What Is the Connection Between Interest Rates and Economic Growth?

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The relationship between interest rates and economic growth is derived from the use of interest rates as a means for achieving desired economic conditions. That is to say that interest rates are tools used to make the economy more stable by limiting undesirable factors like inflation and rabid consumption by consumers. The authority that is vested with the power to make the changes in the rate of the interest in an economy is the central bank of the country under consideration. Central banks use monetary policies as a means of tinkering with interest rates and economic growth. They usually do this by either increasing or decreasing the rate of the interest on the money that they remit to the other banks in the economy. Economies have cycles that are used as a means of gauging the health of such an economy and any gains that may have been made in the economy by the application of several monetary and fiscal policies. When the parties with vested interest, such as economists, businessmen and businesswomen, the government and the various banks observe the macroeconomic and microeconomic trends after analyzing the periodic economic reports, they will come to various informed conclusions regarding the health of the economy. Where there are unfavorable macroeconomic indicators like rising unemployment and inflation, the central bank might decide to raise the interest rate on the money remitted to the banks. This action establishes a link between interest rates and economic growth, because the purpose of increasing the interest rates is to address the unfavorable elements in the economy that are detrimental to economic growth. For instance, the action of increasing the interest rates will have a domino effect on the other banks something that can be likened to a knee-jerk reaction. An increase in the interest rates means that they will tighten their lending policies and also increase the rate of interest they pay on savings deposits. When consumers discover that they cannot have the same easy access to different types of finance for their consumption, they will decrease the rate of such consumption. Another link between interest rates and economic growth is seen in the way in which the increase in the interest rates will cause the consumers to save their money for two major reasons. The first is to conserve their money due to the perceived scarcity of such finance, and the second is to take advantage of high interest rates offered by the banks as a means of encouraging savings. When this happens, the activity in the economy will decrease, and the rate of inflation will go down as a result. Just the same, when the central bank decreases the interest rates consumers will have easier access to finances, and the rate of consumption will go up, stimulating the economy.

High Interest Rates: The Impact On Economic Activities And Growth

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Monetary policy has been operated with a variety of objectives in mind over the years. However, it appears that the objectives generally boil down to adjusting the supply of money in the economy to achieve some combination of inflation control and output stability. Economists generally agree that in the long run, when the resources of the economy are in full use, the level of output is fixed and any adjustment to money supply will only cause prices to change. However in the short run, a period during which excess capacity exists and companies have room to increase production as demand rises, changes in money supply do affect the actual production of goods and services. This is because prices and wages usually do not adjust immediately. For this reason, monetary policy is a meaningful tool for achieving both inflation and economic growth objectives. Perhaps it is also the reason why the policy objective of the Central Bank of Nigeria (CBN) and its monetary policy thrusts are essentially the attainment of price stability and sustainable economic growth. Associated objectives are those of full employment, stable long-term interest rates and real exchange rates. Although the focus of monetary policy has shifted largely in favour of price stability, especially with the adoption of inflation targeting in 2008, the monetary authority acknowledges the need to create a balance with the other macroeconomic objectives of the Government. Nevertheless, considering the recent slowdown in economic growth, the price stability objective of the CBN and the consequent high benchmark interest rate over the last three years may have started to hurt the Nigerian economy. This report reviews the effect of the current monetary policy mode on economic activities and growth. While the monetary policy may have been forced to become reactionary frontloading the liquidity impact of fiscal policy excesses, economic growth is being compromised in the process. In addition, given the level of resource unemployment human and material, monetary surpluses/excesses that are

