The Governor of Bank of Uganda Mr Emmanuel Tumusiime Mutebile has shielded the Central bank’s move to maintain its policy rate at 12 per cent. The governor who on Thursday, 3rd presented the monetary policy statement for October explained that the annual core inflation which the Central Bank uses for its policy rate is forecast to be in the range of 7 to 8 per cent over the next 12 months, before gradually declining to the BoU target of 5 per cent in the subsequent month.
With civil society groups like the Civil Society Budget Advocacy Group (CSBAG) coming out to criticize “Uganda’s approach as more centered on responding to the effects rather than the causes of inflation” the governor guarded the approach in a statement he issued on Friday.
In its insightful editorial of Wednesday October 2, the a daily newspaper urged the government to rein in the current rise in inflation. As the paper correctly noted, failure to curb inflation will jeopardise the prospects for robust economic growth. Because low inflation is so critical for sustainable economic growth, the primary policy objective of the Bank of Uganda (BoU) is low and stable inflation. All other objectives take second place to the control of inflation.
The paramount importance of controlling inflation is also why BoU has operational independence, to implement its monetary policy free of political interference. The specific policy target of BoU is to hold annual core inflation to 5 per cent over the medium term. Over the last 12 months, BoU has been quite successful in controlling core inflation; the average annual rate of core inflation during this period was 5.6 per cent. However, core inflation was 6.9 per cent in September 2013, so our priority is to bring it back down to 5 per cent.
The current rise in inflation discussed in the media has been caused by a food price shock, which is largely the result of drought earlier in the year.
In the last two months (August and September), food prices have risen by more than 11 per cent whereas non-food prices have risen by less than one per cent. Food price shocks are, unfortunately, a regular occurrence in Uganda, which reflects the dependence of our agriculture on the weather and our lack of good storage systems for food. The current food price shock is the fourth since 2006.
The policy tool which BoU uses to control inflation is monetary policy. Monetary policy affects inflation indirectly, through its impact on the total demand for goods and services in the economy (what economists call aggregate demand). There is a direct link between aggregate demand and inflation; the stronger aggregate demand is, the stronger will be inflationary pressures in the economy, and vice versa. However, monetary policy does not have a very quick impact on inflation; normally the full effect of a change in monetary policy on prices will only be felt after one to two years. Hence it is necessary for BoU to look ahead and base its monetary policy actions on forecasts for future inflation.
Monetary policy cannot prevent food prices from rising in the short term following a poor harvest. This is not an excuse, it is simply a fact of life; if the supply of food falls, its price will rise.
However, monetary policy can prevent a food price shock from causing permanently higher inflation. Faced with a food price shock, the objective of BoU is to prevent the higher food prices from being passed through into higher non-food prices.
If this can be achieved, the rise in inflation caused by the food price shock will be temporary and short lived. Once food supplies recover and food prices fall back, inflationary pressures will abate.
To curb the pass through of higher food prices to non-food prices, BoU raises its policy interest rate – the Central Bank Rate (CBR). Raising the CBR will reduce growth in demand and thus inflationary pressures in the non-food sectors of the economy over the medium term.
In September 2013, BoU raised the CBR from 11 per cent to 12 per cent. I hope this will be sufficient to keep non-food price inflation in check. So far, we have observed very little pass through of the higher food prices to non-food inflation. If the pass through remains small, the current rise in inflation should be reversed within the next few months, as the food price shock abates, and core inflation will gradually fall back to BoU’s target of 5 per cent over the next 18 months or so.
However, we don’t know precisely what will happen in the future. If inflationary pressures turn out to be stronger than we anticipate, BoU will have to raise its policy interest rate again, so that these pressures do not take hold.
In setting our interest rate, BoU will be guided by the outlook for future inflation. I am very confident that, over the medium term, core inflation will be brought back to our target of 5 per cent, because BoU has both the policy tools and the determination to achieve this.
Prof Tumusiime-Mutebile is the Governor, Bank of Uganda
The movement in rates Month CBR (%)