One of the CBE’s main objectives is to ensure price stability and control inflation levels. This can be achieved in a number of ways, namely through conducting pen Market Operations and adjusting interest rates and reserve requirements. To reduce inflation, the CBE must adopt contractionary monetary policies which are designed to reduce economic output and growth. The CBE targets 1-digit inflation of around 7%, inflation in Egypt has now reached 15%. So, let’s dive deeper then, into ways in which the CBE can tame inflation in Egypt.
Conducting Open Market Operations
Open Market Operations (OMO) simply refers to the CBE’s purchase or sale of T-bills and Bonds on the open market to indirectly influence/regulate the money supply within the Egyptian economy. The CBE will purchase government securities (T-bills and bonds) to increase the money supply and sell securities off its balance sheet to decrease the money supply. Let me explain further.
When the CBE purchases securities, it deposits more money into the system. This supply of money is what becomes available for banks to loan out to people like you and I, and to Egyptian businesses. This increased availability of money stimulates the economy, which can lead to higher inflation.
On the other hand, the CBE is now attempting to tame inflation. This will entail the CBE’s selling of securities and “withdrawing liquidity from the market” (a term we have been hearing a lot of lately in local news). And if you follow international news, you probably heard statements like “the Fed is ending its tapering program” or “central banks are reversing their quantitative easing programs.”
These statements simply refer to the slow-down or complete halt of the purchase of T-bills and bonds on the part of central banks, in an effort to tame inflation and slow down economic activity. After the global financial crisis and leading up to the COVID-19 pandemic, central banks all over the world began to increase their purchases of T-bills and bonds, to increase money supply and stimulate the economy after a period of restricted growth (as we described above). Some actually argue that today’s high levels of inflation were a direct result of severe tapering and quantitative easing expansionary policies; these effects, exasperated by supply-side shocks and supply chain disruptions resulting from the COVID-19 pandemic, accelerated inflation to even higher levels.
So back to our discussion around the CBE then.
The CBE is no different; it also is attempting to curb inflation which has reached almost 15%. Since August of this year, the CBE withdrew almost EGP 1 trillion of liquidity from banks by selling securities through its OMO, to reduce the supply of money within the system. The less money available at the banks to loan out to you and I, the less we can spend, and the fewer businesses can invest and expand. Such contractionary monetary policies will restrict economic output and may help in taming inflation, but they very well may not. Inflation may still persist and coupled with restricted economic growth; can lead to the feared state of stagflation.
but that’s a different story. You can read more about stagflation here: https://mngm.com/learn/what-does-the-future-hold-for-gold. Let’s move on to interest rates
Adjusting Interest Rates
The Overnight Lending and Deposits Rate & Discount Rates
As you all may know, interest rates simply refer to how much money a lender can charge a borrower. Simply put, if interest rates increase, borrowing money becomes costly, and saving money becomes attractive. So, Egyptians like you and I tend to deposit our hard-earned savings into saving instruments, namely, the highly renowned “Certificates of Deposits” because we will receive a decent amount of interest to supplement our monthly salaries. This in turn will restrict spending and our demand for goods and services, ultimately bringing down inflation. However, the problem with this type of contractionary policy again as we mentioned above, is that it decelerates economic growth. On the other hand, an expansionary policy of reducing interest rates does the exact opposite; it encourages us to borrow at lower costs and spend, increasing our demand for goods and services. This drives economic growth, but with it, inflation rises.
You probably have read/heard in both local and international news, that central banks, including the CBE, have begun increasing interest rates at an unprecedented pace, to levels unseen before in decades. Coupled with selling government securities on the open market through OMO, raising interest rates is another way for the CBE to decrease money supply and tame inflation.
As we previously noted, the CBE’s main objective is to maintain price stability in the market and is mandated with setting in place Egypt’s interest rate policy. The CBE issued a press release on October 27th stipulating that:
“The Monetary Policy Committee (MPC) has decided in its special meeting to raise the overnight deposit rate, the overnight lending rate and the rate of the main operation by 200 basis points to 13.25 percent, 14.25 percent, and 13.75 percent, respectively. The discount rate was also raised by 200 basis points to 13.75 percent.”
For more clarity, let’s dive deeper into what these different types of rates are.
