Bank of Uganda governor on central bank’s role in ensuring macroeconomic stability

Remarks by Prof. Emmanuel Tumusiime-Mutebile,
Governor, Bank of Uganda
At the Sensitization Workshop for Members of Parliament
Imperial Royale Hotel, Kampala
September 16, 2016

Good morning Honourable Members. I would like to welcome you all to this workshop and thank you for finding the time to come here today. We have organised this workshop so that we can hear your views about the work of the Bank of Uganda and so that we can share with you our own perspectives on that role.

In this address I want to discuss the primary role which the BOU plays in the economy, that of maintaining macroeconomic stability, and how this role is shaped by the BOU’s relationship with a number of stakeholders, key among whom is the Parliament which is the legislating organ of Government.

The mandate and responsibilities of the BOU are stated in the 1995 Constitution and in Acts of Parliament, notably the BOU Act and the Financial Institutions Act. The Constitution sets out the functions of the Central Bank in Article 162, the first of which is “to maintain the stability of the value of the currency of Uganda”.

The value of the currency means its value in terms of purchasing power; hence maintaining stability in the value of the currency means controlling inflation.

Why does the Constitution, in setting out the functions of the BOU, prioritise the control of inflation? The reason is that low inflation is a prerequisite for the attainment of many other desirable public policy objectives, such as sustainable economic growth, structural transformation of the economy and poverty reduction.

In particular, private investment is deterred by risk, including the risk of macroeconomic instability. Consequently unless private investors can be confident that inflation will be kept under control, it will be difficult to mobilise private investment on the scale necessary to generate sustainable economic growth, job creation and structural transformation. High inflation also deters domestic savings and encourages capital flight.

As such, low inflation is a complement, rather than an alternative, to other public policy measures which aim to promote the nation’s development objectives. I’m sure that many of you remember the 1980s, when annual inflation rates were continuously in double digits and often exceeded 100 percent, with very damaging effects on economic activity and the welfare of ordinary Ugandans.

If we accept that controlling inflation is an essential public policy goal, we also need to ask why the BOU, and not some other public agency, has been given this responsibility by the Constitution. The reason is that the BOU, uniquely among public institutions, has the policy tools to control inflation, through its monetary policy. In the long run, inflation always reflects an imbalance between what economists call aggregate demand and aggregate supply in the economy.

By aggregate demand we mean overall demand, from all sources, for goods and services. If the overall demand for goods and services in the economy exceeds the capacity of the economy to meet this demand, through a combination of domestic production or imports, prices must inevitably rise.

Monetary policy affects aggregate demand in the economy, mainly by influencing the level of spending by the private sector, which accounts for about 85 percent of total spending in the economy. Inflation can be controlled by the judicious implementation of monetary policy.

The point that I want to stress in this context is that, given that the Central Bank is unique among public institutions in having the tools needed to control inflation, unless the Central Bank makes the control of inflation its priority, it is very unlikely that inflation will be controlled.

In other words, if the Central Bank cannot do that job, it will not get done. That is why the Constitution accords priority to the control of inflation in terms of the mandate of the BOU.

What does the control of inflation mean in practice? Since the 1990s the BOU has agreed with the Government to pursue a target of 5 percent or less for annual core inflation. This target has been stated publicly in many official documents such as the current National Development Plan and budget speeches. We aim to achieve this target of 5 percent for core inflation on average over the medium term, rather than in every single month.

It is not possible to hold core inflation constant at 5 percent, month after month, because core inflation is unavoidably subject to shocks, such as those from the exchange rate or food prices, which sometimes push it above 5 percent and sometimes push it below. However, it is feasible, if monetary policy is conducted properly, to achieve an average rate of core inflation over a medium term horizon, when the temporary shocks to prices tend to offset each other.

Since 2011, the BOU has used a policy interest rate, called the Central Bank Rate (CBR) to implement monetary policy, as part of its inflation targeting framework. When the BOU raises the CBR, we expect that this will bring about an increase in other interest rates, such as bank lending rates and deposit rates. The interest rate is the price of money.

Related: Bank of Uganda cuts interest rate to 14%

Ceteris paribus, a rise in the price of money discourages borrowing and spending and encourages saving; thereby dampening spending pressures in the economy. A fall in the price of money has the opposite effect. Of course, raising interest rates is never popular among borrowers, but faced with mounting inflationary pressures, as was the case last year, we don’t have an alternative if inflation is to be kept under control.

