to rein in the recent spike in inflation, but its action is stoking recession fears.

Consequently, members of the private sector are cautioning against any further increases in interest rates, and have taken the BOJ to task for having increased interest rates in the first place.

But what is the feasible alternative? Since I do not believe that opposition to the rate hikes implies a lack of concern for the current high level of inflation, is the opposition a concern that the BOJ is not leveraging all the tools in its policy toolkit to improve the chances that tackling inflation does not result in a recession?

The concern of the private sector is a legitimate one. If the global factors driving inflation persist, it will require a mix of monetary and fiscal policy dexterity to avoid a full-blown recession. Simultaneously, achieving lower inflation and a soft landing is even more critical an outcome to Jamaica than, say, the United States. This is because the Government of Jamaica has relatively limited capacity to provide meaningful economic stimulus that could coax the economy out of a recession.

In addition, unlike in the United States where generous stimulus payments boosted consumer savings, a part of which is still not yet spent, local savings did not receive a similar boost and, therefore, may have a relatively less important role in lifting the economy out of a recession. Jamaica’s situation would be made worse if the United States were to experience a deep and lingering recession, which would limit Jamaica’s tourism intake and remittance inflows.

Show the alternative

Although it is the BOJ’s responsibility to articulate and implement a policy response, opponents of the current policy should reveal their alternative. Is there a set of arguments that would lead us to believe that the current high level of inflation is temporary, and/or that ignoring the spike in inflation is less damaging than bearing higher interest rates?

This is important because there are risks associated with failing to curb inflation. Surely, this is not lost on a country that has averaged 15.4 per cent annual inflation over the last five decades and reached double digits in 25 of those years, or where the real deposit rate — the nominal rate received on savings minus inflation — has been negative for half of the last 40 years.

If Jamaica’s main trading partners aggressively reduce inflation and Jamaica does not, then it could result in another bout of depreciation of the Jamaican dollar, with the attendant increases in import prices. On the other hand, if the depreciation of the Jamaican dollar is not large enough to offset the higher domestic inflation, relative to that of foreign trading partners, then local exports could become uncompetitive, such that there would be no net benefit to local exporters.

Furthermore, consumers take a double hit from big jumps in inflation. On the expenditure side, a larger proportion of consumers’ income (or savings) is required for a given level of consumption. On the savings side, consumers earn lower real interest rates.

When real interest rate becomes negative, savers would be better off consuming today, rather than deferring consumption to save for future consumption. This is because a dollar saved, plus the interest earned, would purchase a smaller quantity of goods and services in the future as inflation outpaces the interest rate.

Hence, signalling and maintaining a neutral monetary policy stance in the presence of recent big jumps and expected future increases in inflation could, paradoxically, increase current inflation even more by triggering panic buying, as residents pre-empt the expected reduction in the future purchasing power of their income or savings.

As this would increase current demand in the presence of existing supply constraints, maintaining current low interest rate could be adding fuel to the inflation fire.

BOJ toolkit

It is not a foregone conclusion that the policy action of the BOJ will lead to a recession. Although the BOJ has a limited set of tools in its toolkit to engineer a soft landing, it has access to a lead indicator of the health of the economy that should be quite useful in current circumstances. This is the BOJ’s quarterly credit conditions survey that, among other things, tracks changes in the lending standards of deposit-taking institutions.

When institutions tighten lending standards, they may increase scrutiny of loan applications, demand more paperwork and collateral, impose stricter limits on loan sizes and maturities, and tighten covenants. The consequence of this is credit constraints — the inability of some firms to raise the credit they demand to fund all desirable investments, even if they can pay higher interest rates and fees.

The survey captures both past and expected changes in lending standards, and the results are typically inputs in monetary policy decisions, because lending standards influence how monetary policy is transmitted in the economy. However, while monetary policy and the state of the economy can influence lending standards, the standards can change independently of these influences.

If the BOJ is to avoid crash-landing the economy, it would almost surely need the assistance of less restrictive lending standards.

While the BOJ, or the Ministry of Finance, cannot dictate lending standards, it can take into consideration existing and expected changes in lending standards — and, more generally, credit market conditions — when adjusting monetary policy rates to avoid overshooting the targeted reduction in access to loans that can fund demand and drive inflation. The BOJ generally does this, but lending standards should be given greater weight in their decision-making in the current circumstances.

Achieving a soft landing

The above suggests that, while a tightening of monetary policy is a legitimate concern of the private sector, it should not be their sole concern and, arguably, not their primary concern. New business projects, such as greenfield expansions, acquisitions and procurement of more efficient technology that have high expected returns, can remain viable even with higher-than-expected increases in interest rates.

Similarly, highly profitable existing operations can achieve meaningful growth even if they pay higher interest rates. Hence, given tight monetary policy, these firms can still generate growth and assist the monetary authorities to achieve a soft landing. In contrast, restrictive lending standards, and the resulting credit constraints, could cause otherwise profitable investments to be abandoned.

So, can the BOJ tighten monetary policy enough to slow inflation without triggering a significant tightening of lending standards? Ultimately, this is for the BOJ to determine. It is the regulatory authority for banks and could decide if it needs to tweak existing banking policies/regulations to incentivise banks to avoid sharp tightening of their lending standards, while not breaching international regulatory accords or norms in banking.

Finally, the BOJ could issue more inflation-indexed securities, which provide interest payments that increase with realised inflation. The high coupon payments that would be expected today might extract a substantial amount of cash from circulation that would otherwise fund current consumption, thereby reducing inflationary demand.

If the BOJ achieves timely success in taming inflation, declining future interest payments would result in lower cost of debt relative to issuing debt with fixed nominal interest payments. An active market in inflation-indexed securities would furnish the BOJ with information on inflation expectations and real interest rates, and deepen the financial markets.

Delroy M. Hunter, PhD, is the Serge Bonanni Professor of International Finance at the University of South