Par Sen Narrainen

A country’s total production and price level are determined by the interaction of aggregate demand for and supply of goods and services. They can both be influenced by demand management and supply side macroeconomic policies. The two main demand management policies are fiscal policy and monetary policy. The former is laid down by government, and the latter by the central bank.

Why is monetary policy important? 

Monetary policy has great importance because it can be used to influence consumption and investment expenditure decisions of almost all economic operators. It can also, through its impact on the exchange rate of the local currency, affect international trade of goods and services, the international movement of capital and therefore the overall Balance of Payments. 

Monetary policy is so called because it is applied in the monetary sector of the economy. As such, the strategy of monetary policy typically revolves around monetary factors including the money supply and the interest rate. Mauritius has an interest-rate-based monetary policy. 

To understand the importance of monetary policy and its process, one must therefore have a good grasp of the role of interest in the economy. Interest is a return on money that is saved and a cost on money that is borrowed. It is therefore essentially a price – the price of capital/money. There are four other categories of prices in the economy, namely:

(i) product prices (the prices of goods and services).

The main indicator for the level of prices in economies around the world is the Consumer Price Index. 

(ii) wages and salaries (price of labour); 

(iii) rent (generally defined as the price paid for the use of land); and 

(iv) the exchange rate (price of foreign currencies). 

A change in any one of the five prices mentioned above can lead to changes in the other prices and as a result in the behaviour patterns of consumers and investors which in turn impacts on the demand for goods and services and employment across the entire economy. For example, a hike in the policy interest rate may lead to increases in the interest rates at which banks provide loans to consumers, businesses and the government. As it becomes more expensive to consume and invest, both consumption and investment expenditure may slow down or even contract, resulting possibly in a lower GDP growth rate, higher unemployment rate and lower inflation rate. The opposite outcomes may happen in the case of a reduction in the interest rate.

It must be stressed here that banks have no legal obligation to change their interest rates when the policy rate is changed. Announcing a new policy rate is typically a signal of the direction in which the MPC would like market interest rates to move, i.e. its policy stance. 

Three possible monetary policy stances  

The central bank can take either a dovish, hawkish or neutral policy stance. 

The Dovish stance: The policy stance of the MPC in Mauritius in recent months can be described as accommodative or dovish, meaning that the BoM is prepared to accommodate the country’s economic growth strategy. An accommodative stance also implies that a raise in the interest rate is ruled out.  

The Hawkish stance: If the MPC deliberates that the top priority is to curb the inflationary pressures in the economy, it can take what is sometimes referred to as a hawkish stance, i.e. do what is necessary to control inflation even if it may result in a contraction of the economy.   

Real interest rates have been very low and even negative for a prolonged period.

The Neutral stance: Monetary Policy stance can also be neutral if the central bank assigns equal priority to curbing inflation and promoting economic growth.  In a neutral stance, the MPC can either cut or raise the interest rate or leave it unchanged.

The most sensible approach to monetary policy is to have a MPC that is flexible enough to switch between a hawkish, dovish and neutral stance as the economic situation warrants.

Besides setting the policy rate, the BoM can use monetary policy instruments such as the statutory reserve requirement, open market sales/purchases of securities which are known as open market operations, special deposits, direct credit control, moral suasion, the exchange rate, among several others to conduct monetary policy. While policy rates are typically set by the MPC, the application of the other tools is part of the day-to-day operations of the BoM. In practice, central banks use at least one or a mix of the tools.  

Understanding the transmission mechanism

Another important feature of the monetary policy process is the transmission mechanism. In an interest-rate-based monetary policy framework, the transmission mechanism is basically the channel through which a change in the policy interest rate impacts on demand and prices, and as such is crucial to determining the effectiveness of monetary policy. 

As explained above, monetary policy is implemented in the monetary sector of the economy. However, its outcomes, as a demand management policy, are intended to play out in the real sector of the economy where a change in the interest rate would influence consumption and investment decisions, thereby impacting on aggregate demand and employment and also on the price level. As a result, the monetary sector and the real sector are connected via the impact of the interest rate on consumption and investment decisions – the transmission. 

In practice there are two sequential transmission mechanisms. The first one relates to the operational goal of monetary policy – the transmission from a change in the policy rate to market interest rates, often referred to as the intermediate goal of monetary policy. This first transmission mechanism plays out in the monetary sector. When the MPC announces a change in the policy interest rate, banks usually react immediately by adjusting their rates on short-term deposits and their lending rates in the same direction. If this first reaction happens, yields on medium and long-term bonds will also change, and it can be said that the operational goal of monetary policy has been achieved. In such a situation, there are better chances for monetary policy to attain its ultimate economic goals. 

