Tight Monetary Policies Risk Stifling Economic Growth, Undermining Business Confidence


Jan 18 , 2025
By Tesfaye B. Lelissa (PhD)


Officials defend their policies, stating the dangers of double-digit inflation, which can erode living standards swiftly. They argue modest sacrifices now can prevent runaway prices later. Critics worry that overzealous tightening will diminish supply, paradoxically stoking inflation if demand remains robust. The problem is to guide the economy between these two extremes. Policymakers should decide how to suppress inflation without snuffing out the very spark that drives expansion, writes Tesfaye Boru (PhD).


In a bid to curb inflation, which is still at double digits, and preserve financial stability, policymakers have implemented strict monetary measures that economists warn could dampen growth. The key components, such as benchmark interest rates, higher reserve requirements, and mandates on bond purchases, contain price increases but also threaten to dehydrate consumption and investments. An inflationary paradox is emerging, where overly tight controls slow economic momentum and job creation.

The Central Bank, adhering to a Keynesian view, keeps interest rates at 15pc to curb spending by making loans more costly. Banks should hold seven percent of deposits as reserves and maintain liquidity ratios of 15pc, further tightening credit. Lenders should allocate a fifth of their loan portfolios to government bonds to fund public projects. If consumers and businesses pare back spending and expansion in response, the economy risks sliding into stagnation before any inflationary benefit can fully materialise.



Already, consumers face rising living costs and reduced access to credit. More considerable expenses, like cars and housing, are often put on hold. Retailers report weaker sales, and restaurants see fewer customers. Service providers, from hairstylists to tech consultants, struggle to retain clientele as cash-strapped households cut discretionary spending. While these could help to quell inflation, they can inadvertently fuel higher prices if businesses reduce supply or raise fees to offset lost revenue. Such a policy can ultimately deepen the slowdown.

Seeking to alleviate the strain, the Central Bank lifted the annual lending growth cap by four percentage points to 18pc, offering banks a formal opportunity to issue more loans. Yet many bankers say high interest rates and liquidity constraints still make them cautious about fresh lending. Borrowers, too, balk at the cost of capital. Even with a higher lending threshold, few see an immediate investment surge. The climate remains constraining for entrepreneurs hoping to expand, as the spectre of expensive financing casts a long shadow.

Liquidity pressures mount across the financial system. Data show that 20 out of 29 financial institutions are strapped for cash, forcing them to borrow in the interbank market rather than lend. This shortfall means entrepreneurs face steeper hurdles when seeking credit for machinery, inventory, or payroll. With borrowing costs at an average 15pc, many firms scale back plans or pass higher expenses to customers, feeding cost-push inflation as the authorities try to bring prices down.

Such conditions create a vicious cycle. As businesses retrench, wages and hiring lag, weakening consumer spending. Households then tighten budgets further, compounding the economic slowdown. Meanwhile, faith in policymakers erodes if people see little improvement in living standards or job prospects. Although the Central Bank has liberalised the foreign exchange regime to lure outside capital, high interest rates and binding liquidity rules can undercut those efforts. Even exporters benefiting from more favourable conversion rates struggle if they cannot secure affordable financing to boost production.

Sectoral disparities become pronounced. Industries that do not rely heavily on bank loans, like certain cash-based retailers, may keep afloat, while capital-intensive manufacturers and agricultural producers, who need credit to buy equipment or expand, stagnate.

In other emerging economies, investors shifted to unregulated or speculative avenues when conventional lending dried up, sometimes fueling risky bubbles. Turkey’s experience with tight monetary policy saw production costs soar and inflation remain stubbornly high, a cautionary tale for Ethiopia if external shocks like higher global commodity prices exacerbate local pressures.

South Korea once deployed targeted financing to develop priority industries while fending off uncontrolled speculation. Ethiopia might pursue a similar strategy, directing loans to sectors like agriculture, manufacturing, and exports that can spur job creation and generate foreign currency. Brazil offers another example, cutting its benchmark rate from 14.25pc to 6.5pc when growth stalled. This shift revived consumer spending and business investment.

A moderate rate cut in Ethiopia could unlock capital, expand supply, and potentially moderate prices over time.



Policymakers could also refine the lending-cap framework. Instead of imposing a flat limit, they might tie the cap to indicators like GDP growth or unemployment. When the economy begins to falter, banks would have room to lend more freely, stimulating business activities. Another lever is lowering reserve requirements. Canada, for instance, sets a two percent requirement, supported by tight regulatory oversight rather than large capital buffers. Easing Ethiopia’s seven percent ratio during economic stress could unleash funds for loans without undercutting financial stability.

Mandatory allocations to government bonds also tie up substantial capital. Banks have to direct 20pc of their lending to Treasury securities and another one percent to buy bonds issued by the Development Bank of Ethiopia (DBE). Critics argue these rules sideline funds that could power private-sector growth. The Central Bank could follow the European Central Bank’s example by offering emergency loans to institutions under strain. During the eurozone crisis, the ECB pumped more than a trillion euros into banks, propping up lending and averting widespread failures.

Foreign exchange liberalisation could yield greater benefits if backed by tailored incentives for exporters, echoing South Korea’s tax breaks on exports. Those policies propped export growth, stabilised currencies, and built national reserves. A balanced approach is key. Reducing interest rates too much might unleash inflation, but a calibrated mix of monetary relief and structural improvements could expand production sufficiently to keep prices in check. Infrastructure investments, reminiscent of China’s road-and-rail expansions, might also slash logistics costs and raise productivity, stabilising consumer prices over time.

If consumers curb spending and businesses delay expansions, the economy risks a double bind: climbing prices and slowing incomes. Households feel squeezed by rising costs and uncertain wages. Many banks find the lending cap insufficient, citing hefty funding costs and bond mandates. Without more liquidity measures, conditions may worsen, especially if global commodities spike. Policymakers could enhance public confidence by implementing timely changes. Businesses worry that absent interventions might cause the economy to edge toward stagnation, undermining employment and growth prospects. Meanwhile, households confronting relentless price hikes may lose faith in official pledges to contain inflation.



PUBLISHED ON Jan 18,2025 [ VOL 25 , NO 1290]



Tesfaye Boru Lelissa (teskgbl@gmail.com), president of Global Bank S.C.





How useful was this post?

Click on a star to rate it!

Average rating 5 / 5. Vote count: 2

No votes so far! Be the first to rate this post.


Editors' Pick




Editorial




Fortune news