channelled to productive use are unlikely to cause inflation. It is therefore believed that the perceived structural disconnect in the economy can be helped by balanced monetary policy actions among which a single digit lending rate is central. Aggregate Demand Channel Has Been Negatively Impacted Economic theory and research outcomes have identified a number of ways through which monetary actions are transmitted to the real economy by altering the amount of money in the economy; directly or indirectly. Directly through the sale and purchase of short term government securities in open market operations, or indirectly through the use of the short term benchmark interest rate. The first channel of impact is through the aggregate demand on both the output and prices, a process called the demand channel. When monetary policy is contractionary or tight as is currently the case in Nigeria, borrowing costs increase, making it less likely for consumers to demand commodities they would normally finance such as houses or cars. And for businesses, they become less likely to invest in new equipment, projects, or buildings. Theoretically, the reduction in the level of economic activities will push inflation lower because lower demand usually leads to lower prices. The retail lending rate rose from an average of 18.36% in 2007 to 23.50% in 2012. During the same period, the monetary policy rate (MPR) rose from an average of 9.13% to 12.00%. However, the MPR declined to as low as 6.08% in 2010 before the commencement of the current spate of monetary tightening. The retail lending rate has however trended upward even at the low MPR in 2010; indicating a disconnect between the MPR and the retail lending rate at this point. This could be blamed partly on the curtailment of lending by banks during the global financial crisis as asset prices collapsed. The period was characterised by a sharp dry up of bank credit to both the corporate and retail consumers, as the regulator battled to sanitise the banking system. While the monetary policy approach to resolving these issues has worked to stabilise the industry, the punitive classification of risk assets may have raised the bar on credit evaluation thereby weeding out some classes of borrowers. An important parameter in that process is the dynamics of the retail lending rate in which the prime lending rate declined compared to an increase in the maximum lending rate between 2009 and 2012. The decline in prime lending rates indicates an increased preference to supply credit to selected prime customers, usually corporate organisations. Impact On Companies Balance Sheets An increase in interest rates also tends to reduce the net worth of businesses and individuals. This is called the balance sheet channel of impact; that makes it tougher for them to qualify for loans at any interest rate, thus reducing spending and increasing price pressures. This occurs by making many erstwhile feasible projects unprofitable at a higher hurdle rate as the Weighted Average Cost of Capital (WACC) increases with each interest rate hike. It therefore introduces the problem of adverse selection to the lending process a situation where the level of interest rate weeds out likely quality credits, leaving only the potentially bad ones; a scenario that may be playing out in Nigeria. An interest rate hike also makes banks less profitable in general and thus less willing to lend. This is called the bank lending channel. The fall in credit demand accompanying a monetary contraction robs the bank of the credit margin which cannot always be substituted for by trading/holding of liquid assets, including government securities. However, where monetary tightening results in higher real yields on secured and liquid assets, and is followed by widespread deleveraging, the fall in deposit rates could allow for a substantial spread which would enable banks remain profitable.

