Celebrating Inflation "Triumphs" While the Economy Gasps for Air

May 25 , 2024.

For a long time, the debate among Ethiopia's policymakers and those in the academia centred on the effectiveness of monetary policy measures in impacting the real economy, particularly inflation. In a country where the majority live on a subsistence rural livelihood and a significant segment of the population operates within the informal economy, it was unsurprising to witness a silent consensus. The central bank was viewed as helpless in using interest rates to tame inflation, leaving fiscal policy as the primary tool for macroeconomic stabilisation.

However, recent developments suggest a shift in this paradigm.

Central Bank Governor Mamo Mehiretu and his team at the National Bank of Ethiopia (NBE) appear to have overturned this long-held view. Unlike his predecessors, Governor Mamo chose to take the liberal orientation of central banking, setting targets for inflation and prioritising price stability as anchors of his policies. No other central banker dared to commit publicly to clearly defined goals.

Inflation, which has plagued Ethiopia for decades, showed a noteworthy retreat, dropping to 23.3pc in April 2024 — a marked decline of 10 percentage points compared to the same period last year. The Governor and his team appear to be on track to meet their goal of reducing year-on-year inflation to below 20pc by July this year. Their moderate success can be attributed to stringent monetary policy measures, including lowering broad money growth from a high of 58pc last year to 28pc last month. Finance Minister Ahmed Shide also reported to federal legislators that his government has curtailed its direct borrowing from the central bank.

However, this aggressive position on monetary tightening demands closer scrutiny beyond policymakers' celebratory rhetoric. It offers little reprieve for average Ethiopians, whose purchasing power is eroded while job opportunities dwindle.

Indeed, a reduction in the monthly inflation rate is often seen as a positive development in a productive economy, typically driven by manufacturing advancements that boost the supply of goods. However, when price drops stem from reduced credit availability amidst stagnant supply levels, the benefits to household consumption are inconsequential. The potential for recession looms larger, with the sharp contraction in available credit to the private sector threatening more harm than sustained growth.

Despite inflation figures receding, wages remain stagnant, and the Birr continues to depreciate against a basket of major currencies such as the Dollar, Euro and Pound Sterling, leading to negligible changes in household disposable income. The government's shift from direct central bank borrowing to increased domestic borrowing to finance its budget deficit has crowded out the private sector. As a result, the limited credit available is funnelled into the state treasury rather than finance new capital projects or employment opportunities.

Understandably, the sentiment among many Ethiopians contradicts the official narrative of the road to price stability. Imported goods, largely paid-for forex obtained through the parallel exchange market, reflect the Birr's value eroded, making any reported deceleration in inflation seem irrelevant to the average consumer. Policymakers must weigh the consequences of crowding out the private sector against the benefits of reducing external loans and operating within a tight monetary policy framework.

Historical parallels offer insights into the complexities of using monetary policy to keep inflation at bay during economic uncertainties.

The 1974 recession in the United States, driven by the Federal Reserve's tight monetary stance, demonstrates the risks of aggressive monetary contraction. The Fed's actions, including a major deceleration in money growth and rising interest rates, exacerbated economic decline. Policymaking under uncertainty requires a delicate balance, and the Federal Reserve's failure to adjust its approach in response to deteriorating economic indicators was a regrettable misstep with painful outcomes.

Ethiopia's current situation mirrors these challenges.

The Central Bank's measures, though aspiring to curb inflation, risk undermining economic growth. Higher interest rates by commercial banks reduce consumer spending and business investment, slowing GDP growth. Although less responsive to monetary policy changes than the industrial and service sectors, Ethiopia's reliance on agriculture confounds the impact of monetary tightening. High interest rates slowed industrial and service sector growth, affecting overall economic performance.

Empirical analysis shows the importance of boosting agricultural output to achieve durable price stability. In an economy where the share of agricultural production in the GDP represents 30pc, its growth negatively affects inflation, indicating that increasing production can help to respond to inflationary pressures effectively. Conversely, growth in the service sector and money supply positively relates to inflation, implying that these sectors drive consumer prices.

Data from the Ethiopian Economics Association (EEA) unveils these dynamics. Efforts to control inflation through monetary tightening may have stabilised prices in the past but also slowed economic activities. In the decade beginning in 2010, Ethiopia's GDP growth rate fluctuated, corresponding with periods of stringent monetary policy.

Supply-side constraints further exacerbate inflationary pressures. Ethiopia faces issues such as low productive capacity, limited access to land, high import tariffs, and domestic conflicts. These factors, combined with excessive money supply and corruption, are believed to drive inflation upward. Demand-side constraints include monetary and fiscal instability, low savings, high lending rates, and contracting investment.

The redistribution effects of inflation have also widened the gap between different income groups. Households in lower-income groups suffer welfare losses disproportionately. The disparity deepens relative poverty, particularly in Gambella, the Southern, Afar, Oromia, and Tigray regional states.

Addressing these issues requires comprehensive policy interventions derived from the political-economic worldview of the political leadership at the helm of political power. It should be no less disturbing to see that the incumbent Prosperity Party (PP) has never articulated the political economy of its persuasions for public debate.

Ethiopia's experience also reveals its economy's structural transformation. The service sector's rapid growth, outpacing agriculture and industry, has further strained supply-demand balances. In the 2023 fiscal year, the services sector recorded a growth rate of 7.9pc, three times larger than the agriculture sector. Its share in the GDP growth was 3.1pc, while the agriculture sector's share was two percent. This shift from agriculture-led to service-led growth has increased aggregate demand faster than supply, leading to inflation.

Recorded examples demonstrate the broader implications of monetary policy during such structural transformations of an economy. The Federal Reserve's approach during the 1970s recession — marked by a rapid deceleration in money growth — can offer lessons for Ethiopia. Policymakers must avoid the extremes of over-tightening or excessive expansion and aim for a flexible and data-driven approach responsive to changes in economic conditions.

The Federal Reserve's actions, particularly its restraint on money growth and interest rates, were initially justified given the economic data available for policymakers at the time. However, as conditions worsened, a more aggressive monetary expansion was needed. The failure to adjust deepened the recession, demanding a balanced policy response.

Milton Friedman's wisdom that the choice should not be between inflation and unemployment but between unemployment now and later should resonate among Ethiopia's macroeconomic policymakers. Efforts to curb inflation by curtailing banks from lending more than the 14pc cap on their previous year loans' ceilings could trigger deeper economic downturns in the future. The trade-off between suffocating businesses and taming inflation can be managed carefully to avoid irreversible economic damage, such as bankruptcies and underinvestment in capital.

The Federal Reserve's rigid approach, pegging the federal funds rate within a narrow band, was found to contribute to the money stock's procyclical behaviour. A more flexible approach, unshackled from rigid interest rate pegs, could have allowed a responsive monetary policy. The central objective should have ensured money growth aligns with long-term price stability while supporting economic activities.

Ethiopia's lessons from past monetary policy missteps are clear. Governor Mamo and his advisors are wise to balance inflation control with economic growth, ensuring that their measures do not undermine productive capacity or aggravate supply-side constraints.

PUBLISHED ON May 25,2024 [ VOL 25 , NO 1256]

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