To control core inflation, the BOU takes a forward looking approach. This is because monetary policy operates with significant lags. A change in the interest rate today will not have its full impact on prices for at least one year ahead. Therefore, in setting the policy interest rate, the BOU makes a forecast of inflation, 12 months ahead.

If we believe that inflationary pressures are increasing and will push core inflation above the target of 5 percent during the coming 12 months, we will normally raise the CBR, and vice versa. In that way we can act to curtail inflationary or disinflationary pressures before they materialise. In our Monetary Policy Statement issued after the Monetary Policy Committee meeting where we set the CBR, we explain the policy decision and make public our 12 month forecast of inflation.

As I have just mentioned, our target for core inflation is intended to be achieved over the medium term, hence our performance should be judged by looking at average core inflation rates over a medium term horizon, such as a three year horizon. Over the last three fiscal years, from July 2013 to June 2016, annual core inflation has averaged 4.9 percent, which is within the BOU’s target. As such I think it is reasonable to argue that we have established a track record of delivering low inflation over a medium term horizon and that the private sector can, therefore, be fairly confident that future inflation will also be held close to the target level. In turn that should remove one of the most important sources of uncertainty for private investors planning long term investments in our economy.

Related: August inflation falls to lowest level in 16 months

Let me now turn to the BOU’s relationship with Parliament and the wider society. As I discussed earlier, the BOU’s mandate and functions are derived from the Constitution and legislation enacted by Parliament. The BOU must always conduct its business in accordance with this legislation.

The Constitution also confers operational independence on the Central Bank. Specifically, article 162 of the Constitution states that:  “In performing its functions the Bank of Uganda shall conform to the Constitution but shall not be subject to the direction or control of any person or authority”. This type of provision, guaranteeing the operational independence of the Central Bank, is now common around the world and has become synonymous with the notion of a “modern central bank”. Why do central banks have operational independence?

The justification for operational independence is that this is needed to protect monetary policy from political interference. The conduct of monetary policy is often unpopular; borrowers are unlikely to welcome a rise in interest rates, even if this is necessary to curb inflation. In turn politicians must be responsive to the interests of their constituents, including those who have borrowed money or those planning to borrow.

A central bank which is not independent would, therefore, likely be subject to political pressure to keep interest rates lower than is required to control inflation. The result will be that inflation will be higher than would be the case if the central bank’s monetary policy was insulated from political interference.

Furthermore, the private sector would soon come to understand the nature of the political pressures on the central bank and their implications for inflation, with the result that private sector expectations of inflation would rise, making actual inflation even harder to control.

The result would be the worst of both worlds. Inflation would be higher and that, in turn, would mean that interest rates would also have eventually to be higher in order to prevent inflation rising out of control. Neither the borrowers nor the ordinary consumers, who would have to pay higher prices, would benefit in the long run.

The operational independence conferred on the BOU by the Constitution does not mean that the BOU is unaccountable. On the contrary it is accountable to Parliament, like all public institutions.

Under Article 163 of the Constitution, the BOU’s financial accounts must be audited by the Auditor General and a report on these accounts must be submitted to Parliament. Under section 49 of the BOU Act the BOU must submit an annual report of its activities and operations to the Minister of Finance which should then be submitted to Parliament within three months of the end of the financial year.  Under Article 90 of the Constitution, Parliamentary Committees have the right to call the Governor or other officials of the BOU to appear in person to give evidence or to provide documents. Finally, the appointment, or reappointment, of the Governor, Deputy Governor and members of the Board of Directors are all subject to approval by Parliament.

Consequently, although Parliament cannot direct the BOU on how to perform its functions, it can scrutinize and assess the work of the BOU. If Parliament believes that the BOU is failing to meet the objectives mandated by law, it can say so publicly and even, in the final analysis, refuse to approve the re-appointment of the Governor or Deputy Governor, or the members of the board, if it is of the view that the BOU’s performance warrants this.

From my standpoint as a central banker I have no desire to evade accountability to the elected representatives of the people. A lack of accountability is not acceptable in a democratic society. But the BOU should be held accountable specifically for what it is mandated to do by law, and that which it has the tools to achieve: the control of inflation. Our target for inflation has been made explicit to the public. Please judge us on our performance in meeting this target.

Thank you for listening.

Emmanuel Tumusiime-Mutebile is the Governor, Bank of Uganda