A delayed climax
Most experts expect inflation to peak in the first half of the year, marking the end of the Banco de la República’s interest rate hike cycle.
But the latest Consumer Price Index (CPI) figures were not very encouraging as they came in above expectations and raised inflation expectations again.
This delay in the peak of inflation will pose new challenges for monetary policy in the coming months, as its actions will slow economic activity if the Bank’s formula of raising interest rates continues.
Inflation that doesn’t let up
Inflation for food and some regulated goods and services not controlled by monetary policy – such as fuel, transport and public services – reached the highest levels since 1999.
Inflation reached 13.2% last year and was 1.78% in January this year alone, a higher figure than expected by the board of the Banco de la República.
Even assuming that the problems in the supply of these goods will be resolved this year, doubts remain about the future behavior of the services component in the basic basket. DANE recorded an increase of 8% last year, explained by the increase in prices for food services provided outside the home and at the table – with an annual increase of 19.7% and rising.
If the pressure on services continues or the negative effects of the war in Ukraine continue to spread, it is very likely that inflation will not reach its peak in the near future.
This, in turn, would lead to the restrictive monetary policy remaining tight or the bank ordering new interest rate hikes, which would have undesirable consequences as a weakening cycle begins that could last until the third quarter of this year.
The Bank’s current formula, supported by the transmission mechanisms of monetary policy, could have catastrophic consequences in an economic scenario with large supply shocks to prices and the end of the expansion cycle of domestic demand and public and private consumption from mid-2022.
The cost of rising interest rates
Continued interest rate increases will slow productivity, leading to a decline in investment levels in the weakest sectors as well as a decline in consumption through more expensive credit card spending. This, in turn, will lead to a decrease in demand for financing for consumption and production activities.
If we add to this the likely decline in exports and imports, the economy will suffer a contraction that will be aggravated by the non-payment of many loans and microcredits that affect precisely the most vulnerable sectors of the productive fabric.
In this scenario, the prophecy of lower inflation will finally become self-fulfilling. However, this would come at a huge cost to economic and social well-being, with financial intermediaries, “drop-by-drop” credit markets, and individuals and legal entities that derive income from high interest rates being the net winners.
Political economy or economic policy?
Changes in interest rates affect domestic demand.
But not all economists share the idea that inflation is solely due to excess demand. Post-pandemic events and recent supply shocks are impacting demand patterns, but there is no consensus on what role the interest rate plays. There is wide divergence among analysts regarding the transmission mechanisms of monetary policy to minimize the gap between effective output and its long-term potential level.
For many economists, the interest rate also plays an important distributional role. This flies in the face of mainstream monetary policy, which sees interest rates as simply the cost of money – so making them more expensive slows down inflation – and that’s all.
A good example of these discrepancies are the interest rates on productive loans and microloans, which remained high despite the economic downturn during the worst phase of the pandemic. Both government spending and monetary policy were expansionary during this period, and subsidies for production and consumption were also provided. However, microcredit rates remained so high that they are around 58% annually – which of course counteracts the formalization of companies and employment.
The very high cost of credit to support production and entrepreneurship cannot, as is often claimed, be attributed solely to imbalances between supply and demand in the credit market. Rather, they are explained by the power of private banks and development institutions, their scope for action and brokerage rates, which are not reduced in times of storm.
This example confirms that we are dealing with an issue of “political economy” and not “economic policy”.
A different way of looking at the matter
An alternative view of the scope and limits of monetary policy suggests that the supply of money adjusts to the demand for credit, which implies that the interest rate does not simply play the role of price equalization but rather plays a “distributive” role.
The relationships between interest rates and inflation are even more complicated in economies such as ours, where income levels are highly unequal, financial informality persists and monetary policy operates asymmetrically.
For this reason, it is important to explore other perspectives that take into account features such as: Although there are signs that overall inflation is declining, concerns remain about the impact of monetary restrictions on the supply of certain goods in the basic basket. These goods – especially food – weigh more in the shopping baskets of the poorest households, and even more so among the “extremely” poor, which have increased as a result of the pandemic.
Is it a good strategy to maintain such high interest rates even though a slowdown is expected almost this year and there are no clear short and medium-term growth strategies in the development plan?
Many of us believe that this is not the right strategy. The impact on informality and poverty would be even worse if supply does not increase to help curb inflation and if banks also maintain high interest rates.
Although the inflation rate is expected to decline, it is not certain that this will happen in the first months of 2023. Due to the disaster in Rosas, Cauca, there is currently different regional pressure on certain foods. There are also current pressures in the education sector via the school calendar A.
All of this will, of course, affect inflation expectations and interest rates of the Bank of the Republic, which in turn would lead to an increase in the cost of production and consumer credit.
In addition, we must take into account the tendency of banks to increase interest rates when inflation exceeds the target set by the Bank of the Republic, as is currently the case. Banks, on the other hand, do not lower their interest rates when inflation declines due to the aforementioned monopoly power and the imperfections of financial markets.
No less important is the question of whether the “extreme poor” and all those belonging to categories A and B of SISBEN IV are interested in the issuer’s intervention rate and in the interest rates of the formal financial market. Obviously not. Most of them are excluded from the system, they buy on loan from convenience stores and weekly credit shops at interest rates well above usurious rates, and they acquire money in the informal market by paying interest rates “drop by drop.”
This extra-bank market is growing with the high interests of formal banks, which have different credit exclusion and rationing mechanisms. In this way, formal bank credit in Colombia does not reach 50% of GDP, while in other countries in the region, such as Chile and Panama, this credit is over 90% of GDP.