Inflation: What will it take to tame it?

Since the turn of the year, the country has been witnessing steady increase in the price of essential commodities before the government inflation cap of 5 per cent got blown away some four months ago by mainly imported inflation, resulting from the Russia-Ukraine war and in part, the effects of Covid-19 pandemic.

By close of September, inflation had hit double digit, rising from 9 per cent in August to 10 per cent by the close of last month.

According to Uganda Bureau of Statistics (UBOS) latest Annual Gross Domestic Product (GDP) statistics, Uganda registered economic growth of 4.6 per cent in Financial Year 2021/22, which is lower than the pre-Covid-19 target of 6.5 per cent. The country also registered shortfalls in revenue collection of Shs1.4 trillion. Consequently, per-capita output growth in 2021 remained negative for a second year.

 The gloomy performance of the economy has been further dampened by significant increase in prices of essential commodities and services such as fuel, soap, cooking oil, some food items, education services, and building materials.

 As a result, monthly headline inflation increased to 7.9 per cent in July 2022 from 2.7 per cent in January 2022. During the same period, according to Bank of Uganda (BoU) statistics, the shilling faced pressure against the dollar depreciating by 7.4 per cent to Shs3,791.6 from Shs3,528.8. Importantly, since early 2022, there have been heightened inflationary exchange rate risks.  

Not alone…                          
Now, Uganda’s economy is not the only one struggling with escalating inflation—increase in the price of commodities. Developed economies such as the U.S, United Kingdom, Sweden, Japan and China are facing it rougher.
When US moves to fight against inflation as it has been doing for months, the rest of the world takes the hit, with an economy like that of Uganda often times being part of a collateral damage.

The primary cause of the U.S. market chaos whose spill over the economy is dealing with stems from the Federal Reserve’s (also referred to as the Fed) tackling of sickening inflation.
 
The Economist, a publication focusing on, among others, international business, noted in its previous edition that the Fed’s attempt to tame inflation after losing the first three or four rounds since prices began to surge in 2021, are now swinging harder than before.

The Central Bank expects to raise the federal funds rate to nearly 4.5 per cent by the end of the year and higher still in 2023. Although the outlook for rates is, according to The Economist rippling through America’s financial system, it is outside America where the financial effects of the Fed’s monetary tightening have been most severe. Uganda is one of the perfect examples, considering that she is a net importer.

A strong dollar, in effect, exports America’s domestic inflation problem to weaker economies. As part of the measures, the central bank supports their local currencies by raising rates in line with the Fed, but often times, it is at the expense of even lower growth, further exposing the poor to more economic hardships.

BoU employs a policy interest rate  -  the Central Bank Rate (CBR) which is an operating target of monetary policy. The CBR is intended to guide short-end interbank interest rates, which are expected to influence other interest rates in the economy, such as commercial bank deposit and lending rates.

Expert analysis, titled: “Implications of the contractionary fiscal and monetary policies on Ugandan economy” produced by Civil Society Budget Advocacy Group (CSBAG) with support from OXFAM Uganda, discloses that at its June 2022 meeting, BoU’s Monetary Policy Committee (MPC) increased the CBR by 1 percentage point to 7.5 per cent.

The CBR was subsequently increased to 8.5 per cent in July and further increased to 9 per cent in August 2022.  However, the excess structural liquidity in the system was beginning to spillover to the interbank foreign exchange market, causing volatility in the exchange rate.

 To minimise the spillover, on June 23 2022, the expert analysis further noted that BoU increased the Cash Reserve Requirement (CRR) from 8 percent to 10 percent of deposits. The increase in the CRR locked-in, on average, more than Shs600 billion of structural liquidity.

However, raising the CBR as opposed to other options like Open Market Operations (OMO) has a lower implication on other economic parameters like the domestic debt stock. Hiking the CBR and the Reserve requirement ratio tend to push commercial banks to raise the lending rates and reduce the amount of loanable funds.  

Much as fiscal policy is needed to boost productivity and address some of the supply side challenges, monetary policy is needed to create a stable and predictable economy in which the fiscal policy intervention beneficiaries (Private Sector) operate.

