The Central Bank Bets on Signals Over Ceilings

Jul 25 , 2026. By Eyob Tesfaye (PhD) ( Eyob Tesfaye (PhD) - etesfaye48@yahoo.com - is a macroeconomist and policy analyst. )

The Central Bank's break with financial repression is real, but its success depends on the Bank's readiness and the treasury's discipline. These are things it does not fully control, argued Eyob Tesfaye (PhD) - etesfaye48@yahoo.com - a macroeconomist and policy analyst. This commentary reflects the views of only the author and does not represent any institution he is affiliated with.

The National Bank of Ethiopia (NBE) has set aside the tools that governed its money for decades, the credit caps, surrender rules and directed lending of an era of financial repression, in favour of market signals. This month, it scrapped its temporary credit cap, raised the policy rate by one percentage point to 16pc and introduced a targeted reserve-requirement framework.

This is no cautious tweak but a deliberate break with financial repression. However, its promise will be decided less by the Central Bank's nerve than by two things it does not fully control, the readiness of the banks and the discipline of the treasury.

For decades, policymakers steered the economy with ceilings and directives. Those tools may have bought short-term calm, but they distorted markets, hemmed in banks and starved productive sectors of credit. The temporary credit cap of 2024 was the approach in miniature. Meant to curb runaway lending, it quickly proved unenforceable. Two years on, most banks had already breached their limits, while the cap punished the very industries, manufacturing and long-term development projects, that Ethiopia most needs to drive growth.

Scrapping it is, therefore, more than a technical fix. It is a declaration that interest rates, not quotas, will now guide lending across the economy.

The rate rise was a deliberate move by the Monetary Policy Committee (MPC) to confront inflationary pressure and restore credibility. With prices stubbornly high at 13.4pc, driven by fuel and food costs, the committee signalled its intent to anchor expectations and strengthen monetary discipline. The targeted reserve requirement adds precision. Rather than blanket restrictions, banks will face differentiated reserve ratios keyed to their loan-to-deposit profiles, a design that does more than discipline liquidity, since it can also steer credit.

Banks that channel lending into speculative or short-term activity will carry heavier reserve burdens, while those financing manufacturing, agriculture and infrastructure can operate with lighter ones. In effect, reserves become a calibrated incentive rather than a blunt, one-size rationing tool, encouraging banks toward the sectors that underpin long-term growth.

Nonetheless, the Central Bank may sharpen its tools, but unless the banks sharpen theirs, transmission stays blunt. For any of this to work, the banks themselves have to modernise. Interest-rate signals and targeted reserves transmit only if lenders can manage liquidity dynamically and withstand shocks. They will need to strengthen their liquidity-management frameworks, run stress tests against different reserve scenarios and build systems that anticipate policy shifts rather than react belatedly. This is the hidden difficulty of modernisation.

Kenya shows both the promise and the pitfalls. In the early 2000s, the Central Bank of Kenya (CBK) made the Central Bank Rate (CBR) its primary anchor, replacing direct lending controls, thereby sharpening transmission and improving transparency. Yet commercial banks often resisted aligning their lending rates with the CBR, citing risk premiums and structural inefficiencies. A later experiment with interest-rate caps backfired by cutting credit to small businesses.

Ethiopia should make its signals credible and ensure banks respond in practice, not only in theory.

Ghana's reforms of the 1990s offer another lesson. The Bank of Ghana dropped credit rationing in favour of interest-rate targeting, which helped stabilise inflation and build credibility, but fiscal dominance repeatedly undermined monetary discipline. When government borrowing ballooned, rate signals lost their force.

Ethiopia faces the same danger. The Treasury bills absorb liquidity and crowd out private borrowers. Targeted reserves may ease it, but fiscal synchronisation will be essential if the country is to avoid the pitfalls Ghana fell into.

Nigeria is more cautionary still. The Central Bank of Nigeria has long leaned on its Monetary Policy Rate (MPR), adjusting it often against inflation and currency pressure. Yet structural constraints, weak transmission channels, fiscal imbalance and a reliance on oil revenue have dulled its effect. Nigeria's record shows the limits of rate rises in economies where fiscal policy runs roughshod over monetary discipline.

Ethiopia should avoid the trap by strengthening its analytical capacity and ensuring that fiscal authorities support, rather than undermine, monetary policy.

This points to the scaffolding the reform needs. The break gains force when fiscal authorities synchronise borrowing with monetary goals, so that Treasury issuance does not swamp liquidity. When financial markets deepen, with active interbank trading, broader bond issuance and capital-market growth providing the channels through which policy rates ripple across the economy.

The banks are part of the same structure. Higher rates and targeted reserves demand sharper liquidity management, stress testing, dynamic reserve planning and risk-based pricing. As banks modernise, signals flow more clearly into credit conditions. That in turn strengthens the foreign-exchange market, because banks that price risk through rates and liquidity models engage more readily in hedging and arbitrage. As liquidity improves, spreads narrow and the Birr's credibility rises.

Understandably, the reform has its critics, and each objection deserves an answer. Some argue that borrowing costs will cripple business, with loan rates climbing above 20pc. That ignores inflation's corrosive effect; with headline inflation at 13.4pc, real borrowing costs are already negative. Higher nominal rates restore credibility and anchor expectations rather than choke activity. Firms may face tighter conditions, but stability outweighs the short-term discomfort.

Others warn that government borrowing will crowd out private credit. Treasury bills will indeed absorb liquidity, yet targeted reserve requirements can redirect what remains toward productive sectors, ensuring scarce liquidity reaches the industries that drive growth. A third critique holds that targeted reserves are merely another administrative control. Indeed, the IMF has cautioned against swapping one control for another. Not a rigid quota system, this is a flexible reserve-adjustment mechanism that, unlike the repression it replaces, operates through market signals while maintaining safeguards.

The reform is unfolding against rapid expansion of the GDP, which is projected to grow 10.2pc in the 2025/26 fiscal year, led by industry, services and agriculture. In such a high-growth setting, a Central Bank's willingness to tighten signals a preference for lasting stability over a short-lived credit boom, and to investors it reads as a country edging toward a transparent and rules-based regime. By dismantling financial repression and adopting modern tools, the Central Bank is building credibility and aligning itself with global best practice.

However, the reach of the change runs beyond the Central Bank. In rewriting its own playbook, the Central Bank has pressed the commercial banks to rewrite theirs, on liquidity management, stress testing and risk pricing. The effort will hold only if fiscal synchronisation and market development reinforce it. Together, these pieces let monetary signals pass clearly into credit markets and, by extension, into a deeper and more durable foreign-exchange market.

The policy change also clears a path toward inflation targeting, provided the supports are secured. Fiscal authorities need to synchronise borrowing with monetary objectives, financial markets need to deepen to carry the signals, the Central Bank needs to communicate transparently and strengthen its analysis, and its independence needs to be protected. With those pillars in place, Ethiopia can move from bold signals to a credible inflation-targeting regime that anchors expectations.

For a country balancing fast growth against inflation, this should be seen as a deliberate break with the past. It serves as a sign that Ethiopia intends to join the economies in which interest rates, not administrative fiat, guide what comes next.

PUBLISHED ON Jul 25,2026 [ VOL 27 , NO 1369]