The Central Bank of Samoa has three monetary policy objectives: 1) to keep inflation low and stable, 2) to maintain a sufficient buffer of foreign reserves, and 3) to promote economic growth.

It fulfils these by managing demand (spending) in the economy. To influence demand, it determines the level of lending rates required to achieve its objectives. It then works backwards to determine the policy rate and liquidity levels required to achieve the desired lending rates.

Since 2010 (following the global financial crisis), the central bank has kept its policy rate close to zero and liquidity high. Subsequent economic shocks from dengue, zika, typhoid, measles, cyclones, floods and tsunamis prevented the central bank from raising rates.

The combination of a low central-bank rate and high liquidity pushed down the lending rates of commercial banks.

The policy rate is not the sole determinant of commercial bank lending rates. Other factors influence the price of loans, including but are not limited to the size of a bank’s balance sheet, product mix, country risks, policy rate, cost of funds, liquidity, regulatory and overhead costs and the level of competition.

Despite Consumer Price Index (CPI) inflation rising sharply in 2022, the central bank left rates at emergency low levels. That’s understandable given Samoa did not have runaway domestic demand which could have fuelled employment growth and put upward pressure on wages.

Its high inflation was driven by tradables (imported)inflation, particularly a spike in food, fuel and shipping costs. The central bank’s foreign currency reserves were not a problem either as drawdowns on overseas budget support loans at the height of the pandemic and a lift in personal remittances from Samoan workers overseas boosted reserves to a record level.

Also colouring the backdrop was uncertainty around the pace of economic recovery in the aftermath of the pandemic, which meant the Bank of Samoa did not raise its policy rate while other central banks did.

Creating space to cut or raise rates to support mandates Samoa’s economy rebounded quickly once pandemic-related border closures ended. Activity is now above 2019 levels and is expected to strengthen on the back of growing international arrivals, private investment and commercial agriculture.

This will likely see the current account deficit widen and the level of foreign reserves retreat as more of the reserves are used to fund the deficit in the current account. Inflation is falling rapidly towards its target band of 3–4%.

So, the central bank is keen to return its monetary policy settings to neutral (an equilibrium or steady state) to create space to raise or cut interest rates to focus on its objectives.

Over the next two to three years, we expect a gradual increase in policy rates towards 2–3% (from current levels of 0.46%), liquidity to fall and commercial bank lending rates to stabilise.

We don’t expect the decline in liquidity to put upward pressure on banks’ cost of funds or lending rates. We think a stabilisation of lending rates is the most likely outcome. That said, the distribution of liquidity could be uneven, and banks with tight liquiditymay choose to raise deposit and lending rates independently of moves by the central bank.

Once the equilibrium monetary policy rate is reached, it will be a more effective tool in managing inflation, foreign reserves and GDP. At that point, lending rates are more likely to move in line with the policy rate. Policy rates above the equilibrium will mean the central bank is tightening and will most likely result in in a rise in commercial bank interest rates.

Similarly, if the central bank takes the policy rate below neutral, we would expect lending rates to follow. For now, consistent with the Central Bank of Samoa's forward guidance, commercial banks should prepare for gradual falls in liquidity to levels consistent with a 2–3% equilibrium policy rate of the central bank. This will take place over the next two to three years.

This article is part of a research paper prepared economic analysts from the ANZ Bank.