A week after the decision taken by the Central Bank to raise interest rates, the rumblings about the decision are still going on. I had hoped to write this week about the changeover to the euro, in continuation with last week's contribution. However, the Central Bank decision must take priority because it has an important impact on the economy.
Maybe the realisation of the full impact of such a decision has not sunk in yet with most people. In any case, some will be better off and others will be worse off. However, will the economy be better off?
Let us start with the premise posed by the Central Bank itself in its statement. The Central Bank feels that a tightening of monetary policy is called for. This is required because the Central Bank's external reserves are decreasing and the trend is a downward one.
This is a reflection of the increasing interest rates in the eurozone and, therefore, a narrowing of the differential between the euro interest rates and the Malta lira interest rates. The Central Bank is seeking to maintain the attractiveness of the Malta lira assets, particularly bank deposits.
Another aspect that is worrying the Central Bank has been the rapid growth in the imports of consumer goods and the further acceleration in the rate of inflation. An increase in interest rates is expected to dampen demand and hence reduce the increase in the rate of inflation.
The Central Bank does admit that the economy still seemed to be recovering modestly but it claimed that the primary focus of monetary policy is essentially the stability of the currency to create the preconditions necessary for economic growth.
The main beneficiaries of this interest rate increase are the savers, who see an increase in their income following the adjustment in the interest rates offered by banks. Those who will be worse off are the borrowers, who will have an additional burden in that their interest rate payments will increase. Those on fixed incomes will also be worse off also because an increase in interest rate, in spite of it dampening demand, will contribute to higher costs and presumably to higher prices.
In fact, this is indeed a puzzle for which we will only have an answer in a few months time. Although, according to economic theory, an increase in interest rates is expected to lead to lower inflation, will the dampened demand lead to a drop in prices that is higher than the increase in costs which higher interest rates cause?
More specifically, one needs to look at the goods and services that are leading to the increase in inflation. If the demand for such goods and services is price inelastic, demand may decrease but not sufficiently to offset the increase in costs.
Moreover, even if demand were to decrease significantly, would it make suppliers reduce their prices? I really doubt it because of the small size of the market relative to their total market. This could lead us to the vicious circle that had been experienced in the 1970s, where inflation was accompanied by low or even negative economic growth.
Another big headache for the Central Bank is the outflow of capital. An increase in interest rates should stem this outflow. If only this were true! Why is there such an outflow? Banks and collective investment schemes are quite liquid, as shown by the way any bonds put on sale are being mopped up.
Could it be that Maltese savers are putting their money in foreign institutions because they are seeing few investment opportunities? Could some of this money be undeclared income/profits? Could it be that the Maltese public is afraid that we will not change over to the euro at the beginning of 2008, and so is switching back to foreign currencies for fear of even worse decisions? If these three hypotheses were correct, would an increase in interest rates stem the outflow? I do not think so.
On the other hand, the increase in interest rates is bound to hurt the Maltese consumer, in some cases even dramatically. I have in mind those paying back house mortgages. It is also bound to hurt economic operators who borrow money to finance their investment. This is happening at a time when other costs are already eating away at the purchasing power of consumers and at the competitiveness of firms operating in Malta.
The Maltese economy is so small that one can identify the real causes of certain trends. This allows for economic policies to be more targeted. This leads me to ask if there were other options to address the concerns of the Central Bank other than resorting to an increase in interest rates?
The Central Bank takes its decisions independently of government and other institutions. This independence is guaranteed, and rightly so. However, this does not preclude an exchange of views with those responsible for fiscal policy to assess other options. The interest rate puzzle is not easy to resolve and one hopes that the Central Bank took the right decision, because so far there are more questions than answers.