The Monetary Policy Committee of the Reserve Bank of Malawi (RBM) last week made a very important decision. The MPC decided to reduce the Policy Rate (PR) by 4 percentage points to 18 percent, and maintain Liquidity Reserve Requirement (LRR) at 7.5 percent. This is the third time in a period of six months that the MPC has reduced the rates. In November 2016, the MPC reduced the PR by 3 percentage points to 24 percent and in March 2017, the rate was reduced by a further 2 percentage points to 22 percent. Cumulatively, the policy rate has been reduced by 9 percentage points. These policy rate reductions are rooted in declining inflation figures. Headline inflation in October 2016 had declined to 20.1 percent. Similarly, in February inflation fell to 16.1 percent and 12.3 percent in May 2017. This is, so far, the longest downward trend in inflation in over five years. By May 2017, inflation has continued to decline for 10 consecutive months.

The issue that has always bothered Malawians is the response of commercial banks to these PR reductions. The expectation is that once the RBM makes its policy decision to reduce the policy rate, the banks will, in similar fashion, reduce lending interest rates. The figures indicate that after a 3-percentage points reduction in March 2017, the average base lending rate of commercial banks declined to 31.64 percent from 33.60 percent before the PR was reduced. The banks also increased the average savings rates to 6.77 percent during the review month, from 6.58 percent recorded in March 2017. Put simply if you deposit K100 in the bank, you get K6.77 Kwacha as interest on your deposit, while if you borrowed K100 from the bank you will pay K31.64 in interest payment. The difference between these two rates is called the interest rate spread. The interest rate spread has reduced, from 28.04 percent in November 2016 to 24.87 percent in April 2017. Is this therefore good news?

Unfortunately for the consumers, the reduction in interest rate spread is not necessarily good news. This is because in most cases there seems to be some confusion about bank interest rates and interest spreads, both of which are too high in Malawi. However, to answer the question of whether the interest rates are high in Malawi, one needs to understand the concept of real interest rates. This is because even though the nominal interest rates— the rate that the banks officially display —are important, it is the real interest rate that makes economic sense. The real interest rate reflects the change in purchasing power derived from an investment based on shifts in the rate of inflation. The real interest rates determine who gains or who loses from a nominal interest rate change. The simplest definition of real interest rate is the difference between the nominal interest rate and the rate of inflation.

In cases where inflation is positive, the real interest rate is lower than the bank advertised nominal interest rate. For example, if a citizen put money into a savings account with an interest rate of 6.77 percent (the average savings rate for April 2017), and the rate of inflation remained at 14.6 percent (the inflation rate for April 2017), the real value, or purchasing power, of the funds in savings will have decreased, as the real interest rate would be -7.83 percent, after accounting for inflation. In other words, with the current rates of interest on savings and inflation rate, it is stupid to keep money in a savings account in Malawian banks.

For investors, if it seems that the nominal lending interest rates are decreasing then it is a good thing. Not necessarily. Take the case of the three policy rate adjustments and their effect on the real interest rate one would pay in case of getting a loan from the bank. In January 2017, the average base lending rate was 33.6 percent and inflation stood at 18.2 percent. In this case the real base lending rate (after accounting for inflation) was 15.4 percent.

When the RBM reduced the policy rate in March 2017, the banks followed by reducing their average base lending rate to 31.64 percent in April 2017. However, if one considers the inflation trends (14.6 percent in April 2017) then the real average base lending rate was 17.0 percent. In simple terms, the base lending interest rate increased from 15.4 percent in January to 17.0 percent in April 2017.

It is commendable that the RBM has taken this pragmatic move to review the PR when the conditions change. The next stage is to ensure that real interest rates should go down and not only nominal interest rates. The challenge is how to do that. This is extremely important since economic theory and practice has concluded so many times that increases in lending rates negatively affect the economic growth of a country.