Inflation Dynamics in East Africa

24Feb2012
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In spite of good macroeconomic performance over the past decade, inflation in four leading East African economies – Ethiopia, Kenya, Tanzania and Uganda – has risen sharply. The inflation rate in Ethiopia was nearly 40 percent in October 2011 before leveling off to 32 percent in January 2012. Although inflation in Uganda decelerated to 25.7 percent in January 2012 from a high of 30.4 percent in October 2011, it is still far higher than expected, compared to the 3 percent rate at the end of 2010. Kenya saw its inflation peak at 19.7 percent in November 2011, before dropping to 18.3 percent in January 2012. For Tanzania, it reached 19.7 percent in January 2012, which is well above the 10 percent average for the last few years. Sharp increases in inflation could reduce economic growth and exacerbate poverty levels.

Drivers of Inflation

While the main driver of short-run inflation in Ethiopia and Uganda is a surge in money supply, accounting for 40 percent and one-third respectively; oil prices seem to drive inflation in Kenya and Tanzania, accounting for 20 and 26 percent respectively (see table 1). The difference in inflationary effects in these countries may be explained by the differences in the intensity of expansionary monetary policies. Inflationary pressures in Ethiopia reflect monetization of the fiscal deficit while growth in private sector credit is the main source of broad money growth in Uganda and Kenya, resulting in an accumulated monetary expansion.

Table 1: Short and long term contributions to inflation in 4 East African countries  (from inflation equations in the appendix)

Countries

July 2010-July 2011

% of inflation explained by

Observed inflation (%)

Observed broad money growth (%)

Monetary expansion

World Oil prices

World food prices

Cereal production

Ethiopia

39

30

 

 

 

 

Short run

 

 

40

27

13

1

Long run

 

 

52

10

5

4

Kenya

16

17

 

 

 

 

Short run

 

 

14

20

11

ns

Long run

 

 

31

18

10

18

Tanzania

13

16

 

 

 

 

Short run

 

 

20

26

9

5

Long run

 

 

19

ns

ns

34

Uganda

19

25

 

 

 

 

Short run

 

 

32

21

13

ns

Long run

 

 

52

ns

ns

14

Source: AfDB computations (2011).

Note: ns denotes not statistically different from zero.

These findings emanate from the analysis of the main determinants of inflation in the four leading East Africa economies: (a) exogenous factors (i.e. world food and fuel prices); (b) structural characteristics (i.e. domestic production); and (c) policy variables (i.e. monetary, fiscal and exchange rate policies). It is worth noting that in the short run exogenous factors and structural characteristics are outside the influence of these countries, mainly due to production capacity constraints. On the other hand, the adverse weather conditions in recent years have further worsened the food situation in the region, causing a sharp increase in food prices. Moreover, rising global oil prices have been transmitted to domestic inflation, and exacerbated by rapid depreciation in exchange rate across all four countries.

Recent Responses and Dialogue on Inflation in East Africa

The main response to inflation across four countries has been monetary tightening with different degrees of intensity.

In Ethiopia, the policy response has focused more on tackling supply shock-induced effects, initially through administrative price controls. As price controls proved ineffective, they were suspended on all goods except for two commodities, which is a clear demonstration of the inefficacy of administrative action to control inflation.

In Kenya, the Central Bank of Kenya has attempted to constraint growth credit to the private sector through large interest rate adjustments, in order to rein in inflation. In 2011, the Central Bank raised interest rates from 6.25 percent in May to 18 percent in December. It also revised the cash reserve ratio by 50 basis points, from 4.75 percent to 5.25 percent.

In Tanzania, policy responses have mirrored developments in Kenya. The Bank of Tanzania hiked the Central Bank rate by 200 basis points to 9.6 percent, and increased cash reserve requirements on government deposits from 20 to 30 percent, as part of a strategy to reduce money supply.

In Uganda, The Central Bank of Uganda has attempted to tame inflation by focusing on demand factors, driven by rapid growth in private sector credit and more recently a widening fiscal deficit (IMF, 2011). It increased the Central Bank Rate by 400 basis points to 20 percent, and then to 23 percent in November.

However, these adjustments to the Central Banks Rates have had minimal impact on inflation but stopped it from rising. This has raised the questions as to the extent to which inflation can be managed by manipulating interest rates when there are multiple factors at play, including exogenous shocks and supply side factors.

On 14 February 2012, in Nairobi, Kenya, the African Development Bank convened a High Level Policy Dialogue on inflation in East Africa with the view to make future policy responses more effective. Central bank governors and high level officials from Ethiopia, Kenya, Tanzania and Uganda commonly agreed upon areas of continued policy dialogue and research:

  • Reevaluation of existing models of inflation
  • Reassessment of policy objectives pursued by central banks
  • Assessment of the extent to which structural factors and supply shocks impact on inflation
  • Central banks to devise new tools of monetary policy intervention with a view to address the weakening monetary transmission in the face of financial innovation
  • Need to reflect on the applicability of inflation targeting under current institutional set-ups
  • Authorities must accelerate diversification strategies in order to address the binding constraints that hamper effective supply response in the real sector.

Comments

David Munezero - Rwanda 17/12/2015 11:57
You have talked about the Inflation Dynamics for East Africa, And I thank you; But how it is for Rwanda? Thank you.
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