Research Analyst, CMMB
The sky is not falling.
This was the comment made by the Prime Minister the last
time inflation broke the ten per cent threshold back in
October 2006. But try telling this to the low- and middle-class
or the people who live on fixed incomes like the pensioners
who feel the pinch every day at the supermarkets and the
Inflationas measured by the retail price index (RPI)
compiled by the Central Statistical Office (CSO)rose
to ten per cent in the 12 months to January 2008. Interestingly,
this monthly increase of 2.1 per cent was the highest since
2003, as inflation measured at 7.6 per cent at the end of
December 2007, to the disbelief of many.
While the rise was primarily caused by the spike in food
prices, core inflation also increased significantly for
the month. Food price inflation, which has been the main
culprit for the rise in prices, increased to 21 per cent,
compared to 17 per cent at the end of December 2007. Core
inflation, which removes the volatility of food prices,
rose to 5.7 per cent representing the highest month-on-month
increase since this indicator was established in 2003 and
reveals the existence of underlying inflationary pressures
According to the Central Bank of T&T (CBTT), the
latest inflation data confirm that T&T continues to
face the systemic consequences associated with high oil
prices and a booming economy.
Although supply side constraints are partly responsible
for the increase in food prices and consequently headline
inflation, other factors have been driving underlying inflationary
conditions, specifically, continued net fiscal injections
and rapidly expanding bank credit. According to the CBTT,
net fiscal injections in the first four months of the fiscal
year 2008 were ten per cent higher than the same period
of the last FY.
Also, bank credit expanded by close to 22 per cent in 2007,
while consumer credit has been growing at around the same
The rise in the inflation rate prompted the Central Bank
to take harsh action, raising the repo rate by 25 basis
points to its current level of 8.25 per cent. The bank even
reverted to using tools that it had been trying to phase
out, specifically the reserve requirement. The CBTT had
previously been reducing its dependence on the statutory
reserve requirement as a major monetary policy tool through
two phases of declines in this ratio from 18 per cent in
2003 to 11 per cent in 2004.
In February 2008, however, they increased this reserve requirement
to 13 per cent of commercial banks prescribed liabilities.
The implementation of the third phase, which was to bring
the commercial banks on par with non-bank financial
institutions at nine per cent, has been stalled, pending
appropriate economic conditions.
The fact that the CBTT is willing to revert to archaic measures
in itself suggests that they may be out of options. They
have tried increasing open market operations, heightening
intervention in the foreign exchange market, even special
bond issues specifically to mop up excess liquidity; which
have evidently been ineffective in combating inflation.
Does this mean drastic times, drastic measures?
Because the financial system is still liquid, albeit declining
due to the aggressive liquidity measures pursued last year,
the reliance of commercial banks on the CBTTs repo
facility has been diminished.
Additionally, interbank lending rates have consistently
been about 25-50 bps below the repo rate, so that any increase
in the repo rate will be virtually ineffective since the
commercial banks will continue to borrow interbank when
they need cash.
An increase in the repo rate will result in an increase
in the prime lending rate, while deposit rates remain unchanged
(as we have seen in the past), thereby widening banks
spreads and profits.
The T&T financial sector is experiencing what can be
described as an economic anomaly high interest rates
alongside a very liquid financial system. (Alternatively,
one way to view this is that interest rates may not be considered
high at current levels.)
The TTD yield curve exhibited an upward shift during the
past year. The yield on the 90-day Treasury bill rose by
26 basis points to 7.12 per cent by the end of 2007, while
the yield on the 180-day debt management bill ended the
year at 7.37 per cent, 35 bps higher than at the start of
the year. On the longer end of the curve, yields were relatively
There is no doubt what direction domestic interest rates
are heading: the TTD yield curve should shift upwards. Policy
direction in T&T is likely to reflect developments in
the local economy, and particularly the evolution of inflation,
despite the fact that the correlation between US and TT
policy rates is high at 90 per cent. Interestingly, however,
the correlation between TT and US Treasury bill rates (for
which the data set is greater and will give a better indication
of interest rate correlation) is at 0.75, while the correlation
between the TT inflation rate and TT T-bill rates is 0.82.
This shows that interest rate movements in T&T are more
sensitive to domestic monetary conditions, rather than US
monetary policy stance.
The authorities can use the argument that inflation is not
just an issue in T&T, but it is a global phenomenon.
Indeed, we are seeing the threat of inflationary pressures
globally and more so among the emerging markets. In the
midst of easing monetary policy in the US, it is difficult
for many countries to determine the appropriate policies
to pursue as they must attempt to temper inflation without
stunting economic activity and real Gross Domestic Product
(GDP) growth. In the Caribbean, we also saw the Bank of
Jamaica raising rates by a cumulative 185 bps for this year
so far, as the Jamaican authorities struggle with inflation,
which has hit almost 20 per cent.
The main reason for the global increase in prices generally
stems from growth in global aggregate demand from rapidly
developing countries like China, India, Brazil, etc.
In T&T, the CBTT has a formidable challenge ahead. Economic
growth continues its buoyancy on the back of record high
oil prices, but at the same time, rapid acceleration in
economic activity is raising aggregate demand, fuelling
inflationary pressures. Interest rate differentials between
the US and TT short-term rates are back to comfortable levels,
as last seen around the beginning of 2004.
The widening interest rate differential can in fact be very
beneficial to T&T. The capital account of the Balance
of Payments recorded a substantial deficit of 14.2 per cent
of GDP at the end of 2006. Private capital outflows had
risen significantly, as in the context of a highly liquid
financial system the private sector rebalanced their portfolios
and increased exposure to foreign assets.
If local rates continue on their current path, while the
US continues its easing cycle, then the widening interest
rate differential would encourage capital inflows through
the capital account of the balance of payments, thereby
narrowing the deficit on the capital account.
Overall, pressures still exist in the economy. Fiscal injections
remain high, the financial system still remains fairly liquid,
inflation is rising, and on the external accounts there
are large outflows from the capital account of the balance
of payments. These factors will continue to place upward
pressure on domestic interest rates, and are likely to give
the Central Bank sufficient reason not to follow the lead
of the US.
Given current conditions and expectations in T&T, interest
rates are generally expected to increase until the CBTT
sees that inflation is no longer a major threat