High rates normally lead to an appreciation of the currency, as foreign investors seek higher returns and increase their demand for domestic assets. The recent surge in foreign portfolio investment alludes to this. At over 12% yields on government securities, Nigeria appears to be the only country with a sovereign risk rating of BB- that offers such a significant return on risk free assets. This is in addition to the sustained positive real return over the last two years as the monetary authority keeps it so at every level of inflation. In return, the surge in foreign portfolio investments has resulted in an increase in the value of the naira in recent times. However, through the exchange rate channel, exports become less competitive with their volumes reduced as they become more expensive. On the other hand, the level of imports rises as they become cheaper. While it can be argued that our non-oil export industry is small, the naira value of oil export earnings, the major source of government revenue, becomes lower with implications for fiscal expenditure profile and outlook. For instance, the adoption of a 160/$ exchange rate for the budget 2013 revenue assumption may weaken the government revenue profile in 2013 if the current monetary policy stance sustains the exchange rate at 155/$, a very strong possibility. Declining GDP Growth And Lower Inflation Sustained sharp and/or miscalculated monetary policy tightening could push the economy into a recession where consumers tend to cut down on spending to as low as subsistence; business production declines; leading firms lay off workers and stop investing in new capacity; and foreign appetite for the countrys exports fall. The recent slowdown in the Gross Domestic Product (GDP) growth is indicative in this regard. Although it has been argued in certain quarters that a combination of structural constraints which could not be addressed with monetary policy actions and supply side shocks flooding for instance are largely responsible for the slowdown. These limitations are denying the huge small and medium scale subsector access to finance due to high interest rates and loan policies that rob the nation of substantial complementary growth that could cushion the effects of the structural constraints. All sectors currently depend largely on natural factors to survive, such as climate and increased land use in agricultural sector. And many of them will perform better, grow faster and provide mass employment with sound financial inclusion premised on affordable credit. Within the parlance of the quantity theory of money, monetary tightening pushes the economy towards the point where less money chases more goods. This happens when consumers are broke and firms cut back on hiring and spending; leading to a decline in the general price level as we have seen in recent times. Monetary policy also achieves this through expectationsthe self-fulfilling component of inflation. Inflation In Nigeria Is A Structural Phenomenon The debate on whether inflation is a structural or monetary phenomenon has been ongoing for some time. The constrained business environment which continues to keep the economy well below its production possibility frontier is also worthy of note. Another factor is the structural disconnect that allows fiscal excesses to create systemic liquidity without any productive impact with strong implications for price stability. The resolution of these issues is at the heart of a balanced monetary policy framework.

However, contrary to the CBN position that inflation in Nigeria is a monetary phenomenon, it has been argued and now supported by recent research outcomes that inflation in Nigeria is structural in nature. The implication of this is that the increase in the prices of goods and services, caused by the myriads of

supply side constraints especially infrastructural challenges, is very high. It has been argued that this effect is big enough to sustain inflation rate in the double digit region if the monetary contraction continue to add to the supply side problems. One argument that highlights this conclusion is the fact that inflation rate were at their lowest during the period of accommodating monetary policy in 2007-08. And in those periods, economic growth was also high. Monetary Easing With Declining Inflation The 2007/08 period was preceded by strong institutional development and fiscal commitment to economic liberalisation. Investment in infrastructure was also modest with high expectations upon which long term productive investments could be made. And investment was growing alongside aggregate demand in an environment of both high liquidity and monetary accommodation. Monetary aggregates broad money, net credit to the economy, and credit to the private sector grew at an average annual rate of 52.80%, 176.9% and 72.10% per month respectively, between 2007 and 2008; while inflation rose but remained in single digits for most of the period. The global recession which started in 2008 and the oil production shock caused by the Niger Delta insurgence arguably contributed to the volatile economic conditions afterward. The periods of monetary easing through 2009-2010 coincided with a peak in inflation; perhaps a lag effect of earlier monetary expansion and primarily due to the sharp depreciation of the naira. It was also the period of major moderation in inflation from the peak of 15.60% to 11.80% as the exchange rate stabilised and the adjustment was priced into costs; it might as well be a result of the global economic recession. This suggests that barring structural constraints, given the typically high marginal propensity to consume in an economy with vast idle resources and high absorptive capacity, high liquidity will not necessarily cause inflation. In the presence of heavy structural constraints, what monetary tightening does is to simply add to the constraints and force down aggregate demand and prices with limited impact. Effective Inflation Management The problem of unproductive liquidity injections from fiscal excesses has been identified, and this could compound systemic liquidity and pose a threat to exchange rate stability and price levels. The problem is a product of the structural disconnect in our economy which allocates the highest financial flows to the smallest contributor to growth. Therefore, it is believed that targeted market rules and regulations as well as quantitative monetary interventions and incentives, as proven by the positive outcomes of some of the recent rules around interbank and foreign exchange market activities, would suffice at managing such liquidity. In addition, a money-based policy otherwise known as quantity-based anchor, which regulates aggregate demand, may be more effective. This is because a monetary policy system that monitors the flow of liquidity and uses the open market operation to mop up any excessive and unproductive injections directly will do better than a generalised benchmark interest rate that punishes all sectors of the economy regardless of whether they benefit from the liquidity flow. While they tend to have the same effect on short term market rates, a targeted approach will have a more positive impact on economic activities as businesses can access longer term finances (through the capital market) at relatively cheap rates. Policy Reversal Review Is Imminent The monetary policy has a strong role to play in expanding financial inclusion and ensuring that proper financial intermediation other than securities trading remains the hallmark of the banking system. An important task in this regard is working with the fiscal authority on the roles of the monetary authority in the development strategy of the government. The current weakness of that handshake is constraining the monetary authority to a reactive stance at the expense of a supportive monetary policy direction,

