The Central Bank Increased The Interest Rates!

By Hema Senanayake –July 30, 2016

Hema Senanayake

The Monetary Board met on July 28, 2016. On that meeting the Monetary Boarddecided to increase the main interest rates of the Central Bank. Accordingly, what is known as the Standing Deposit Facility Rate (SDFR) and the Standing Lending Facility Rate (SLFR), have gone up by 50 basis points each, to 7.00 per cent and 8.50 per cent, respectively with immediate effect. The resultant effect of this decision is that the market interest rates will go up. Why did they do it? On the same day, the central bank issued a press release explaining as to why the Monetary Board took this decision.

According to the press release, we can presume that the Monetary Board had three main concerns in taking this decision. The Board intends to keep the inflation rate at mid-single digits and secondly, the Board wants to contain the widening trade deficit and thereby support the balance of payment situation. This decision making process is interesting and could appear logical, but unfortunately it is not so. Hence, the resultant effect could be that the central bank would not achieve what it wants to achieve namely the above mentioned three objectives. Why do I say so?

With a view to simplify my answer, now, I invite readers to participate in making the decision made by the Monetary Board. Let us begin it. If there is a certain simple parameter in the economy which parameter correlates to inflation and to the trade deficit then you could change the inflation rate and the trade deficit by changing that parameter. Since, the Balance of Payment is strongly linked to the trade deficit, if any economic parameter changes the trade deficit then that parameter effectively correlates to the Balance of Payment too. It means that, if there is an economic parameter that could change the inflation and trade deficit, then that parameter could effectively change the Balance of Payment situation too. So far it is simple. I assure you that it will remain simple until the end of my argument.

Now, you are told that private sector credit growth is the economic parameter which correlates to the said three variables, namely, inflation, trade deficit and the Balance of Payment. This means that, if you allow private sector credit to grow, and as a result the inflation might increase, trade deficit might get widen resulting to have negative pressure on the Balance of Payment. Conversely, they might say that if the private sector credit growth is contained or reduced, then the inflation might be reduced, the trade deficit might also be reduced resulting positive effect on the Balance of Payment. So, private sector credit growth is the important parameter. Based on this information, what decision you want to make now? You may decide, in favor of the reduction of private sector credit growth, so that you might expect to contain inflation and to reduce trade deficit which would result in having positive impact on the Balance of Payment. Yet, there is one more step in this process.

Then, again you would further be informed that, if you increase the rate of interest, then people would borrow less and less and as a result private sector credit growth would be reduced. As you may see, now, it made simple, you would decide to increase the rate of interests, as was decided by the Monetary Board, so that private sector credit growth would be reduced in achieving the reduction of inflation and trade deficit; reduced trade deficit would support the Balance of Payment situation as mentioned above. It seems all very logical but not so. What is the problem?

The problem is that it is not the private sector credit growth that matters, instead the total domestic credit growth is what matters and the total credit growth does not purely depend on the rate of interests. In fact the total domestic credit growth is something that depends on a lot of variables. I repeatedly insisted that the central bank lacks certain important policy tools to contain the credit growth without increasing the interest rates. Keeping market interest rates low would reduce inflation than increasing the rates to keep inflation low.

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