Dr Joseph Mverecha
All across the world economy, Central Banks are preparing for a mighty battle against inflation which remains stubbornly high in industrial countries notwithstanding the staccato of recent successive, often sharp increases in interest rates. Recent international press headlines clearly show policy makers doubling down in their fight against inflation, as shown in the few quotations below:
“Fed minutes may reveal a steep rise in interest rates on the horizon,” ran a press headline for one of the leading financial papers in the USA.
“Bank of Korea feels increasing pressure to raise rate amid undying inflation”, ran the Korean Times recently.
“The BOK is projected to deliver back-to-back 25-basis-point rate hikes this month as upward inflationary pressure appears to be growing again,” Daishin Securities researcher Lee Da-eun said.
“The Bank of England on Thursday lifted interest rates by 50 basis points…annual CPI inflation is expected to fall to around 4 percent towards the end of this year, alongside a much shallower projected output decline….,” the Bank of England said.
For the most part, this policy direction is consistent with both the theory and practice of monetary policy — the art and science of monetary policy has been tried and tested over decades now, across industrialised and emerging markets, as well as developing economies.
When the economy’s aggregate demand surges above production capacity, or potential output, the economy is characterised by a positive output gap, imparting upward price pressures in the economy. In this case, the economy is “hot” and policy leans against the wind to cool the economy. Usually, there are clear micro and macro data metrics which policy makers watch closely looking for signs to confirm that the economy is indeed overheating.
These include tight labour market conditions, strong jobs market reports (as currently in the USA), surging retail sales, rising order books, widening current account, robust domestic credit expansion, among others. The converse applies for a negative output gap.
Policy makers typically pour over a dense set of data and economic indicators. They will be gauging the pulse of the economy and seeking to unpack the underlying currents in the economy and in particular to answer the question — where is aggregate demand in relation to potential output and where will be the economy over the next 9-12 months?
The key question is — does high inflation always imply high interest rates as the corrective measure? More concretely, will the high interest rates policy in Zimbabwe leads to durable inflation stability? Policy makers and economists have been debating this question particularly as authorities sharply hiked interest rates to 200 percent in July 2022 in response to rising inflation pressures with month on month accelerating to 30.7 percent in June 2022.
The jury may still be out there, but it is highly unlikely that the high interest rate policy will yield desired results for Zimbabwe for the following reasons:
- Inflation in Zimbabwe is exchange-rate premium driven
That inflation in Zimbabwe is exchange rate driven is beyond dispute. Across the spectrum, policy makers, academia, industry and other stakeholders — there is broad consensus that inflation in Zimbabwe is mainly exchange rate premium driven. Inflation mainly reflects the difference between the parallel market and the official auction exchange rate.
A distinct pattern is clear — where authorities have allowed flexibility in the exchange rate adjustment in line with new money growth, the parallel market has consistently collapsed and inflation has sharply declined in tandem (check June-Sept 2020; May-July 2022).
Where Authorities have held back on the exchange rate adjustment, the parallel market has drifted and inflation sharply accelerated in tow.
This is a long run relationship consistent with macro and monetary theory, but amplified in the short run by expectations augmented adjustment dynamics.
This kind of cost push inflation may not be corrected by interest rate hikes; even positive real rates will not guarantee durable inflation.
Interest rates may curb speculative borrowing but will not be sufficient to collapse adverse expectations in the absence of exchange rate policy alignment.
In the context of Zimbabwe, endogenously determined expectations are mainly influenced by the exchange rate, particularly the interplay of official and parallel market exchange rate.
- No local aggregate demand problem in Zimbabwe
As already highlighted, interest rates are a perfect monetary policy tool, when the economy is overheating and has an aggregate demand driven positive output gap. This is not the case for Zimbabwe. There is simply no evidence, micro or macro, that the economy has at any point in the recent past experienced sustained and high local currency aggregate demand.
The economy is not overheating, has no surging local currency aggregate demand (granted, there is US dollar demand driven more by the USD cash informalisation).
Zimbabwe dollar real demand for money in 2022 was at least 20-24 percent below 2019 levels.
Important to remember that local currency aggregate demand took a nosedive following the currency reforms in the last quarter of 2018. Quite simply not possible to put forth a strong case for a strong local dollar demand in the economy.
The current account deficit is not widening, infact in surplus, itself a reflection of exports growth but also how far real disposable incomes have declined over the past few years.
Sharply escalating interest rates against all the above evidence is not totally dissimilar from NATO high altitude bombing — prodigious and indiscriminate, leaving in its wake an asteroid trail of collateral damage.
But the policy will achieve an undesired outcome — as the bier in chief on the funeral procession for the local currency. The high interest rates have occasioned wholesale migration from the local currency. In June last year, the share of local currency deposits in the economy was about 41 percent.
Following the raising of interest rates to 200 percent, the local currency share of transactions has retreated to 24 percent according to the latest ZimStats release.
That is a major retreat. By end December 2023, that ratio will likely be less than 12 percent. By all accounts, re-dollarisation is gaining momentum, unassailably.
Is it case closed for the Zimbabwe dollar? Maybe not, but it will require a mighty miracle to save the local currency. To give the local currency a fighting chance, authorities must urgently review interest rates to 50-60 percent to promote some lending in local currency while simultaneously increasing demand for local currency through taxes. Both policy shifts are urgent. If implemented judiciously, concurrently and consistently, there may yet be a chance for local currency revival, however, remote and fast receding.
It would be a major setback from a policy perspective if the local currency continues on the outward march to the Kuiper belt — the frozen fringes of the economy. The US dollar dominance while aiding stability, has several unintended consequences.
Over the next two years, the US dollar strength, on the back of Fed aggressive interest hikes, will bleach the Zimbabwean economy.
Deflation will likely set in, as the strong US dollar wilts exports. An appreciated US dollar will also create an importers’ paradise, particularly with the rand beating a haste retreat thanks to the SA energy crisis and low investor sentiment. This will fuel massive externalisation in Zimbabwe, with the “Nephilim” from near and far flooding the economy in search of the greenback.
Meanwhile, local US dollar credit expansion, will imply more demand for US dollar cash, with ever growing informalisation of us dollars (2 percent taxes and 15 percent surrender), leading to shortages of US dollars. At which point, we will be back to where we were — where we started. Are we heading in this direction? Time will tell.
Joseph Mverecha is an economist with a local commercial bank. He writes in his personal capacity. He is reachable on [email protected]