Soaring prices pushed the Central Bank to raise interest rates to restrain them. Sherine Abdel-Razek explores the causes and consequences of the move There's an economic rule of thumb: each cycle of strong economic growth fed by an active private sector, an increase in money supply and a hike in investments, is usually followed by spiraling prices and cost of living. This can be dealt with by tightening the money supply through increasing interest rates to attract more deposits, which is the course of action the Central Bank of Egypt (CBE) chose to take last week. CBE's Monetary Policy Committee (MPC) decided to increase the overnight lending and deposit rates by 0.5 per cent, bringing them to 10.5 per cent and 8.5 per cent, respectively, as a part of its inflation targeting policy. When formulating decision, the MPC monitors macroeconomic indicators, focusing on domestic inflation, monetary aggregates and real sector performance, in addition to US interest rates. While the move was expected, some analysts believe that it could have been avoided for some time. According to a report issued by EFG Hermes on the eve of CBE's move, recent inflation and macroeconomic data do not imply the need for a rise in policy interest rates, given the temporary nature of inflation drivers and stable monetary aggregates. "This, together with the government statements regarding its relative bias in favour of growth in the event of a growth/inflation trade-off, leads us to believe that a rise in policy interest rates is not warranted at this point," stated the report. While the increase in price is usually felt by the man on the street no matter what the official figures show, last week's move came while the figures themselves are striking . The Consumer Price Index(CPI), the main inflation measure in Egypt, surged from 4.4 per cent in March to 9.6 in September, 2006 -- its highest ever level since January 2005. The rise in disposable income following a reduction in income taxes, a growing economy and greater job creation, has contributed to price increases. This is combined with the seasonal effects of price hikes of food products and real estate, one- off rises in the prices of telecommunication services, utilities, tobacco and energy products which occurred in the second quarter of 2006. HC Securities research notes highlighted several increases in energy prices that are being shouldered by the end consumer. The price of 90-octane fuel rose from LE1.00/litre to LE1.30/litre; diesel prices rose from LE0.60/litre to LE0.75/litre; and natural gas prices hiked from LE0.22 to LE0.286 per cubic metre. Meanwhile, electricity prices rose by seven per cent in the last quarter, and all combined affected output prices of different industries. What made the increase even more tangible is the rise in import prices from Europe, Egypt's main trading partner, reflecting the weaker US dollar exchange rates vis-à-vis the Euro, Sterling and Yen. What also limited the risk of raising interest rates was the stabilisation of interest rates on the dollar. At its 25 October meeting, the US Federal Reserve Bank maintained its target Federal funds interest rate unchanged at 5.25 per cent for a third month in a row. Egyptian monetary authorities monitor the US Federal Reserve's decisions on interest rates for their impact on dollarisation in the Egyptian banking system. "Growing fears over the narrowing interest rate differential between the Egyptian pound and American dollar have now subsided," commented HC Securities. It continued that because the MPC raised rates, there is now a 3.25 per cent differential -- up from 2.75 per cent before the move. This differential reinforces the stability in the EGP/ USD exchange rate and limits dollarisation. Since April 2006, the MPC has held the overnight lending and deposit interest rates at 10 per cent and eight per cent, respectively, as rising inflationary pressures remained contained and macroeconomic data indicated most inflation drivers were of a temporary nature and supply-side related. The move, especially the increase in deposit rate, is hailed by analysts who think it will continue to realign inter-bank rates within the corridor range, in addition to encouraging a rise in commercial banks' short term deposit interest rates. This effectively reduces the significant spread between the banks' lending and deposit rates, as well as reducing negative real interest rates. As expected, local banks followed the CBE's move last week and started to increase interest rates on Egyptian pound deposits, after it had been declining for 16 months. Among banks that have increased their rates are Piraeus, Alexandria Commercial and Maritime, the National Bank of Greece, Egypt, BLOM Bank Egypt, Suez Canal, Arab African International Bank. Moreover, interest rates on CBE's certificates of deposits (CDs) climbed last week to a record high of 10.20 per cent on 280-day CDs, their highest in 14 months.
