Businesses and Prime Rate Decisions In Ghana by Sampson Akligoh1

The use of the prime rate by the Bank of Ghanas Monetary Policy Committee (MPC) as an intermediate target for achieving price stability remains the most credible option for conducting monetary policy for Ghana. It has improved the credibility and transparency of monetary policy which is essential for modern financial market development. While the use of the prime rate has generated concerns from a section of the public in recent times, this article highlights that these concerns are largely due to a knowledge vacuum of sorts. Nevertheless, the downward stickiness of interest rates in response to prime rate reductions signal market failure in the adjustment process which needs to be corrected. A possible corrective measure is to peg a transaction interest rate (such as the overnight interbank lending rate) to the prime rate, among others.
Ghana: Prime Rate Dynamics
20 18 16 Rate (%) 14 12
F08 F07 F09 6 7 J07 J08 8

-0 7

A07

A08

A07

A08

-0 8

8 Months

Source: Databank Research

The Use of the Prime Rate

The Monetary Policy Committee (MPC), which has the mandate to initiate proposals for the formulation of monetary policy and to provide the statistical data and advice necessary for its implementation, adopted the prime rate as a method of monetary control in 2002. The prime rate is an indicative interest rate used by the MPC to steer the economy on a continuous path of macroeconomic stability, especially price level stability. It therefore serves as a leading indicator of interest rates in the economy. This implies that if the prime rate is increased, transaction interest rates should move in tandem and vice versa; while a neutral position should keep transaction interest rates steady. This approach to monetary policy postdates other traditional methods of monetary control which proved relatively ineffective. The prime rate works by directly controlling the amount of money available to the public and consequently inflation. Under instances of an upward review of the prime rate, commercial banks also increase their transaction interest rates which then affects the borrowing and saving decisions of consumers and businesses. The premise of focusing on money supply is that if the amount of money in circulation is not guided in tandem with output growth, real sector productivity will be disrupted. Indeed, monetary experts believe that unguided money supply trends will lead to price level instability which will inevitably hurt households and businesses. Practically, the logic of guiding money supply through interest adjustment is not an end in itself. The use of prime rate is intended to achieve the final targets of monetary policy. The final targets of monetary policy include sustaining and improving output growth, creating employment, and ensuring price level and currency stability; but Ghanas Central Bank has adopted inflation targeting which means that all other final targets of monetary policy are secondary to inflation.

In essence, the MPCs decisions on the prime rate will therefore be influenced largely by the expected path of short term inflation. The modus operandi is that the MPC will pose a question to itself: whats the future path of inflation over a prescribed policy horizon; and what decision on the prime rate do we take today to ensure that inflation remains within our target? [The MPC currently has a single digit inflation target over the medium term]. If the MPC expects inflation to increase above its policy target over the period, it will increase the prime rate today to ensure that inflation converges towards its target over the period and vice versa.

Debate: Prime Rate vs. Borrowing Costs

Businesses have been concerned with upward revisions of the prime rate on the premise of the associated high cost of borrowing. Inevitably, decisions on the prime rate will reflect in transaction interest rates as the MPC intends to influence the amount of money that is available to the public. It is in this regard that when the prime rate is increased, businesses have a genuine concern on its impact on the cost of borrowing.
Ghana Prime Rate & Base Rate Dynnamics
33.00% 28.00% 23.00% Rate 18.00% 13.00% 8.00% Dec.2003 Dec. 2004 Dec. 2005 Pe riod Base Rate Prime Rate Dec. 2006 Dec. 2007 Dec. 2008

Source: Databank Research

Basically, businesses assert that when the prime rate is increased, the cost of borrowing typically increases further leading to higher prices in the economy- a phenomenon termed the price puzzle. But the premise of this argument is inconsistent with the inherent monetary policy stance. The truth is that monetary policy operates in an industry and market environment that should be relatively efficient.

