Why Bank of Uganda favours raise in rates

In response to soaring inflation, the central bank has not shied away from tightening monetary policy. After raising rates for the second consecutive time in weeks, the Monetary Policy Committee said “monetary policy stance will have to be tightened even further so as to ensure inflation eases back to target in the medium-term.” In this explainer, Robert Madoi unpicks the set of hard choices at the bank’s disposal.

Why did the central bank describe the Monetary Policy Committee (MPC) meeting it held at the start of this month as “extraordinary”?

The Bank of Uganda (BoU) wasn’t expected to return this past week with a Monetary Policy Statement. At least not with one that proffered another hike after the central bank yanked its benchmark lending rate in June. The one percentage point hike in June (from 6.5 percent to 7.5 per cent) was the first of its kind since 2018. Traditionally, the MPC issues an inflation statement after a couple of months. Not this time, though.

For the second time in as many weeks, the central bank hiked its lending rate by one percentage point to 8.5 percent. One economist told Saturday Monitor that this past week’s hike is the strongest indication yet that the Ugandan economy is overheating. It comes barely days after the Uganda Bureau of Statistics (Ubos) confirmed that the consumer price index (CPI) measure of inflation hit 6.8 percent in June. So, the incremental change to the base rate—for a second consecutive time—was in every sense extraordinary.

How does the central bank rate help to bring down inflation?

With the overheating indicators on the dashboard flashing red, the central bank is hoping that a tight monetary policy will help it slam the brakes on inflation. It, however, faces a set of hard choices around not acting either too quickly or too slowly. This is such a difficult balancing act not least because an overdose of either can tip Uganda into recession.

Since both headline (6.8 percent) and core (5.5 percent) inflation have contributed to the overheating problem by rising in recent months, the central bank is hoping that its tightening cycles will help to cool inflation. More cycles haven’t been ruled out. While addressing the media this past week, Mr Michael Atingi-Ego—the BoU deputy governor—attributed the general increase in prices and fall in the purchasing value of money to “the balance of risks tilted to the upside.” He, for instance, cited “higher domestic food crops prices due to the effect of prolonged weather” and “a faster shilling depreciation as advanced economies raise their policy rates to control escalating inflation.”

So, in a nutshell, rising interest rates can help to bring down inflation insofar as cooling demand for imported goods is concerned. Ultimately, the drop in demand results in the prices of the product in question going down.

Does suppressing consumer demand come with any risks?

Yes. Speaking this past week, Mr Atingi-Ego illuminated the “downside risks” of “weaker domestic consumption and investments as higher inflation reduces consumers’ real incomes and tighter financial conditions constraining private sector access to funding.” Put simply, it could tip the country into recession, especially if suppressed consumer demand stifles economic growth. The situation is already dicey, with a spending downturn blipping on the radar, thanks to soaring living costs.

What pains are to be expected at both macro and micro levels?

Myriads of pain, unfortunately. Borrowers from commercial banks and renters—to mention but two—will from the looks of it come under pressure sooner than later. When the central bank hikes its base rate, commercial bank lenders and landlords ask commercial borrowers, savers, and renters to do the heavy lifting.

Since a hike in the central bank rate (CBR) translates into higher interest rates on credit, businesses are likely going to feel the pain of borrowing expensively, moreover at a time consumer demand is dipping. A jump in loan default rates could be witnessed in the future as commercial banks recall loans.

What sort of risks or dangers is the government looking at here?

Speaking at last month’s ABSA-NTV post budget dialogue, Mr Patrick Ocailap—the Deputy Secretary to the Treasury—made clear the fact that when the US sneezes, small economies such as Uganda catch a cold. The US Federal Reserve has taken aggressive action to cool inflationary pressure. This will have wide-ranging implications.

“The holders of US assets globally are likely to move their assets back to the US because the interest rates are attractive and they will be able to deal with their inflation levels from there,” Mr Ocailap said, adding, “If those who have been participating offshore by bringing their dollar-denominated assets to our treasury bond and bill markets get [them] out, it means then that the exchange rate kicks in. Pressure upwards kicks in.”

The CBR hike will likely make Government securities profitable items for banks. Consequently, we should expect banks to cut back on their lending as they push up their investments in securities. The equity market could also witness a surge in people looking to liquidate their investments there in favour of government paper, one analyst told Saturday Monitor.

The same analyst added thus: “On a macro level, government borrowing from the domestic market is going to increase. Already, our debt levels are in the red.

“In the next financial year, expect the government to raise taxes to be able to pay back its debt and finance public expenditures.”