The current low inflation is not sustainable

No one in government could come out with a clear message to the population until yourself, appeared on Bukedde TV and authored a number of media articles to explain what was going on to the largely uninformed Ugandans.

Due to the escalating domestic inflation, imports to Uganda peaked at the expense of exports. Basic economics goes like this: when inflation increased, starting not actually in 2011 but way back in 2008, the countries that export to Uganda (notably, Kenya, China, India, UAE, EU, COMESA members, and USA) preferred to increase the volume of their exports to take advantage of the high prices offered by Ugandans, yet these and other countries where we export were unwilling to buy Uganda’s exports since inflation had made them expensive.

Indeed our exports declined by 5.3% between April 2010 and March 2011, while imports increased by 18.3% over the same period. Consequently, Uganda’s current account deficit (the excess of expenditure over export receipts) increased from US$ 647 million before walk to work to a whooping US$ 2.7 billion today.

This is what partly affected the exchange rate in the sense that the demand for foreign currency (particularly the US dollar) increased since importers (the KACITA members who closed shop in November 2011) buy in dollars, while the supply of these dollars had reduced since Uganda’s exports (which bring in dollars) dwindled on account of high inflation, among other factors.

Core inflation fools us!

Consequently, the shilling lost value. It lost the value quite swiftly than usual i.e. from about Shs. 2200 to Shs. 2750 per dollar in hardly a month (a tendency we call exchange-rate overshooting in economics) because the market fundamentals that affect the foreign exchange rate (i.e. demand and supply of currencies, real income differentials, inflation rate differentials, and productivity changes) had been overridden by market expectations (i.e. economic and political rumours, speculative opinion about future exchange rates, bad news about market fundamentals, and real interest rate differentials).

The market expectations were further worsened by Bank of Uganda Governor, Emmanuel Tumusiime-Mutebire’s media utterances when he told the Financial Times of the UK that government had raided the Treasury, took off with about two months of the country’s reserves to purchase fighter jets. Although Mutebire later denied having let out government secrets to the media, and for that matter to the nowadays hostile media of the UK, few could accept his denials.

When a rumour was concocted thus, “Mutebire has resigned as BOU Governor”, taking the advantage of the resignation of the Afghanistan’s Central Bank Governor at the time, the pit in which the shilling was falling could became deeper.

Mr President, supply shocks, which take the form of higher (or lower) inflation than expected for a given level of demand, are always more difficult for policymakers to deal with than demand surprises.

Nevertheless, the Bank of Uganda’s framework for inflation-targeting allows temporary supply shocks to be largely ignored, so long as they do not feed into inflation expectations. The credibility that had been established, prior to the 2008 – 2011 incessant movements in inflation, meant that they no longer did so. And there are no signs that the BOU has changed its policy stance.

Price surprises in this country often come from the most volatile components of the consumer price index — food and fuel. As BOU’s operating guide, it uses a measure of core inflation that excludes such components. This gives the Bank, and economic observers, some confidence that they are looking at the underlying trend of inflation. In my view this is a wrong strategy.

The short- to medium-term credibility of monetary policy is established by keeping inflation low for a reasonable time. Empirical evidence demands that inflation expectations of private sector forecasters and businesses should be low for a six- to ten-year horizon. All macroeconomic indicators right now show that the honey moon (of low inflation) might not take long.

Erratic government policies

Given the policy framework, when the government changes fiscal policy, it needs to think of how these changes will affect inflation and, consequently, interest rates. Unfortunately this is not the case with your government, Mr President.

There are massive challenges that the future is sure to bring. Two of these challenges are already apparent: the low productivity growth rate and a rapid population growth. Both these factors create uncertainty about the growth and level of production potential of our economy.

Unfortunately, the current fiscal policy, though expansionary by stance, is focused more on areas that will boost productivity only in the long term — health, education, and physical infrastructure. Not much effort has been put in areas that would boost productivity in the short- and medium-term, such as direct investment in agriculture to boost food production.

We all know that food shortages have been the main driver of headline inflation in Uganda. It has been raining heavily since September, but go around the country and see the amount of planting currently going on. Minimal! Farmers don’t have modern farm implements; they don’t have seed, pesticides and fertilizer.

Mr President, you need to guide your government to refocus on a solid and realistic budgetary process that does not require frequent adjustments during the fiscal year — one that does not include too many one-off measures and open-ended commitments. Those erratic adjustments we have had in the last couple of years, with supplementary funding reaching 20% the original budget, tend to make markets (both portfolio and direct investors) nervous.

Like I wrote here a few months ago, you must compel your government to come up with a workable fiscal rule to guide its fiscal policy formulation. In order to enforce fiscal discipline and to ensure that fiscal policy supports the stability-oriented monetary policy, your government and Bank of Uganda should emphasise fiscal policy coordination to ensure fiscal sustainability.

Although BOU noticeably strives to put up with international standards, notably the Code of Good Practices on Transparency in Monetary and Financial Policies, as laid down by the IMF, it is doubtable whether government equally abides by the IMF’s Code of Good Practices on Fiscal Transparency. These codes are important instruments to support clarity in discussions on the necessary coordination between monetary and fiscal policy.

Dominance of fiscal policy

Mr President, another factor that is likely to undermine your government’s control over inflation is dominance of fiscal policy over monetary policy. There are a couple of strands in the theoretical literature on the interaction between fiscal and monetary policy, which essentially assert that fiscal policy will eventually dominate in determining long run monetary policy.

There are important spillovers in credibility between fiscal and monetary policies. Moreover, it is easier for everyone — policymakers and the private sector alike — when the frameworks for both monetary and fiscal policy are clear and understandable.

In the building of credibility, apart from achieving the established objectives, and certainly it is the most important factor, communication plays a key role. There is need for clear and timely communication about the quantitative objectives and about the framework of the mechanisms that enable the authorities to attain those objectives.

One thing I have noticed is that the banking sector and the private sector no longer take Bank of Uganda’s monetary policy guidance seriously. Banks no longer listen to the dictates of BOU’s monetary policy. The central bank has since May this year been reducing the Central Bank Rate and Bank rate (at which it lends to banks), but a big majority commercial banks has not followed suit. Even when Governor Mutebire called upon these banks to follow the monetary policy stance, they refused.

It now clear that Bank of Uganda no longer has control over commercial banks. A big majority of the 24 commercial banks now operating in Uganda is foreign. These are banks with huge amounts of excess reserves from their mother banks and they lend each other instead of borrowing from BOU. As a result the effectiveness of BOU’s monetary policy has been greatly undermined. Some commercial banks are actually more powerful than BOU. This is what Prof. Joseph Stiglitz, on his last visit here, advised BOU to avoid — allowing banks that are too-big-to-fail and too-intertwined-to-fail.

That is why my damn feeling is that, with banks lending money at exorbitant rates and government failing to invest in food production, it will not take long for the current low inflation rates to spike back into double digits.

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