The Bank of Uganda raised the central bank rate (CBR) by 400 basis points to 20.0% on October 4. At the same time it raised the rediscount and bank rates to 25.0% and 26.0% respectively. The increase in the CBR is far more aggressive than most analysts had anticipated.
According to several analysts, such tightening indicates the seriousness with which the BOU regards its price stability mandate. This view confirms Professor Emmanuel Tumusiime-Mutebile’s remarks.
“The increase of four percentage points in the CBR which I have announced today should be seen as a clear signal of the Bank of Uganda’s determination to bring inflation under control,” the Governor told the journalists on October 4.
The recent increase in inflation rate explains the aggressive tightening of the monetary policy. Pushed by an acceleration in food inflation, headline inflation reached 28.3% in September from 21.4% in August. The food index accelerated 8.4% (monthly) having averaged 1.0% during the previous 4-month period. As a result food inflation rose to 50.4% from 42.9% in August. Base effects still suggest that headline inflation will peak soon, albeit at a much higher level than we have been anticipating. Nonetheless, the increase in inflation over the past year has justified the tightening of the monetary policy stance. Indeed, with BoU targeting a level of 5% for core inflation in the medium term while actual core inflation registered 27.5% in September from 20.1% in August, BoU needed to tighten monetary policy.
The current inflationary pressures in Uganda are broad-based. Besides food price pressures, other components of the CPI have exhibited sustained pressure recently. The rent, fuel and utilities components of the CPI rose 11.4% (monthly) to register a 26.6% (annual) increase in September from 12.1% (annual) in August. Unwinding base effects of the reduction in mobile communication costs in 2010 have pushed the transport and communication sub-index to a growth rate of -1.4% (annual) in Sep (11.7% monthly) from an average of -11.1% (annual) in the prior 12-m period. The education sub-index was the only other component of the CPI with a growth rate (10.3% (annual) lower than 20.0% (annual) in Sep.
Commitment to curb inflation explains the recent move of increasing the CBR significantly. The BoU acknowledges that inflation pressures have been primarily caused by food supply shortages due to reduced output in the region. But it has seen the need to demonstrate its commitment to lower inflation by tightening monetary policy aggressively. The BoU still commits itself to tightening further should upward pressures on inflation persist. Contrary to many other central banks facing inflationary pressures emanating from supply side shocks, the BoU is adamant that slowing domestic demand via higher interest rates will be a key component of the transition mechanism. The moderation in the growth rate of commercial banks’ claims on the private sector to 39.6% (annual) in Aug from 44.4% (annual) in Jun presents tentative evidence of this.
Seeking to support the local currency amidst depreciation pressures is another reason for pursuing a tight monetary stance. Another key component of the transmission mechanism will be the currency. In fact, BoU also admits that the weakness of the Uganda Shilling worsened inflation outcomes this year. USD/Uganda Shilling has increased by more than 25.0% over the past year, with the BOU doing little to support the Uganda Shilling over most of that period. With broad-based USD strength now evident, the BOU probably realises that Uganda Shilling depreciation could become disorderly, worsening the inflation outlook. Hence, the aggressive tightening of monetary policy seems to be also directed at improving confidence towards the Uganda Shilling. Given these developments, persistent pressure on headline inflation and the aggressive tightening of monetary policy, we expect yields to rise further (perhaps another 300-400 bps for T-bill yields) in future T-bill and T-bond auctions. This increase in yields could revive capital inflows, helping to support the balance of payment, although global risk sentiment remains poor. The current account balance already recovered in the second quarter of this year to a deficit of USD410.9m from a deficit of USD689.7m in the first quarter of this year. Most of the recovery was attributable to an increase in current transfers rather than a marked reduction of the trade deficit. But the tightening stance of the BoU will probably assist in restraining imports as well, bolstering the overall BOP.
