Three years [almost] of inflationary targeting; what do we know so far?

“Central banks are mysterious institutions, the full details of their inner workings so arcane that very few outsiders, even economists, fully understand them” Liaquat Ahamed, in Lords of Finance. [Currently reading]

We swipe the access cards and walk through the revolving door to the elevator. Then we make it to level 7. To a heavily air conditioned boardroom. We sit. We wait for the governor to deliver a statement on inflation projections and the benchmark lending rate for the month. On the boardroom walls are framed pictures of previous bank governors. It is not that lavish a boardroom, but as we wait, looking around is perhaps the only option. The governor arrives. Face down. Walks in with a swagger. Then he sits. An aura of silence ensues for about 15 seconds. Staring at a piece of paper, he issues a monetary policy statement. The issuance of this monthly statement started in July 2011. 

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The policy known as Inflationary Targeting started in July 2011, at the height of double digit inflation. The bank every month issues a statement on what they project inflation to be in the next short and medium term. The governor, Prof. Emmanuel Tumusiime-Mutebile, then also announces the Central Bank Rate (CBR) – a benchmark lending rate. A signal to the market on the direction of interest rates. 

At the time the monthly issuance came in, the bank wanted to stem runaway inflation, so it increased the rate monthly, until November 2013, peak at 23percent. In turn, commercial banks also sent their interest rates through the roof, and by January 2012, the rates had gone up from an industry average of 21percent to 27.2percent.

The monthly increase in CBR slowed credit uptake by the private, which by then was growing at about 30percent year-on-year. The high interest rate environment slowed this growth. Bank of Uganda was criticized for the policy. Some economists and self-appointed-pseudo economists say the policy was hurting borrowers, slowing economic growth and not curbing inflation at all. Traders went hay wire overthe rates, closing their shops in protest of banks increasing lending rates onexisting loans. They even met the president – he met them, just that – but Prof. Mutebile remained steadfast about the policy.

Traders shut their shops in January 2012 protesting the high interest rates. Photo from The New Vision 

Dr Louis Kasekende, Deputy Governor BoU, at a recent conference on Transitioning to Modern Monetary Policy told central bankers from the sub-saharan region that the aim of the policy was to “influence bank deposit rates and wholesale bank funding rates, which determine the marginal cost of funds for banks, and thereby bank lending rates. These interest rates are clearly much more relevant for the saving and borrowing decisions of private sector agents in the real sector of the economy, and therefore for aggregate spending, which is what monetary policy ultimately aims to influence.”

As a result of the high interest rate environment, there was an increased number loan defaults, which increased to 4.2 percent at the end of 2012 from about 2 percent in 2011. Already, the fourth quarter of 2013, they had gone up to 5.9 percent, the highest for any quarter since March 2004.  Mortgage uptake slowed and so did the agricultural sector lending. Economic growth in 2011/12 also slowed to 3.2 percent, the lowest in over a decade. The government watched on, helpless. Ugandans worked hard, businesses collapsed, others survived and journalists wrote stories.

By the end of 2012, BOU had eased – or rather the template word, cautiously eased – the rate to 12 percent, lower than the July 2011 rate. The bankers meanwhile were also partly reacting. Average lending rates declined to 24.77percent. Currently, the policy rate is at 11.5percent, whereas bankers are lending at 22.14percent on average. Not good enough. Some economists say. Even BoU officials.

Dr Kasekende: “So far we have been less successful in influencing bank lending rates, which have proved more sticky [sic] than other interest rates.”

Adding, “Therefore, the acid test of monetary policy implementation in an ITL (Inflationary Targeting Lite) framework is the extent to which changes in the policy interest rate set by the central bank are transmitted to other interest rates in the economy which in turn affect private sector spending.”

Other governors in the room seemed to agree, as they were facing similar challenges in their countries. Stanbic Bank, Uganda’s largest bank, at the beginning of the year announced it was going to start setting interest rates based on CBR. An overriding factor why BoU is optimistic that this policy will be effective on commercial bank interest rates.

Ms. Antoinette Sayeh, Director, IMF African Department also says, “There is broad consensus that additional research is needed to fully understand the transmission mechanism of monetary policy in Sub-Saharan Africa, including on the sluggish response of lending rates to the recent loosening of monetary policy.”

On inflation. According to the UBoS, core inflation, which excludes food crops, energy, fuel and utilities, contributes at least 80percent to the entire headline inflation. BoU also targets core inflation because it considers it less volatile and when Inflationary Targeting came in, core inflation was at 15.6percent. As core inflation increased, so did headline inflation. Once it declined, then headline inflation would follow suit. The BoU projection: Core inflation to be in the 5percent range for the next twelve months. 

“The reason why we target core inflation is that we have potentially better control over core inflation than headline inflation. The goods and services whose prices are excluded from core inflation are generally more volatile and more subject to supply price shocks than are other prices in the consumer basket. Because the prices of food crops and fuel are mainly determined by developments on the supply side of the market, such as the abundance of the harvest, they are largely outside of the control of monetary policy,” Mutebile explained.

When BoU was implementing the ITL, it slowed borrowing and increased costs production. Then, no jobs were being created and some companies were not growing. Foreclosures also increased. Loan defaults were on the rise. Traders cried foul, all in vain. Customers started reading the terms and conditions of the loans clearly. Has inflationary targeting been a success? The bankers say "yes" whereas the citizens would want to disagree. 

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After reading his statement, not so flawlessly, we ask questions. Bullishly he answers “I did not say that”, “it is none of your business.” “Yes.” “I do not think so.” He then walks out confidently, knowing that the market will react positively to the news.