why it was imperative for the bou to tighten monetary policy in 2011, by raising interest rates. interest rates are the main tool of a modern monetary policy in a market economy. the rationale for raising interest rates last year was threefold. first, higher interest rates discourage borrowing by the private sector and, therefore, could be expected to bring about a slowdown in credit growth, which had been growing very rapidly in 2011 as i have already mentioned. secondly, higher interest rates could encourage households to increase their savings and, therefore, reduce consumption. both of these channels work by dampening the growth of private sector expenditures, thereby easing inflationary pressures as demand for goods and services weakens. it is a basic principle of economics that the price of goods and services is positively related to their demand. thirdly, higher interest rates can provide support for the exchange rate, by attracting foreign portfolio investment. a stronger exchange rate takes some of the heat out of the inflation of the prices of imported goods and services. the bou ’ s policy interest rate – the central bank rate ( cbr ) – was raised from 13 percent in july 2011 when it was first introduced as the main policy tool of monetary policy, to 23 percent in november. it has been kept at 23 percent in the subsequent two months. the bou does not fix commercial bank interest rates ; that would be counterproductive in a market economy because it would distort business decisions and lead to borrowers being denied access to credit, because banks could not properly cover their costs of lending. the commercial banks must be free to set interest rates which reflect market forces and the specific characteristics of individual customers ; for example the credit risk of borrowers. the cbr acts as a benchmark to guide commercial bank interest rates upwards or downwards. hence when we raised the cbr we expected that commercial banks would raise their lending rates, as the marginal cost of funds was increased. this has happened. most of the banks have raised their prime lending rates and average bank lending rates have risen since the middle of 2011, as can be seen in figure 5. the interest rates paid on large term deposits have also been raised, reflecting the competition among banks for these deposits, although disappointingly most small depositors have not seen much benefit in terms of higher deposit rates. bis central bankers ’ speeches in the last two to three months we have seen clear signs that our policies to fight inflation are starting to work. bank credit growth has slowed markedly since september

2011, from an annual rate of 47 percent in september to 34 percent in november. the exchange rate against the us dollar has strengthened by about 15 percent since mid october, partly as a result of foreign portfolio capital inflows attracted by the higher interest rates in uganda. fuel prices have just started to edge down as a result of the strengthening of the exchange rate. in addition the food price shock has begun to abate. as a result of these positive developments, both headline and core inflation peaked in october and then fell back in november and december, as can be seen in figure 4. monthly inflation rates, which provide a good indicator of current inflationary pressures, fell very sharply in november and december ; monthly core inflation averaged only 0. 6 percent in november and december, which was much lower than the average of 3. 8 percent in the previous four months. annual inflation rates are still high – headline and core inflation stood at 27 percent and 29. 2 percent respectively in december – and we still have a long way to go to comprehensively subdue inflation, but we are moving firmly in the right direction. i am confident that if we persevere with our monetary policy stance we will be able to pull inflation down to single digits by the end of this year. as inflation falls during the course of this year, it will be possible to start reduce interest rates gradually. figure 5 bank lending rates and the 364 day treasury bill rate, percent : june 2008 – november 2011 source : bou. concluding thoughts i hope that i have helped you to understand the current difficulties facing our economy and the response of monetary policy, the primary objective of which is to control inflation. as i have explained, monetary policy is purely a tool of aggregate demand management. economic policy consists of both demand management and supply side policies. the latter aim to strengthen the productive capacity of the economy ; its aggregate supply. fiscal policy is central to supply side policies although fiscal restraint is also important to support monetary policy in demand management. bis central bankers ’ speeches supply side policies comprise structural policies and mostly sectoral and microeconomic in nature ; they include the construction of public infrastructure, incentives for private investment, competition and trade policies, and agricultural extension services. as a government we need to improve supply side policies to strengthen economic growth over the medium to long term, in particular by improving the quality of public services, the cost and quality of public infrastructure and the business environment. supply side and demand management policies are not alternatives ; they