Emmanuel Tumusiime-Mutebile: Basic principles guiding monetary
policy in Uganda
Speech by Mr Emmanuel Tumusiime-Mutebile, Governor of the Bank of Uganda, at the
annual dinner of Uganda's Bankers' Association, Kampala, 30 November 2012.
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The Chairman and members of Uganda Bankers' Association,
Members of the Diplomatic Corps,
Distinguished invited guests,
Ladies and Gentlemen.
I am very pleased to be here with you at the traditional end of the year annual dinner of the
Uganda Bankers' Association. I would like to thank the Chairman of the UBA for inviting me
to be guest of honour at this occasion, which is an honour I appreciate greatly. I want to take
this opportunity to make a few remarks about the basic principles which guide our monetary
policy in Uganda, especially in the light of the reforms we have introduced over the last
18 months which, of course, are very pertinent for the banking industry.
As you all know, the BOU introduced a new monetary policy framework at the start of the last
fiscal year. The new framework is an inflation targeting lite framework (ITL), similar in its
basic features to that used by many central banks in advanced economies and emerging
markets around the world. The primary objective of our monetary policy is to hold the annual
rate of core inflation to 5 percent over the medium term. That does not mean that we will aim
to keep core inflation at five percent all of the time, because that is neither possible nor
desirable. Prices are subject to supply side shocks which can drive inflation up well above
policy targets, as happened in 2011.
Monetary policy cannot realistically prevent inflation from rising in the short term if prices
have been hit by a large supply shock, such as a food price shock, in Uganda or anywhere
else in the world. What monetary policy can realistically achieve is to bring core inflation back
down over a period of time, which in most cases will probably be in the region of a year at
least, depending on the size and nature of the shock. When faced with a supply side shock
to prices, of the type which hit our economy in 2011, the goal of the Central Bank must be to
ensure that the initial rise in prices triggered by the shock does not feed into a self reinforcing
spiral of higher prices, which would lead to higher inflation becoming persistent. The Central
Bank cannot prevent a temporary rise in inflation, but it must not allow this to turn into
permanently higher inflation. To avoid this, monetary policy has to be tightened to curb
domestic demand, so that weaker demand gradually offsets the inflationary effects of the
supply side shock. This is why we tightened monetary policy in 2011, by raising interest
rates. As you may remember, the Central Bank Rate (CBR) was raised very sharply in the
second half of 2011 because the supply side shock to prices was itself very large; for
example, annual food price inflation rose to 50 percent in September 2011.
Once we saw evidence that inflationary pressures were abating and we were convinced that
inflation was on a downward path, we were able to begin cautiously easing monetary policy,
by reducing the CBR in February of this year. Inflation has now been brought back down to
our medium term target of 5 percent. Looking ahead over the next 12 months, we intend to
set our monetary policy, using the CBR, to maintain core inflation as close as possible to
5 percent.
Although inflation is the primary target of our monetary policy, we are also concerned with
the growth of real output, which is a secondary objective of monetary policy. More specifically
we aim to ensure that real output is in line with its potential level, which is determined by
supply side growth. This means that, in circumstances where real output is below its potential
level, we will use monetary policy to support a recovery of output provided that this does not
undermine our ability to achieve our inflation target. In some circumstances, notably when
the economy has suffered an aggregate supply shock, as was the case in 2011, there is an
unavoidable conflict between achieving both the inflation and output targets. In these
circumstances the inflation target has to take precedence, because otherwise the credibility
of the Central Bank to control inflation will be jeopardized. However there are other
circumstances where there is not an inherent conflict between the inflation and output
targets. With the supply side shocks which hit our economy in 2011 having now abated, the
conflict between the inflation and output targets has also largely dissipated, although it could
re-emerge if the economy were hit by further supply side shocks in the near future.
We estimate that the potential growth of real output of our economy - which is determined by
the growth of the labour force, capital investment and productivity growth - is currently in the
region of 6-7 percent per annum. In the last fiscal year, real output growth was only
3.4 percent; about half of the potential growth rate. As a consequence, a negative output gap
has opened up. Actual output is lower than potential mainly because of constraints on the
demand side, which include constraints arising from macroeconomy policy and those
emanating from the weaknesses in the global economy. Although we expect that real GDP
growth will pick up in 2012/13, it will not be anywhere near fast enough to close the negative
output gap and I do not think that real output in the economy will be restored to its potential
level before 2013/14 at the earliest.
