Monetary Policy

1. What is Monetary Policy?

Monetary policy is one of the tools that governments use to achieve macroeconomic stability. Monetary policy involves regulation of money stock or the short term interest rate to attain monetary policy objectives such as stabilization of output and prices. The responsibility for the conduct of monetary policy generally rests with the central bank of the country, as it enjoys considerable control on regulation of money stock through its monopoly over issue of currency, and creation/ destruction of bank reserves.

2. Why is price stability the objective of Monetary Policy in Uganda?

a) What is low and stable inflation (price stability)?

Price stability implies a condition where businesses and households are able to proceed with their decision making on the basis that the nominal and real values of goods and services remain substantially the same over the planning horizon. There is no explicit numerical value of price stability for Uganda, but an average annual core inflation of about 5 percent or less over the medium-term is targeted.

b) What are the benefits of price stability or low and stable inflation?

1)    Preserves the purchasing power of people’s money and savings
2)    Consumers and businesses are better able to make long-term plans and investment decisions ahead because they know that their money resources would not lose its purchasing power in the foreseeable future year after year.
3)    Interest rates, both in nominal and real terms, would be comparably lower, thereby encouraging investment and improved productivity as well as enabling businesses to prosper in the period of stable prices.
4)    It enables businesses and individuals not to overreact to short-term price pressures by seeking undue price and wage rises, assuming long-term stability prevails.

c) What are the demerits of high inflation?

1)   Inflation erodes the value of money, inducing fear that the agents future purchasing power will decline and erode their standard of living
2)    Inflation encourages investments that are speculative (rent seeking) rather than those that are viewed to be productive activities
3)    Businesses and households are inclined to spend more time, and money, protecting themselves from the effects of rising costs and prices. Businesses, workers, and investors respond to signs of inflation by pushing up prices, wages, and interest rates to protect themselves. This can lead to a 'vicious circle' of rising inflation
4)    Inflation can hurt those whose incomes do not keep pace with the rising level of prices, especially for salary and pension earners.
5)    Loss of business confidence due to uncertainty

3. What is Uganda’s Monetary Policy Framework and who is in charge?

Effective July 2011, the Bank of Uganda reformed the Monetary Policy Framework to an Inflation Targeting-lite to meet the challenges of macroeconomic management generated by the transformation of the economy over the last 10 years, and in particular the rapid growth and diversification of the financial system.
The reforms to the monetary policy framework are intended to strengthen implementation of Uganda’s medium term macroeconomic framework.
The new framework replaces the Reserve Money Program (RMP) that had guided the conduct of monetary policy in Uganda since 1993. The Reserve Money Program is quantity based, focusing on the growth of the Bank of Uganda’s balance sheet.
The Constitution of the Republic of Uganda (1995) and the Bank of Uganda Act of 1993 empower Bank of Uganda to formulate and implement monetary policy directed at the economic objectives of achieving and maintaining economic stability.

4. How does the Inflation Targeting Framework operate?

The primary policy objective of monetary policy remains unchanged: the control of core inflation over a medium term horizon. As part of the process of introducing an inflation targeting lite monetary policy framework, the Bank of Uganda will set an interest rate as the operating target of monetary policy, rather than base money that has hitherto been used. The interest rate will be called the Central Bank Rate (CBR) and will be used to guide the seven day interbank interest rates. The CBR will be set once a month and will be publicly announced, so that it clearly signals the stance of monetary policy during the month. The CBR will be set at a level which is consistent with moving core inflation towards the BOUs policy target of 5 percent over the medium term.

5. What is the Central Bank Rate (CBR)?

Central Bank Rate can be defined as a rate set independently by Bank of Uganda, depending on its forecast of future inflation and other economic variables, like estimate of growth of real economic activity, to influence lending behaviour of commercial banks so as to foster price stability and a sound financial system.

6. What is base money?

Base money comprises of the liabilities of the Bank of Uganda that support the expansion of money supply and credit. It consists of two items: reserve balances of commercial banks at the Central Bank and currency issued. Base money is also referred to as high-powered money or reserve money because of ability to create other forms of money through the money multiplier. Another name for base money is the 'monetary base'.

7. What is inflation?

Inflation is defined as a sustained increase in the general level of prices for goods and services. It is measured as a percentage increase in the price levels over two time periods. As inflation rises, every shilling you own tends to buy a smaller quantity of goods or services.

8. How does Monetary Policy affect the real economy?

The process through which monetary policy affects the prices and economic output is referred to as the transmission mechanism of monetary policy.
Understanding the transmission mechanism is crucial for monetary policy. A stable financial system creates a conducive environment that facilitates savings mobilisation and investment allocation, thereby, allowing for the growth of the economy as a whole.
The transmission mechanism is characterized by long, variable and uncertain time lags. Analytical work done in the Bank indicates that the impact of monetary policy on inflation persists for about six quarters and, the impact on the exchange rate is immediate but wanes after about eight quarters.

9. What is Bank of Uganda’s foreign exchange rate policy?

In line with a liberalised current and capital account of the balance of payments, Bank of Uganda pursues a flexible exchange rate policy regime. In this regime, the price of the shilling visa-vi the US dollar and other foreign currencies is determined by the market forces of demand and supply.
BOUs involvement in the foreign exchange market is limited to occasional interventions (purchase or sale of foreign currency) only to dampen excessive volatility in the exchange rate.
Stable exchange rate movements in either direction (appreciation or depreciation), enables the proper planning by all market players.