Emmanuel Tumusiime-Mutebile: The elements of a modern monetary
policy framework
Presentation by Mr Emmanuel Tumusiime-Mutebile, Governor of the Bank of Uganda, at the
International Monetary Fund-Bank of Uganda Conference on "Transition to modern monetary
policy frameworks in low income countries", Kampala, 17 March 2014.
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Introduction
The Bank of Uganda has now been implementing its inflation targeting lite (ITL) monetary
policy framework for almost three years. I believe that our experience during this period
demonstrates that ITL can be an effective framework for monetary policy, even in low income
countries with relatively shallow financial markets. In my remarks I want to focus on what I
believe are the most important lessons of Uganda's experience in terms of the institutional
arrangements and the policy objectives of monetary policy.
Institutional arrangements
A feasible ITL framework requires a supportive institutional framework, of which two
elements are particularly important. The first is that the central bank must have operational
independence to determine its monetary policy. In practice this means that it must be allowed
to set the policy interest rate to best achieve its monetary policy objectives (which I will
discuss shortly) without interference from other institutions or persons. The importance of
operational independence arises because in most countries the central bank is the only
public institution which has a mandate to promote price stability. A central bank which does
not have operational independence would risk having its monetary policy influenced by other
institutions or persons with objectives other than price stability, which would obviously
weaken the central bank's ability to control inflation.
The operational independence of the central bank should be enshrined in legislation, as is
the case in Uganda where the Constitution states that the BOU shall not be subject to the
direction or control of any person or authority. However, statutory independence is a
necessary but not sufficient condition for the operational independence of the central bank.
To be able to implement monetary policy in an independent manner, the central bank must
also have sufficient instruments at its disposal, which it can use without having to seek the
permission of other authorities. Hence there must be some arrangement for providing the
central bank with marketable instruments (preferably Government securities as they are the
most widely traded and liquid instruments in the domestic financial market) which can be
used for monetary policy operations at the discretion of the central bank. Ideally the central
bank should hold its own stock of Government securities. One possible channel through
which Government securities could be transferred to the central bank is through the
capitalization of the central bank, as has occurred in Uganda.
A second aspect of the institutional arrangements for monetary policy which is critical for the
efficacy of an ITL framework is the absence of fiscal dominance. What does "fiscal
dominance" mean in this context? For an inflation targeting central bank it is imperative that
the Government does not systematically borrow from it to finance the budget, because this
risks undermining monetary policy. Hence if Government is to support the introduction of ITL,
it must be prepared to fully fund its domestic borrowing from the market, and avoid borrowing
from the central bank. Preferably there should be constraints on Government borrowing from
the central bank set out in legislation. In Uganda we have such an agreement in principle to
this effect with the Ministry of Finance, but in practice it has not always been fully complied
with.
Policy objectives
The monetary policy anchor in an ITL framework is a publicly announced inflation target.
Consequently inflation must be the primary objective of monetary policy if the anchor is to
play a meaningful role in monetary policy and to ensure that monetary policy has credibility
with the public. Our primary objective in Uganda is to hold annual core inflation to an average
of 5 percent over the medium term, which we interpret as being over a period of 1-2 years.
Having inflation as the primary objective of monetary policy means that controlling inflation
must take precedence over any other objectives, but it does not rule out the central bank
having secondary objectives for its monetary policy, provided that the secondary objectives
are subordinate to the primary objectives. The secondary objective of the BOU's monetary
policy is to align real output as close as possible with the estimated potential output of the
economy, although there are practical difficulties with estimating potential output.
Why does the BOU target core inflation, a measure of inflation derived from a basket which
excludes food crops, fuel, energy and utilities, instead of headline inflation which includes all
of the items in the consumer basket? Of course, the consumer cares more about headline
inflation than core inflation. 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. This was articulated very succinctly by the former Deputy Governor of the South
African Reserve Bank who wrote that: "... higher interest rates will not help to make the
maize crop grow higher".
The forward looking nature of monetary policy
Why does the BOU frame its policy target for inflation in terms of the medium term?
Consumer prices, even when excluding volatile commodity prices, are subject to shocks from
both the demand and supply side of the economy; for example, movements in the nominal
exchange rate have an impact on the domestic prices of imported goods. These shocks can
operate over a much shorter horizon than that of the transmission mechanism of monetary
policy. The transmission mechanism of monetary policy normally extends over a period of
one to two years. What monetary policy can feasibly achieve is to control average inflation
over a longer term time horizon, which is why we have defined our inflation target as a
medium term target.
The medium term time horizon over which the transmission mechanism of monetary policy
operates mean that monetary policy decisions must be made on the basis of a forecast of
future developments in the economy. Current or past developments, such as the latest
available inflation outturn, are only relevant to the monetary policy decision to the extent that
they provide useful information about future developments, which may not be very relevant at
all. This entails a qualitative shift in the way in which policy makers think about the economy
and make decisions, to embrace a forward looking approach.