The second transmission mechanism relates to the ultimate economic goals of monetary policy. It works through the response of consumption and investment decisions to changes in the market interest rates, in other words, the correlation between demand in the economy and the interest rate. Such a correlation may exist but can range from being very weak to very strong. A correlation of zero or near zero would cast serious doubts on the effectiveness of monetary policy.

While monetary policy decisions may appear simple, usually choosing among three options – increase, decrease or keep unchanged the policy rate, their underpinnings are extremely complex. Monetary policy decisions require a very wide and deep understanding of the macroeconomic situation and the six pillars of the monetary policy framework. They also involve deep and proper analysis of economic data on the various components of the domestic and world economy.

The significant role and high importance of monetary policy in managing a country’s macroeconomic fundamentals are borne out by the fact that most of the members of Monetary Policy Committees around the world are high calibre experts in the fields of economics and or finance. The MPCs in India, United Kingdom and New Zealand are examples of the imperative of such characteristic memberships.

Enhancing the monetary policy process in Mauritius

The recent change in the monetary policy framework by the Bank of Mauritius is a long overdue step in the right direction to enhance the monetary policy process. The BoM itself recognises that the new framework is expected to address the deficiencies of the previous one. An earlier attempt some six years ago to bring about a major overhaul of the monetary policy framework has stalled. The fact that the weaknesses of the previous system have been identified several years ago casts doubt on the effectiveness of monetary policy during the past decade. There are other weaknesses in the broad monetary policy framework that have been impeding on monetary policy effectiveness and which continue to get in its way.

The running theme of excess liquidity

The running theme of excess liquidity (cash and or liquid assets in excess of the statutory requirement) is one of them. The prevalence of excess liquidity in the Mauritian banking system has been a major hitch on the effectiveness of monetary policy for many years – a situation that seems to be ongoing. Banks generally allocate their available funds among three broad categories of assets, namely liquid, loan and investment assets. Liquid assets are the lowest earning assets on the banks’ balance sheets, which means that they would like to keep them at a minimum by lending out as much as they can without compromising the principle of safety in banking.

The CPI does not capture the full impact of inflation on the cost and standard of living.

Sometimes banks can choose to voluntarily hold liquidity in excess of the statutory requirement, which does not represent a big threat to the stability of the banking system. However, non-voluntary excess liquidity can be a serious snag on the effectiveness of monetary policy and a potential threat to the stability of the banking and overall financial system.

One of the most effective ways to shield the economy and stability of the banking system from the adverse impact of excess liquidity is to mop it up. The mopping up exercise which is carried out by the central bank can be quite costly and how much of the non-voluntary excess liquidity it can mop up depends on the strength of its balance sheet. But even a complete mopping up of non-voluntary excess liquidity will only relieve the symptom, especially if the problem is a recurring one. The remedy may then be outside the orbit of monetary policy.

The need to integrate asset price inflation in the framework

Another weakness in the monetary policy framework, rather inconspicuous but nonetheless impactful, is the fact that it gives very little attention to how other price indices, besides the Consumer Price Index (CPI), are performing. Food price inflation and asset price inflation are hurting the most, especially for the low and middle-income families. For example, the price of residential land has skyrocketed in the past three decades, literally crowding out families with modest income (some 50 to 60 percent of the population) from the housing market. From the second quarter of 2019 to the second quarter of 2023, the Residential Property Price Index (RPPI), published by Statistics Mauritius, shows an increase of 51 percent, which is around twice higher than the headline inflation rate during the same period. One of the causes of the recent surge in property prices may be an unintended consequence of the monetary policy stance of the BoM. Real interest rates have been very low and even negative for a prolonged period. 

The average annual food inflation rate was 6.2% in the period 2004 to 2022 while the annual headline inflation rate averaged 4.6%. Mauritius has been experiencing food price inflation every year in that period, even when there was global food price deflation and in spite of government subsidies on the prices of certain food products. For example, families who spend more than 50 percent of their monthly income on food would suffer a decrease in their purchasing power even though the CPI inflation rate may be close to zero.  According to the World Bank, an estimated 200,000 people in Mauritius could not afford a healthy diet in 2021, i.e. 15.3% of the population. 

Asset price inflation should be closely tracked and reported on regularly.

It is clear that the CPI does not capture the full impact of inflation on the cost and standard of living and quality of life of certain segments of the population. The monetary policy framework must be adapted. In particular, asset price inflation should be closely tracked and reported on regularly.