Sampson Akligoh is an Economic Analyst at Databank Research

Businesses and Prime Rate Decisions In Ghana

A09

10
D

-0

-0

-0

Essentially, commercial banks have access to the same information (to price their products) as the Bank of Ghana. In practice, commercial banks do sometimes change their lending rates independent of prime rate changes. If commercial banks realize that there is an increase in demand for money and (or) higher inflationary expectations and the MPC fails to capture that in their prime rate decisions they will increase lending rates irrespective of the monetary policy decision. The MPCs key role is therefore to guide the expectations of banks and the entire financial market; and if the MPC fails to do this, the private sector would be left to do this in an unguided way. Inherently, the use of the prime rate also mitigates future erratic interest rate increases that may result from uncontrolled inflation. The stabilization process that the use of the prime rate facilitates minimizes volatility in inflation rate than would have otherwise been without the use of the prime rate. This reinforces lower and stable interest rates in the future, thereby avoiding an incidence of unguided expected inflation rate and interest rate spirals. For example, if the MPC expects inflation to increase by 200 basis points to 15.0%, it would increase the prime rate (based on Taylors rule) more than the expected rate of increase in inflation. This should ensure that future inflation rate turns lower than it would otherwise have during the period, which evidently should result in a lower future interest rate. Apparently, future declines in interest rate do more than compensate for todays increase in the prime rate. Practically, this means that businesses will benefit from lower interest rates in the future, by accepting monetary policy tightening today. Hence, if the MPC does not increase prime rate today, interest rate increases in the future will be more painful than necessary. Thus guiding the rate of inflation on a sustained path by the central bank will properly facilitate business planning. The challenge, however, is that short term interest rate are influenced by both inflation and demand for real money balances. As a result, prime rate decisions for Ghana must be re-aligned, for example, with Public Sector Borrowing Requirement (PSBR) for it to be more effective.

Ghanas experience with monetary policy operating targets in the past include the direct targeting of the monetary base, credit control regulations, and the use of the bank rate (rediscount rate) which has proved relatively unsuccessful. With an unstable velocity of circulation (of money), the short run relationship between money supply and the economy was very volatile; which, for example, made the direct targeting of the monetary base ineffective. As a small open economy with persistent structural twin deficits, an attempt to directly target the exchange rate through parity will also be difficult. Apparently, this supports the believe in the relative potency of the prime rate as an intermediate target in guiding money supply and facilitating price level stability.
FORWARD INFLATION TREND TO PRIME RATE DECISIONS
22.0% 20.0% 18.0% 16.0% Rate (%) 14.0% 12.0% 10.0% 8.0%
M -0 4 A04 N04 F05 M -0 5 A05 N05 F06 M -0 6 A06 N06 F07 M -0 7 A07 N07 F08 M -0 8 A08 N08 F09 F04

6.0% 4.0% 2.0%

Date Prime Rate Forward Actual

Source: Databank Research

Rationalizing the Use of the Prime Rate

The prime rate is suitable as an operating target when there is a short term relationship between interest rates, real money balances, inflation rate and output growth. The transmission mechanism depends on how responsive these variables are to money market interest rates. In an inflation targeting regime, the framework for monetary policy transmission necessitates a robust short term relationship between interest rates, real money balances and inflation. Evidence for Ghana shows that commercial banks are rigid in changing their interest rates in response to downward revision of the prime rate, but the transmission mechanism is quite strong for upward reviews. The use of the prime rate also facilitates effective communication, credibility and transparency in the conduct of monetary policy. This allows for predictability in financial decision making and a dancing in unison by the market players. But the coordination is more effective if it is based on rational expectations rather than adaptive expectations. Evidence for Ghana during the past 7 years indicates the prevalence of decision shocks. This means that commercial banks responses to prime rate decisions are reactive; which partly explains the parity between transaction interest rates and policy interest rates in the economy.

The on going developments in Ghanas financial sector including a growing banking sector, an active stock market, as well as, plans to establish a commodities exchange will be better enhanced within an interest rate setting monetary policy framework. As a result, the current policy regime remains the best tool for the execution of monetary policy for Ghana. These markets will be better served by the strengths of effective communication (with the market), credibility, and transparency that the use of the prime rate in conducting monetary policy enhances.

Towards Improving the Efficacy of the Prime Rate

The use of the prime rate so far has exhibited some inherent weaknesses which must be addressed to put the economy firmly on the path of sustained economic growth. First, it would be prudent to properly align the prime rate to respond to both inflation and business cycle dynamics. The economy evidently has a high potential output gap due to production inefficiencies, with the prevalence of idle resources; while unemployment is significantly above its natural rate. These indicate that more than 50% of Ghanas inflation could be structural, and therefore cannot be reduced by short-term aggregate demand management. Clearly, it will be beneficial for the regulators of monetary policy to estimate potential output and the natural rate of unemployment which is essential for the effective use of interest rate by the MPC. Second, the downward inflexibility of transaction interest rates to cuts in the prime rate by the MPC indicates the prevalence of market failure which must be corrected with policy intervention. A possible corrective measure is to peg the prime rate to a key transaction interest rate, such as the overnight interbank lending rate. Money market interest rates depend on real interest rates and inflation, and bank base rates must respond to prime rate reductions unless there is evidence of real interest rate increases caused by increased demand for money.
Businesses and Prime Rate Decisions In Ghana

