Central Bank sets new borrowing rates

THE governor of the Bank of Uganda, Emmanuel Tumusiime-Mutebile, has announced a 13% Central Bank rate for July, the first in a series of monthly rates aimed at clamping down inflation through adjusting the cost of borrowing.

Commercial banks will have to pay the 13% interest up from 11% on money borrowed from the Central Bank and in turn transfer the burden to their loan clients thereby making borrowing more expensive during the month of July.

“To tighten monetary policy, the Central Bank rate will be set at 13% for the month of July. The interest rate will be used to guide the seven–day interbank interest rates,” the governor said while addressing journalists at the Central Bank in Kampala.

The seven-day interbank rate is the rate of interest one bank charges another for money borrowed for a week.

Mutebile said the Central Bank would use its daily secondary market operations in the money market to steer the seven-day interbank rate as close as possible to the Central Bank rate.

He pointed out that the shortfall in supply of commodities that has seen prices of food and fuel shoot up is soon subsiding to bring down core inflation currently at 12.2% by the end of the year. “The Bank of Uganda intends to maintain a tight monetary policy stance to curb demand for credit and thus dampen inflationary pressures over the next six to 12months,

“This will ensure that core inflation is pulled back towards the target of 5%,” he explained.

Adam Mugume, the BoU director for research, said tight monetary stance would inevitably slow the country’s economic growth even while reducing demand for loans and the core inflation.

“We believe that in the next three months the tight monetary stance will drive down core inflation to a level between 10% and 12% and core inflation between 12% and 14%. This should increase interest rates and slow the country’s economic growth momentum,” he explained.

Some analysts said they had expected a higher Central Bank rate given one-week interest rates are running above 16%, but given the Central Bank’s stated determination to tackle inflation, it should be positive in the long run.

“With the promise of more tightening still to come, market expectations will be firmly geared towards further policy rate increases, especially if the foreign excahnge threat to the inflation target remains sustained,” said Razia Khan, an economist at Standard Chartered Bank in London.

“For now, the policy rate is at least positive with respect to core inflation. From an economic perspective, the Central Bank is delivering what is needed. Real interest rates are positive with respect to core inflation and given the substantial impetus to inflation as a result of supply-side shocks, yes, there is a requirement not to overdo the pace of tightening” he remarked..

How to live During Inflation

Of the various ills the economy can face, inflation is simultaneously the worst for society as a whole, and yet the easiest for individuals to deal with successfully. The strategies for dealing with inflation are pretty straightforward.
In theory, inflation shouldn't matter at all, "as long as it is predictable". If you know that inflation is going to be 10% next year, you demand a 10% raise (and your boss gives it to you, because he knows that 10% inflation means that the raise doesn't cost him anything). Everybody else does the same and prices, wages, interest rates, stock market returns, etc. are all 10% higher, even though in real terms everyone is standing still.
In practice, of course, it isn't so simple:

• Just because you demand a raise that matches inflation doesn't mean you'll get it.
• When inflation is bad, prices go up every month (maybe every week), but wages and salaries generally only go up once a year. People are always feeling like they're playing catch up.
• Inflation is never really predictable. Everybody has their own guess about what inflation will be, and most of them will be wrong. Whether your estimate is high or low, you'll have problems to the extent that you're wrong. Even if you're wrong in a good way, such as having negotiated a 10% raise when inflation turned out to only be 8%, you're still in trouble (maybe your company has to lay you off).
• Taxes are imposed on nominal returns, so you can find yourself in the perverse situation of losing money in real terms, and yet still paying taxes on supposed profits.

For individuals, the strategies for dealing with inflation are:

1. Be careful about holding cash. This is a big change for people who have come of age since 1981 or so--since then, holding cash has been a perfectly reasonable thing to do. People whose saving and investing experience includes the 1970s, though, remember having a bank account that was earning 5% interest rates that was nevertheless worth 5% less at the end of the year.
2. Don't make long-term, fixed rate loans. Until the inflationary period is over, don't buy bonds. High inflation rates completely destroy the value of long-term bonds. The flip side of this is that borrowing money on a long-term, fixed rate basis (such as a mortgage) can make good sense, if you can get good rate. There are a lot of people who bought a house with a 30-year mortgage at a fixed 6% or 7% and held as rates went up to 14% or higher. They made out like bandits.
3. Invest in "stuff" rather than in money. This can be gold (although I'd hesitate to establish a position at these prices). Even better is stuff that you're going to use anyway. If you're going to use it anyway, and you can get it at a good price now, it makes a great deal of sense to buy stuff now, rather than save cash and then buy it later.
4. Invest for long-term capital gains. Inflation tends to produce illusory profits: you look like you're making a profit even when you're just keeping up with (or even failing to keep up with) inflation--and you have to pay taxes on those profits. This makes investing for income (where a large fraction of the income is really just keeping you even with inflation) a bad deal. It also makes short-term capital gains a bad deal for much the same reason--you have a big (taxable) gain, even if in reality you're just breaking even. Investing for long-term capital gains helps with these issues.
5. Use barter and the informal economy. If your neighbor hires you to help him create a website and you hire him to help you cut down a diseased tree next to your driveway, you both owe income taxes on whatever you're paid. If you instead swap these services informally, you still owe the taxes, but you're expected to declare the income at its fair market value. It's perfectly reasonable, though, to declare the income at what the service would have been worth the previous year.

For businesses, the strategies are similar, except that it's possible to greatly expand on that last point--use barter and the informal economy--by vertically integrating the company so that the steps of producing your product are all internal transfers rather than cash transactions with another company.
If company A produces raw materials, company B refines them, company C builds sub-assemblies, company D makes consumer goods, company E ships them, company F wholesales them, and company G sells them to consumers at retail, imagine what happens as inflation forces prices up at each step along the way--producing illusory profits that each company has to pay taxes on. On the other hand, if one company handles the entire production chain, the only cash transactions are things like salaries and rents--that can be fixed for a year at a time. All the other transactions can be dealt with as an internal accounting matter, with no taxes due.
In addition to vertically integrating, it also makes sense for businesses to reverse the trend toward outsourcing--instead of paying someone else to haul the trash away (a taxable transaction), haul your own trash away (an internal transfer that doesn't incur any taxes). Likewise, in-source anything you can--accounting, legal, maintenance, facilities, etc.Inflation works its harm on the economy in several different ways. None of them are really due to the inflation itself, which is why economists always insist on pointing out that mere inflation does little harm. The harm is done, though. It's just one step removed.

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