Inflation Dynamics in East Africa
Feb 24th 2012
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.
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Mthuli Ncube
Professor Mthuli Ncube is the Chief Economist and Vice President of the African Development Bank, and holds a PhD in Mathematical Finance from Cambridge University, UK, on “Pricing Options under Stochastic Volatility”.
My view is that increasing interest rates as a way of reducing inflation is using the wrong medicine for the correct illness.
The Bank of Uganda has consistently said it did not increase the amount of money in circulation. I want to believe them, on the basis of traditional economics. However, that can only mean one other thing: The bank is being hit by a type of economy it has not handled before: Paper money-less economics on a wide scale. How? Mobile Money systems on mobile phones.
Inflation, by simple definition, is too much money chasing too few goods. At the same time, by simple definition, money is only as valuefull as the number of items it purchases in value. The multiplier effect of money is such that the more times it changes hands, the more items of value it purchases, and the more demand for goods, and the more growth, and the more competition for the goods, and the more a central bank has to get worried with concern to inflation.
Mobile money services in Uganda, M-PESA in Kenya, etc do exactly what is portrayed above.
Before the advent of mobile money services, the ability to move money from one physical location to another was limited by many factors which include, among others, time to take the physical cash, risk involved therein, delays in money transfer from one hand to the other, etc. All these factors would then lead to slow transfer of money from one person to another.
With the coming of mobile money, every phone user was suddenly able to demand goods and services as and when needed for as long as they had a creditor to pay, a debtor to pay, a relative to help out immediately, or a transaction to do on spot.
The effect is that money started to change hands much faster than the central bank was used to. This is because everybody suddenly had access to cash, sellers increased prices of their products due to high demand, buyers started to compete for products because they had the cash, and inflation kicked in.
Increasing interest rates therefore has nothing to do with it.
To prove that interest rate increase can not solve the problem, consider the interest rates charged by money lenders on the streets of Kampala. Before the Central Bank increased interest rates, money lenders on the streets of Kampala used to charge 10% per month (equal to 120% p.a) yet commercial banks were charging 20% per month. In each case, the money lenders had as many clients as the commercial banks did.
When the Bank of Uganda increased interest rates to 28%, the public simply laughed it off, compared to the 120% they were used to. Remember, the majority of Ugandans could not fulfil the requirements and beaurocracies of obtaining loans from Commercial Banks. In a bid not to lose out, money lenders increased from 10% per month (120% p.a) to 15% per month (being 180% p.a) and trust me, they are still making a killing. No change in the level of business.
The Bank of Uganda this week made it worse when the media reported that banks are discouraging lending to the public, even at the prevailing 28% p.a rate. Where do you think the public turns? To the 180% of course!
I think it is time for some new economics. The Central banks can only make the situation worse by increasing interest rates, not any better. Its clear that reduction in drought effects led to reduction in inflation rates, not the tightening of monetary policy.