Third, the MPC can make a cautious move to demystify the use of the prime rate. A key advantage of using the prime rate is that the market participates in the stabilization process; which makes it necessary for them to appreciate the decision making process. The prime rate decision process must be consistent and conducted in a way that will make the market anticipate its actions accurately. This will avert the prevalence of decision shocks which often lead to adaptive responses by the market. These psychological reactions facilitate short term distortions which lead to widening differentials between actual outturns and policy targets. Fourth, demystifying the prime rate can be accompanied by enhancing the credibility of (short term) inflation forecasts. The prime rate must reflect macroeconomic risk, especially expected inflation. If the central bank continually misses its inflation forecast with wide margins, the market will question the credibility of such policy targets. Clearly, this means that monetary policy must be proactive, and not reactive. The credibility of the inflation targeting process can be enhanced if the MPCs inflation target is based on the optimal level of inflation within the context of the countrys natural rate of unemployment and output gap. This will take the burden of targeting single digit inflation from the MPC, and consequently push monetary policy orientation towards managing the optimal level of inflation for the country at a given period. Fifth, the spread between the prime rate and commercial bank transactions rates can be further narrowed to improve the marginal impact of prime rate decisions on transaction rates. This necessitates that the level of the prime rate accurately reflect short term demand for money and the expected levels of inflation. Invariably, if the level of the prime rate does not reflect inflation dynamics, it can lead to negative interest rates which will be unfavorable for commercial banks. For example, if expected inflation is to increase by 10 basis points and the prime rate is increased by 2 basis points; practically commercial banks will increase their base rates by more than the increase in the prime rate. The inability of the prime rate to accurately reflect changes in macroeconomic risk could thereby hurt the effectiveness of the prime rate as an operating target.

Imports constitute on the average about 76% of Ghanas GDP and capital inflows are volatile. Individual forecasts will ensure that average forecast values reflect market expectations as well as policy expectations; which could be potentially more accurate than a central forecast. Another option for improving the prime rate decision making process will be for the MPC to publish its inflation forecast over the policy horizon. For example, if the MPC expects inflation to close the year at 14.5%, it will be worthwhile for the committee to publish the expected monthly path of inflation over the entire period. Specifically, the MPC can publish seasonally adjusted inflation forecast which will form the basis of assessing the efficacy of prime rate decisions. This will minimize anxiety over current inflation and expected inflation outturn by the MPC. For example, if current inflation is 19.7% and the MPC expects inflation in the next six months to be 14.5%, it will be beneficial for the MPC to signal its expected path of inflation towards the policy target. The MPC can achieve this by publishing the forecasted inflation series over the period. A key reform that could also enhance the transparency of the way the MPC conducts its business would be the publication of the voting patterns that resulted in the collective monetary policy stance. The MPC communiqu on monetary policy developments would, therefore, not reflect only the synchronized view of all MPC members; but will also communicate the voting pattern of the members. The dissenting member(s) may not be named, but their opinion can be made available to the public in the communiqu.

Conclusion
The use of the prime rate as an operating target for monetary policy remains the most credible option for Ghana in lieu of the ongoing developments in the countrys banking sector and financial market. The MPC and the prime rate setting process have enhanced the transparency and credibility of monetary policy, especially through its effective communication to the market. But the use of the prime rate over the past 7 years has also exposed some inherent weakness which must be addressed if the credibility and effectiveness of the process is to be further enhanced. The prime rate should be positioned to play a future stabilization role, such that decisions on the prime rate would not seem reactive. In this respect, todays prime rate decisions will be influenced by tomorrows (expected) inflation. This will ensure that future inflation dynamics do not lead to wild swings in future interest rates. Based on rational expectations, commercial banks will increase base rates independent of MPC decisions, as the MPCs role is only to help guide transaction interest rates in a stable manner. The use of the prime rate has faced some challenges which include the stickiness of transaction rates to prime rate reductions. Possible corrective measures for enhancing the efficacy of the prime rate include: pegging the overnight interbank lending rate to the prime rate, allowing the prime rate to respond flexibly to both inflation and business cycle dynamics, and setting the levels of the prime rate to reflect macroeconomic risk. The credibility of monetary policy can also be enhanced if the MPC sets its inflation targets in line with the countrys optimal inflation level.

The Prime Rate Setting Process

Reforms that can potentially improve the credibility and transparency of monetary policy in Ghana do not only entail improvements in policy palliatives; but also improvements in the modus operandi of the MPCs decision making process. Improving the way the MPC conducts its business will not only bring renewed energy and confidence in the process, but will also enhance the credibility and accuracy of the interest rate setting process. Options to consider in enhancing the way the MPC conducts its work include: Individual based inflation forecasting Publishing the forecasted series for inflation over the target horizon Publishing voting decisions of MPC members

The MPC decision process can be enhanced by introducing individual based inflation forecasts. The use of individual inflation forecasts can improve forecast accuracy relative to a central inflation forecast. Forecasting inflation for Ghana is relatively unstable as the economy is exposed to exogenous shocks that are outside the control of domestic policy makers.

Businesses and Prime Rate Decisions In Ghana