Economists' views
Speaking at the high-level dialogue organised by CSBAG and OXFAM last week, the Principal Economist, Macro Economic Policy Department, at the Ministry of Finance, Mr Joel Mulinda argued that almost all central banks in the world are tightening monetary policies to control inflation in their economies.

“Advanced economies spend about 27 percent of their incomes on food and for developing economies like ours, we append about close to 78 percent of our incomes on just food alone.  The food inflation we are dealing with is the most dangerous because it can persist for much longer,” he said. 

He continued: “You have to tighten now. We have had the supply induced inflation but there could be secondary inflation whose impact is already evident in the exchange rate. We are also seeing import demand going up both for the government and private sector.

“These secondary impacts are the most dangerous ones because of the vicious cycle of inflation, leading to complete erosion of the value of money.”
Government is now concentrating on the fiscal side—deploying the national budget resources in sectors with highest returns such as enhancing productivity, infrastructure and human capital development. This will be done in tandem with coordinated monetary policies.

Questions…
Today, circumstances are different as the global environment is between a rock and hard place with levels of inflation taking on another dimension amidst slow growth (below pre-Covid-19 levels). The risks of stagflation (recession) are therefore undoubtedly high.

The questions policy makers should be considering now, according to Mr Julius Mukunda, a seasoned budget and policy analyst, are: When to start tightening inflation? At what speed should tightening be done? How long should the tightening last? And what is the cost of tightening against inflation in terms of slowdown in growth and increase in unemployment?

This is because Uganda commenced FY2022/23 with a tight monetary policy coupled with a contractionary fiscal policy, including raising the policy rate (the CBR) from 7.5 percent in June 2022 to 8.5 percent in July 2022, selling more government securities and increasing the reserve requirement ratio for the banks as well as cutting expenditure releases for FY 2022/23 quarter one.

Given the high interest rate and high-risk structure, the commercial banks have been declining nearly half of loan applications. This could suggest a less effective transmission mechanism through this measure—managing inflation by raising CRB.

 Household expenditure on consumables is expected to remain muted with the higher personal income taxes, reduced government spending, the shilling’s depreciation and higher interest rates.

Growth in credit extension to households in Q4 of FY 2021/22 was 0.6 percent below credit to firms. The interest rate hikes by BoU imply the rise in the cost of servicing existing debt and the cost of acquiring new debt by households.

Contractionary monetary policy coupled with reduced government releases in quarter one of FY2022/23 is expected to dampen the rate of growth and demand. Even though weaker demand reduces upward pressure on the price level (inflation), businesses will reduce production rates.

By all indications, the inflationary situation and therefore the response are both headed in the same direction, up! In the view of the Central Bank, things will not return to normal until at least 2024,signalling a tricky 2023 going by current projections.

“What is the main source of inflation and what is the transmission mechanism of monetary policy actions? We think that the transmission lag is anywhere between 12 and 18 months. So we expect the impact of our tightening to come in around 12 to 18 months,”said Micheal Ating Ego, deputy Governor, Bank of Uganda.

For Adam Mugume, the executive director research at the Central Bank, the job of managing inflation is more complicated this time round.

But as we take monetary policy action, the global side is not helping us either because it is also not remaining constant. That complicates the whole scenario,”he admits.

The complexity is trying to manage using the demand side approach while the real problems is supply side in things like price of fuel which we have no control over. This is not helped by short term events like rise in prices of rice because Tanzania is exporting more to Kenya than Uganda. Then the price of rice where the cause is the shortage of sugar cane plus increase in prices of basic household foodstuffs.

It seems then, that monetary policy is left alone of the next quarter as the Finance Ministry has decided not to cut budget expenditure like it did in the July to September quarter for the the 2022/22 financial year.

The ministry has decided to release the whole Shs7 trillion. This helps households have disposable incomes but the question is: How much can they buy with this money? Even when inflation levels return to the acceptable 5% policy target rate, will the money households have be able to buy the same amount of goods they did a year ago? Not likely!