In many countries,the benchmark reference rate for banks and the broader markets to follow is the overnight-interbank rate, which is the interest rate at which banks borrow or lend money to each other, overnight, after the end of a trading day. In the overnight interbank market, banks with insufficient reserves can purchase funds from banks with excess reserves. However, the borrower must repay the borrowed funds plus interest at the start of the next business day. In the U.S. it’s called the Federal Funds Rate (FFR); other countries refer to it as the policy interest rate or base interest rate. Banks conduct these overnight operations mainly to meet the reserve requirements set by the central bank; we’ll get into what reserve requirements are in the following section.
So, when the CBE raises the overnight rates, as it has, it becomes more expensive for Egyptian banks to borrow money from each other. To offset this effect and make up for the increase in costs, banks, therefore, increase their own interest rates to make it more expensive for customers to borrow. When borrowing costs increase, consumer and corporate spending are reduced, which helps bring down inflation.
The discount rate simply refers to the rate at which banks can borrow short-term loans from the CBE. Again, by raising, the discount rate, borrowing from the CBE will become more costly for banks, again forcing banks to raise their own interest rates.
So, in essence, the CBE raises the overnight, policy and discount rates to influence the banks’ decisions into raising their own lending and deposit rates.
But wait, how and why do some Egyptian banks then offer higher interest rates on CDs and saving accounts to us (customers) as compared to the overnight rates of 13.25% and 14.25%?
The answer is simply, cash management. Some banks simply want more money/deposits to fund their operations and are able to carry more liabilities on their balance sheets. That’s why they offer us high rates of returns, to encourage us to deposit more and more money with them. Other banks prefer to hold fewer deposits on their balance sheets.
Also, these rates stipulated by the CBE are benchmarks or minimums, so yes banks can offer higher rates on savings accounts and CDs but not lower.
In addition, Egyptian banks that offer high rates of returns on savings accounts usually have excess liquidity and their reserves exceed the requirements set by the CBE. Their capital adequacy ratio and leverage ratio (which measure the banks’ solvency and ability to meet their obligations) can be much higher than Basel III requirements and the CBE’s requirements. These banks seldom borrow funds from other banks in the overnight market; on the contrary, they mostly lend out money to banks as they are highly liquid.
Also consider this, if the CBE purchases more and more T-bills and bonds through its OMO and lowers the benchmark rate (tapering & quantitative easing) this increases the prices of government securities but also reduces yields. The opposite is also true; when the CBE sells securities like it is now, and raises the risk-free rate on government securities, corporate bonds become less attractive, as investors flock to the higher and safer returns of government securities. This decreases demand for bonds, bond prices decrease, and yields increase. Therefore, because banks are the biggest investors in T-bills and bonds, receiving lower yields at higher prices will force banks to lower the interest they offer on savings accounts, and the opposite is true.
So, the bottom line is that commercial banks’ interest policies are a factor of their own cash management policies and position in the market; this is emphasized by the wide divergence between policy rates and banks’ lending and deposit rates across the world. So, rest assured, banks never lose money!
Setting Reserve Requirements
Reserve requirements are the amount of money/cash that banks are required to hold in reserve, to ensure solvency and guarantee the banks’ ability to meet their obligation to customers. Banks use what is called “fractional reserve lending” which allows banks to utilize the deposits they hold to loan out and generate returns. However, the central bank requires banks (reserve requirements) to keep a portion of this cash on hand, and not lend it out, to cover any potential large withdrawals requested by customers. The reserve ratio is calculated as a set percentage of total deposits.
As we have read in the news, last September, the CBE raised the reserve requirement from 14% to 18%. Raising the reserve requirement is a contractionary monetary policy and is another way in which the CBE can tame inflation. By doing so, the CBE simply limits the amount of cash a bank can loan out relative to its deposits, which cuts liquidity and reduces the money supply within the system, ultimately lowering inflation but also restricting economic growth.
Bottom Line
We can safely say that in order to tame inflation and ensure price stability, the CBE will need to continue implementing contractionary monetary policy measures such as, offloading/selling government T-bills and bonds, maintaining a high-interest rate environment, and ensuring high reserve ratios. But until when?
Well, there is no simple answer, but normally until the market reaches a new equilibrium and inflation actually starts to subside. However, the CBE will need to keep an eye out for economic growth, as contractionary monetary policies put the breaks on economic output and restricts both domestic and foreign investments. Will we be able to reach this sweet spot without short and medium-term damage to our economy? We all hope so!