Article by bloomberg

Egypt Unexpectedly
Raises Interest Rates
by 200 Basis Points
Egypt’s central bank unexpectedly raised its benchmark interest
rates by 200 basis points for the second time this year in an effort
to control inflation after the government raised fuel and
electricity prices.

The Monetary Policy Committee, led by Governor Tarek Amer,

raised the overnight deposit rate to 18.75 percent, a record high,
the bank said on Thursday. The lending rate was also raised to
19.75 percent. All but one of the eight economists surveyed by
Bloomberg had forecast the rates would remain unchanged.

The decision brings the total increase in borrowing costs to 700

basis points since the central bank floated the pound in November
before securing a $12 billion loan from the International
Monetary Fund. The weaker currency, coupled with cuts in fuel
and electricity subsidies, has helped drive inflation to about 30
percent. The IMF in April signaled a preference for curbing
inflation through interest rates.
The “temporary” rate hike was aimed at easing the effect of recent
subsidy cuts and tax increases , which tilted inflation risks “more
strongly to the upside,” the bank said. It said that the necessary
measures will be taken to lower inflation to 13 percent by the end
of next year, and that the bank envisages “a measured easing of
the monetary stance” as soon as underlying inflation begins to
slow.

Impact ‘Diluted’

Hany Farahat, an economist at Cairo-based CI Capital Holding

and the only one surveyed by Bloomberg who’d predicted a rate
increase, said his expectation was based on the steep fuel-price
hikes and the IMF’s backing for higher rates. But he said that an
appreciation of Egypt’s currency would be a “more constructive”
way of capping inflation.

“The impact of today’s hike would be diluted as banks are unlikely

to pass it on to their deposit and savings rate,” he said.

The government on Thursday raised household electricity prices

by as much as 42 percent, just a week after it increased fuel prices.
The decisions add more pressure on Egypt’s 93 million
population, half of which lives near or below the poverty line.
Consumer prices rose 29.7 percent in the 12 months through June.

The central bank last raised interest rates by 200 basis points in
May, saying the move was to contain “demand-side pressures.
IA:

This article is concerned with the Egyptian central bank’s decision to increase interest
rate as an attempt to control inflation. Recently after Egypt's decision to float the
Egyptian pound inflation has hit an all time high reaching around 30%. Inflation is
defined as the general increase in prices and fall in the purchasing value of money. As
an attempt to control inflation the Egyptian government raises interest rates in the bank
to 19.75% and deposit rates to 18.75%. The central bank believed that demand pull
inflation was occurring as there was an increase in Egypt's exports after the
devaluation. The Egyptian government have also cut subsidies off of fuel and electricity,
causing electricity prices in households increased by 42% this has drastically increased
inflation.

Diagram 1: The effect of the subsidy cut and increased interest rate.

The economy was at equilibrium at Q1,P1 and then after the government cut the
subsidies this shifted the SRAS curve to the left, this drove up inflation as now people's
real wages were less as there was an increase in price level creating a new equilibrium
at Q2,P2. This caused stagflation in the economy as now there is less output and higher
inflation. This increase in price level increased inflation in Egypt to 30%. As a response
the government has implemented contractionary monetary policy by raising interest
rates by 2% causing a shift from AD1 to AD2. This decrease in AD caused the economy
to slow down and reach a lower price level subsequently leading to lower inflation. This
shift in AD falls in line with Friedman’s theory which states that in order to decrease
inflation, unemployment has to rise above the natural rate. In terms of the diagram the
increase in AD shifts the rate of unemployment from the natural rate at Q1 to a higher
level at Q3.

This policy should decrease inflation as AD will decrease because of a decrease in

investment and a decrease in consumption. As the interest rate increases investment
will decrease as now borrowing money from the bank to invest is becoming less
attractive. As this policy takes place Egyptians will consume less as it will discourage
consumer spending as now cost of borrowing money from banks will be higher so
Egyptian’s would rather not borrow money to buy a house or a car as they will have to
pay a high interest thus slowing down the economy. Another thing the central bank has
done was set deposit rates at 18.75% as an attempt to increase remittances which
would make the currency appreciate subsequently decreasing imported inflation.

The action taken by the central bank may be diluted for two reasons. First reason being
that the inflationary gap that was caused in Egypt was by cost push inflation rather than
demand pull because the fuel and electricity supply shocks. This would mean that
supply side policies would be more effective than demand side policies as the inflation
is caused by increased price level. The second reason this policy may be diluted is
because banks are unlikely to pass on it onto their deposit and savings rate. Although
they may not pass it on this policy may prove the central bank's credibility or could be
seen as an attempt to decrease inflationary expectations.

Although the “temporary” exchange rate increase was aimed at decreasing the
inflationary effect of the subsidy cuts it will also have a large effect on unemployment.
Now as firms invest lest and consumers spend less, firms will need to lay off workers in
order to still make profit thus increasing unemployment. Also considering that what is
occurring is cost push inflation, by implementing demand side policies the government
will be increasing the rate of unemployment past the natural rate which will decrease
inflation. This sparks a problem as if the expected natural rate of unemployment is
higher than Q1 then this policy could just cause stagflation and a higher unemployment
rate. Although unemployment may be high in the short run, in the long run the economy
will adjust and unemployment will go back to the natural rate.

A better alternative to this would be to appreciate the currency as that will not cause a
significant fall in output or unemployment but it will also help reduce imported inflation
and help increase job opportunities. Unlike the policy this wouldn’t create a spare
capacity in the economy. This could be done through increasing exports or increasing
remittances.

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