Inflation forecasts spanning the time horizon of the monetary policy transmission mechanism
are the most important inputs for monetary policy decisions in an ITL framework. Inflation
forecasts need to include both forecasts derived from quantitative models and qualitative
judgements about how the factors which influence inflation, such as fiscal policy and the
exchange rate, will evolve over the medium term. Policymakers also need to think in terms of
probabilities and risks; for example, what is the probability that aggregate demand growth will
accelerate over the forecast horizon? and given this probability, do we need to take action to
forestall a rise in inflationary pressures?
The role of the exchange rate
Policy towards the exchange rate is one of the most difficult and challenging aspects of
implementing an ITL monetary policy framework in a low income open economy. Both the
BOU's primary and secondary policy monetary policy objectives are domestic objectives:
inflation and output stabilization respectively. The policy interest rate is only used to influence
these two objectives. But that does not mean that policy makers can be indifferent to the
level and rate of change of the exchange rate.
The exchange rate is of crucial importance for low income economies for at least three
reasons. First, these economies generally exhibit a strong and rapid pass through of
exchange rate movements to domestic prices. Volatility in the nominal exchange rate imparts
volatility to domestic inflation. In mid 2011, a very sharp fall in the nominal exchange rate
against the dollar, by 18 percent in three months, made a large contribution to the
acceleration of inflation in the third quarter of that year; this is not an experience we wish to
repeat. Secondly, exchange rate volatility is very disruptive for firms which have to transact in
foreign exchange markets. Thirdly, an overvalued real exchange rate is damaging for the
competitiveness of traded goods industries and discourages private investment in these
industries, which in turn retards long term economic growth and development, as a large
volume of research, including research by IMF staff, has demonstrated.
The approach that we have adopted at the BOU is to dampen short term volatility in the
nominal exchange rate through sterilized intervention in the interbank foreign exchange
market; i.e. sales or purchases of foreign exchange accompanied by secondary market
operations to keep the stance of monetary policy (the interest rate) unchanged. Our
experience shows that sterilized interventions can be effective in influencing the exchange
rate. For example, when the exchange rate was depreciating very rapidly in the last few days
of February following announcements by donors that they would suspend aid, the BOU
intervened and was able to stem the depreciation. The effectiveness of sterilized intervention
most probably arises from portfolio balance effects in the context of imperfect capital mobility.
We also attempt to lean against prolonged overvaluation of the real exchange rate, also
using sterilized intervention. However, there are constraints on the extent to which this is
practically feasible. Sterilization to stem appreciation involves the issuance of domestic
securities to mop up the liquidity created by foreign exchange purchases, which requires that
the central bank must have a sufficient quantum of securities at its disposal for this purpose.
It is also expensive for the central bank because of the large interest rate differential between
domestic currency securities and the assets in which the central bank holds its foreign
currency reserves. In Uganda this differential is currently about 11 percentage points.
The speed of transition to ITL
I would like to make a brief comment about our experience with regard to the speed of
transition from a monetary targeting framework to an ITL framework. When we first began
considering adopting an ITL framework we had envisaged a prolonged transition period not
least in order to provide time for strengthening technical capacity. In late 2009 we began the
transition the process of transition by adopting what we called a "flexible monetary targeting
regime", which involved the introduction of more regular interventions in the money markets
to try and dampen volatility in interbank interest rates, although without targeting a particular
interest rate, and a monthly review of the monetary targets with the possibility that they might
be revised to take account of changes in the macroeconomy. However the transitional
monetary policy regime proved somewhat unsatisfactory in that it did not provide a clear
anchor for monetary policy. The flexible aspect of the monetary targeting framework arose
because the BOU had lost confidence in the efficacy of applying rigid monetary targets, but
the framework provided no other monetary policy anchor to replace the monetary targets. As
a result, the BOU accelerated the transition and adopted an ITL framework in July 2011, with
the inflation forecast as the anchor for monetary policy. Furthermore, our technical capacities
have been strengthened by the experience gained from implementing the ITL framework;
which has involved substantial "learning by doing".
Communications policy
Good communications are integral to an effective ITL framework. Therefore the BOU
completely has revamped its communications policy, the main goal of which is to explain to
the public and the markets the reasons for our policy interest rate decision and to make
public our forecast for core inflation. As communications policy will be the subject of one of
this afternoon's sessions, I will not go into the details except to note that we have been
pleasantly surprised at how much coverage the BOU's monetary policy now receives from
the media, both local and international, and the close attention which many of the informed
market participants, such as the international banks, pay to our monetary policy statements.