particularly in relation to interest rates. In the run up to a new year and the attendant monetary policy course, it must be noted that the Nigerian economy faces its own economic cliff to which a commencement of monetary tightening reversal and a comprehensive review of the financial intermediation process and policy transmission channels is important. Such a review will increase access to finance for small scale businesses that are major employment creators. Other sectors such as manufacturing, especially the food and beverages, housing, and construction, would increase their share of GDP while the increasing aggregate supply is likely to create competition that would have a positive inflationary effect.

Link: http://www.finpipe.com/interest.htm When interest rates change, it is the result of many complex factors. People who study interest rates find that it is as difficult to forecast future interest rates as it is the weather. Since interest rates reflect human activity, a long-term forecast is virtually impossible. After the fact, explanations are many and confident! Some of the major factors which help to dictate interest rates are explained below. Supply and Demand for Funds Interest rates are the price for borrowing money. Interest rates move up and down, reflecting many factors. The most important among these is the supply of funds, available for loans from lenders, and the demand, from borrowers. For example, take the mortgage market. In a period when many people are borrowing money to buy houses, banks and trust companies need to have the funds available to lend. They can get these from their own depositers. The banks pay 6% interest on five year GICs and charge 8% interest on a five year mortgage. If the demand for borrowing is higher than the funds they have available, they can raise their rates or borrow money from other people by issuing bonds to institutions in the "wholesale market". The trouble is, this source of funds is more expensive. Therefore interest rates go up! If the banks and trust companies have lots of money to lend and the housing market is slow, any borrower financing a house will get "special rate discounts" and the lenders will be very competitive, keeping rates low. This happens in the fixed income markets as a whole. In a booming economy, many firms need to borrow funds to expand their plants, finance inventories, and even acquire other firms. Consumers might be buying cars and houses. These keep the "demand for capital" at a high level, and interest rates higher than they otherwise might be. Governments also borrow if they spend more money than they raise in taxes to finance their programs through "deficit financing". How governments spend their money and finance is called "fiscal policy". A high level of government expenditure and borrowing makes it hard for companies and individuals to borrow, this is called the "crowding out" effect. Monetary Policy Another major factor in interest rate changes is the "monetary policy" of governments. If a government "loosens monetary policy", this means that it has "printed more money". Simply put, the Central Bank creates more money by printing it. This makes interest rates lower, because more money is available to lenders and borrowers alike. If the supply of money is lowered, this "tightens" monetary policy and causes interest rates to rise. Governments alter the "money supply" to try and manage the economy. The trouble is, no one is quite sure how much money is necessary and how it is actually used once it is available. This causes economists endless debate. Inflation Another very important factor is inflation. Investors want to preserve the "purchasing power" of their money. If inflation is high and risks going higher, investors will need a higher interest rate to consider lending their money for more than the shortest term. After the very high inflation years of the 1970s and early 1980s, lenders had to receive a very high interest rate compared to inflation to lend their money. As inflation dropped, investors then demanded lower rates as their expectations become lower. Imagine the plight of the long-term bond investor in the high inflation period. After lending money at 5-6%, inflation moved from the 2-3% range to above 12%! The investor was receiving 7% less than inflation, effectively reducing the investor's wealth in real terms by 7% each year!