Thursday 6th March, 2008


Drastic times, measures?

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By Vangie Bhagoo

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 produce markets.

Inflation—as 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 in T&T.

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 pace.

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 CBTT’s 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 unchanged.

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

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