The central bank has raised rates by over 550 basis points from 0.50% in September 2021 to 6.0% as of the latest monetary policy meeting, with the next meeting being scheduled for the 29th of September 2022 (where we expect even further hiking of rates). A common question that we are often asked as it relates to policy action is where are the effects? This is especially as it remains the case that the inflation rate is still being above the target range despite the multiple rate hikes. Hence, this article will touch on the transmission mechanism, more specifically the idea of monetary policy lag and the resultant implications/key takeaways for the average investor.
Monetary Policy Channels
Firstly, we would like to highlight that in the absence of pure counterfactuals, it is difficult to say what the rate of inflation would have been in the absence of the BOJ’s policy interventions. We do however lean on the side of it likely being higher in an alternate world where the policy rate remained at 0.50%. Our reasoning for this is the fact that imported inflation is a major component of the structural inflation for a small open economy with a flexible exchange rate like ours. A recent study for example, would suggest that depreciation of up to 7.4% could lead to a pass-through to inflation of up to about 70 basis points (on point-to-point inflation). This brings us to the different channels through which monetary policy operates, namely the exchange rate channel, the interest rate channel, and its impact on expectations. The exchange rate channel works by impacting the supply (via open market operations) and demand (domestic vs foreign rate differentials, as higher rates, make Jamaican investments more attractive) and can arguably have a fairly quick impact. This channel utilizes Jamaican dollar liquidity to dampen volatility in the foreign exchange market to temper imported inflation. For example, the Jamaican dollar has outperformed international peers by a significant margin vis a vis the USD (for example the MSCI emerging market index which tracks the performance of a basket of emerging market currencies has shown a decline of 8% for the YTD compared to an appreciation of 0.8% for the JMD), during a period of extensive BOJ intervention.
Credit Channel and Effect Lag
The credit channel reflects the impact of policy rate changes on credit creation in the domestic economy. That is the ease and price at which financial intermediaries are willing to extend loans to consumers which in turn drives economic activity and in theory, contributes to inflationary impulses. The Bank of Jamaica has identified the credit channel as an important aspect of the domestic monetary transmission mechanism and estimates that policy decisions affect inflation in Jamaica through the credit channel with a lag of between 4 and 8 quarters i.e., between 1 and 2 years(Evidence has even suggested that speed of adjustment to policy rate increases are asymmetrical with rate hikes being priced faster than cuts). Several factors contribute to this lag. Firstly, while policy rate changes affect shorter-term rates quicker, the pass-through to longer-term rates tends to be slower and less perfect. This might be due to reasons including a lack of deepness in the domestic financial market (i.e., think thinly traded domestic bonds which lead to less price discovery). Secondly, investment spending which is integral to the real economy tends to be planned and hence the demand for investment spending by firms tends to adjust gradually to rate changes.
Given what we have outlined concerning the speed of the effects of tightening monetary policy, what should the enterprising investor be wary of? Firstly, the effects of reducing J$ liquidity and incentivizing saving in Domestic currency show fairly quickly (for example looking at how responsive treasury bill rates are to the policy rate). Therefore, this means that as the BOJ continues to become more restrictive in their policy actions, the investor would be wise to do their prior due diligence when considering a trade which effectively bets against the Jamaican Dollar, for they would almost explicitly be “fighting the central bank”.
Lastly, another key takeaway is that we likely have not yet seen a full pass-through of the impact of rates on the real economy. That is, while domestic credit growth has slowed, we have not seen wide-scale increases in consumer rates such as deposit rates. While there were proclamations from several domestic institutions of an impending increase in lending rates, it is very likely the full extent of the policy rate increase has not yet been passed on. Therefore, if the rate hiking cycle continues, which we expect in the short-medium term, one should expect to see its impact prolificating throughout the economy more broadly in the coming quarters. As such, this means all else being equal, the negative ramifications of the current policy stance are likely to be seen further in the coming months, which may act as a drag on growth and the performance of certain asset classes. That is, the opportunity cost for owning equities rises greatly if investors can earn 8% on treasuries, particularly in the context of slowing growth and higher borrowing cost, effectively creating a drag on company earnings.
Monetary policy acts with a lag and hence, we likely haven’t seen the full impact of the hiking cycle. This, therefore, represent a potential headwind for the domestic economy and by extension the performance of equities and as such, we do believe this is a space that domestic investors should pay keen attention to when considering how they position their portfolios going forward.
Written by Peter- George Simon
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