Is there a threshold inflation rate in Mauritius?

A nebulous aspect of monetary policy making in Mauritius is the relationship between the inflation rate and economic growth. One school of thought which is gaining wide recognition in economics postulates that not all inflation is inimical to economic growth. An increasing number of research papers have concluded that inflation has a positive or no impact on economic growth up to a point – identified as the threshold inflation rate – above which it adversely impacts on economic growth. Is this the case for Mauritius?

Has the existence of a threshold inflation rate in Mauritius been investigated and considered when setting up the targeted range of inflation? What is the threshold inflation rate in Mauritius? Is it zero, 3.5% or some other rate? It is important to settle that matter in order to ensure that monetary policy decisions are appropriate.

It is clear that the monetary policy process in Mauritius needs a comprehensive overhaul to enhance its effectiveness and to avoid harsh unintended consequences that may totally negate all the good intentions of policy makers.

Defining the Monetary Policy Framework

The Central Bank in Mauritius, which is the Bank of Mauritius (BoM) conducts monetary policy within an established Monetary Policy Framework (MPF). Broadly defined, the MPF in Mauritius stands on six main pillars.

First, a legal framework. The Bank of Mauritius Act 2004 assigns to the Bank of Mauritius the responsibility to conduct monetary policy and manage the exchange rate of the rupee, taking into account the orderly and balanced economic development of Mauritius. The same legislation also provides a statutory and institutionalised framework for a Monetary Policy Committee (MPC) at the BoM to formulate and determine monetary policy. The MPC was established on 23 April 2007, and it held its first interest rate setting meeting on 30 June 2007. The responsibility of the BoM and its MPC is to preserve the value of money by keeping inflation low, stable and predictable.

Second, the exchange rate regime. There are two types of exchange rate regimes – the fixed exchange rate and the floating exchange rate regime, each with different implications for monetary policy. According to economic theory, under the former a country loses sovereignty on monetary policy while under the latter the monetary authority has greater independence in setting interest rates or money supply growth rates in order to influence demand in the economy. The arrangements under any exchange rate regime are not the same for all countries. 

Mauritius is known to have a Managed Float regime since the BoM intervenes in the foreign exchange market to influence the exchange rate and/or smooth out any volatility. However, Mauritius does not have a predetermined path for the exchange rate. Such a regime is also commonly referred to as a dirty float in contrast to a clean float where the determination of the exchange rate is left entirely to market forces.

Third, the structures that are set up by the Central Bank itself to enable and guide the conduct of monetary policy on the basis of its legal mandate and in compliance with the requirements of independence and accountability. The BoM introduced a new Monetary Policy framework effective 16 January 2023 with the main objectives of enhancing the monetary policy transmission mechanism and strengthening the effectiveness of monetary policy. The new framework features the following noticeable changes, namely:

(i) The introduction of a flexible inflation targeting regime whereby the headline inflation target has been set by the BoM with the concurrence of the Finance Minister, within a range of 2 to 5 per cent with the aim of achieving the mid-point of 3.5 per cent over the medium term. The minister of finance and the Bank of Mauritius must have weighed the pros and cons of setting an inflation target before taking such a crucial decision. One of the various benefits of inflation targeting is that it brings greater clarity on the central goal and strategy of monetary policy. 

(ii) A new policy rate known as the Key Rate to signal the stance of monetary policy. At the time the new framework became operational the Key Rate was set at the same level as the Key Repo Rate which it had replaced. The BoM provides an Overnight Lending Facility to banks at their discretion at the Key Rate plus 100 basis points; as well as an Overnight Deposit Facility at their discretion at the Key Rate minus 100 basis points.

(iii) The overnight interbank rate replaces the yield on the 91-Day Bill as the operational target for monetary policy. 

Fourth, the institutional features of the banking and financial markets including, among others, the money and financial markets, the degree of expertise in monetary policy matters inside and outside of the central bank.

Fifth, the code of conduct which sets out minimum standards of ethical and professional conduct that MPC members must follow. 

And sixth, the political economy. The definition of the Monetary Policy Framework may be broadened further by adding the political economy of policy making. While less prominent as a feature of the MPF, especially in text books and other publications relating to monetary policy making, the influence of political economy on policy decisions in Mauritius can never be taken lightly.

Sen Narrainen
Dr Streevarsen (Sen) Narrainen was a Senior Economic Adviser at the Ministry of Finance and Economic Development and a member of the Monetary Policy Committee of the Bank of Mauritius.