A negative output gap tends to dampen inflationary pressures, because it means that
aggregate demand in the economy is weak relative to aggregate supply. Consequently, in
the current circumstances it is possible to use monetary policy to try and boost domestic
demand and, therefore, real output without jeopardizing our objective of controlling core
inflation at 5 percent. This is why we have reduced the CBR over the last few months; we
would like interest rates to fall to stimulate a recovery of bank lending and thus a recovery of
demand for goods and services from the private sector.
However, it is necessary to recognize the constraints and limits on our ability to achieve our
objectives for output. First, as I have already mentioned, the current coincidence of interests
between our inflation and output objectives will only last as long as there are no further
supply sides shocks to the economy. Secondly, in an economy which still has a relatively
shallow financial system, the overall impact of monetary policy on aggregate spending in the
economy is not large. The main transmission channel of monetary policy to the real economy
is through bank lending to the private sector, but the stock of bank lending is only 16 percent
of GDP. A large share of household spending in the economy is not directly affected by
monetary policy, although there may be some indirect effects through employment.
Furthermore, there are other factors, as well as monetary policy, which affect both the supply
of, and demand for, bank credit, such as the level of household indebtedness and the value
of assets such as land and property which are used as collateral for loans.
I would now like to turn from the objectives of monetary policy and make a few remarks
about its operational modalities, and in particular the role of the Central Bank Rate in our
monetary policy framework. In effect the CBR performs a dual role. It acts as a guide for
short term interest rates and it provides a very visible signal of the stance of monetary policy.
In modern monetary policy frameworks, the signaling of the stance of monetary policy plays
a very important role in guiding expectations about the economy and the actions of the
Central Bank. That is why we announce the CBR publicly at the start of every month and
explain the thinking behind our interest rate decision.
Since the ITL framework was introduced, we have been able, using our regular interventions
in the money market, gradually to bring short term interbank interest rates quite closely into
line with the CBR. The average 7 day interbank rate for November was 12.6 percent, which
is very close to this month's CBR of 12.5 percent. In turn other interest rates such as those
paid on wholesale deposits are now also moving roughly in line with the CBR. As such the
CBR is now proving quite effective in influencing the marginal cost of funds for commercial
banks. We have been less successful in influencing the path of bank lending rates; they
followed the CBR up in the second half of 2011 but have been much slower in coming down
this year, with the result that interest rate spreads have widened. I hope that, as our financial
sector becomes more competitive and sophisticated, we will see bank lending rates become
more responsive to changes in the marginal cost of funds for banks and interest rate spreads
being reduced.
Finally I will briefly touch on the instruments of monetary policy. In the past, the main
instrument of monetary policy was the regular primary auction of Government securities,
which we used as a tool to control the monetary base. Under the ITL monetary policy
framework, our operating target is the interbank interest rate, not the monetary base, and the
tool we use to influence the interest rate is secondary market operations in the money
market, mainly repos and reverse repos. The primary auctions of Government Securities are
now used to fund the Government's domestic borrowing requirement and to refinance the
existing stock of securities as they mature, rather than as an instrument of monetary policy.
Furthermore, the Government will fund fully its domestic borrowing requirement from the
market, by issuing securities, without recourse to any funding from the Central Bank. It is
possible that we might occasionally use a primary auction of securities for monetary policy
purposes in the future, but this will be the exception rather than the rule and if we do so we
will announce this explicitly, to avoid any confusion.
I hope that you have found these remarks useful. As I noted earlier, transparency and
communication play a vital role in modern monetary policy frameworks, so it is very important
that the public and especially decision makers in the banking and business communities
have a good understanding of what the Central Bank aims to achieve and how this will affect
the economy.
Lastly, I would like to congratulate the Uganda Bankers' Association and its members for all
of their efforts to over the course of this year and in particular for their work in developing and
promoting a code of ethics and good banking practices to guide all members of the UBA.
Thank you for listening to me.