Central Bank increases dose of bitter medicine to avoid uncontrolled inflation

As in almost all economic policy decisions, the Central Bank has had to choose, and this time it has been between a growing economy with high inflation or one that grows less but with price increases under control. The latter, precisely, is what is being pursued by the increase of 1.50 percentage points (to 4%) in the monetary policy rate, announced by the issuer on the night of Wednesday, April 27.

The decision is not easy as Costa Rica still faces high unemployment (13.3% in the quarter ending in February 2022). After the 4.1% drop in production in 2020, due to the impact of the pandemic, it recovered and grew 7.6% in 2021, with which part of the lost jobs were recovered; in 2022 the momentum is maintained, which is good because it increases job opportunities.

However, a phenomenon that began to be felt since the second half of 2021, and that threatens to overflow in Costa Rica and the entire world, was the acceleration in inflation due, among other aspects, to the rebound in the demand for goods after the pandemic, the increase in shipping costs and, this year, Russia’s invasion of Ukraine.

In this way, Costa Ricans are seeing increases in prices that have not been seen for a long time (in March the consumer price index rose 5.8%, the largest increase since November 2014).

Inflation hits the poorest households hardest because they are the ones with the fewest options to defend themselves against it, and if it is food that rises, it still affects them more because it is the families with fewer resources that dedicate a greater portion of their spending to they.

But in addition, inflation influences many other indicators: it reduces real returns, it has an impact on the prices of regulated products, on fuel taxes, on rental contracts and on the definition of wages, which in turn influence company costs.

To the extent that real rates fall (interest is enough to buy less) capital can be transferred to dollars and seek better returns abroad and thereby also generate pressure on the exchange rate.

But in addition, as the Central Bank has made clear, there is a risk that the upward behavior of inflation will persistently affect expectations and thus generate the so-called “second round effects”, which would make the increase in inflation more lasting. .

the bitter medicine

As the Central Bank does not want inflation to get out of hand, it has decided to apply a bitter medicine: raise its monetary policy rate, which is the tool it has to influence the rest of the market rates and thus make consumption more expensive , thereby lowering the demand for goods and services and the pressure on prices.

“To signal the firm commitment of the Central Bank to low and stable inflation in the medium term, to contain inflationary expectations, to bring the monetary policy rate closer to a neutral position more quickly, and to contribute to a more rapid convergence of inflation towards the range of tolerance around the goal of the Central Bank, the Board of Directors determined that on this occasion it was necessary to make a stronger upward adjustment of 150 basis points”, explained the entity in a statement sent this Thursday.

The tolerance range defined by the authority for inflation is between 2% and 4%. To stay within the goal, in just four months the Central Bank has increased its monetary policy rate four times, thus taking it from 0.75% in December to 4% on April 28. This last increase was the strongest, of 1.50 points.

An increase of this size had not been seen in the records since 2006, Juan Robalino, an economist who directs the Institute for Research in Economic Sciences (IICE) of the University of Costa Rica, called attention.

Robalino explained that, according to an IICE research project, they estimate that this latest increase could have a negative effect on the growth forecast for 2022, between -1.5% and -1.75%. The growth projected by the Central Bank, last January, for 2022 was 3.9%. This April 29 will publish new projections.

“This would be the consequence of an increase in lending rates (for loans) of around 2 to 2.5 percentage points. Deposit rates (for savings) at six months are also expected to increase between 1 and 1.5 percentage points. Surely this increase in the policy rate will also increase the intermediation margin (the difference between both rates)” explained Robalino.

However, added the economist, this measure helps reduce inflationary pressures and reduces the rate differential between the domestic and international interest rates, which reduces upward pressure on the exchange rate.

“Both inflation and the exchange rate are variables that greatly affect the well-being of Costa Ricans,” said Robalino. And the economist Ennio Rodríguez, president of the College of Economic Sciences, agrees with him.

“In general, any increase in the interest rate has a negative effect on growth, but inflation has a pernicious effect on income distribution and affects the most vulnerable groups to a greater extent, in addition to other distorting effects on the economy. ”, Rodriguez commented.

“This is the dilemma for central banks. Now, in the current circumstances of Costa Rica, there is no room for an expansionary monetary policy, so the Central Bank must at least move towards a neutral monetary policy as soon as possible, so that it does not feed inflation. Therefore, the magnitude of the increase in the announced monetary policy rate is not surprising,” added this economist.

For Rodríguez, there is no justification for maintaining a monetary policy rate below the neutral rate, since the Central Bank would be fueling a domestic inflationary force, perhaps the critical one, he added, is whether it should have done so more quickly, if the previous adjustments to the monetary policy rate were timid in the face of the change in international and national circumstances.