Frequently asked questions (FAQs) about the conduct of monetary policy in Uganda 1. What is Monetary Policy? Monetary policy is one of the tools that Governments use to achieve macroeconomic stability. By using the monetary policy to regulate the quantity of money, governments attempt to influence the overall price level and economic activity in accordance with the overall Macro-economic Policy Framework for the nation. This goal coined as "macroeconomic stability" - low unemployment, low and stable inflation, high economic growth, and balance of payments viability - is usually administered by the country’s Finance ministry. Almost all central banks assume the responsibility of maintaining low and stable inflation and stability in the financial sector. The contemporary central banking dates back to the aftermath of economic depression of the 1930s, when governments, inspired by the economic thinking of John Maynard Keynes, realized that increased money supply and excess credit availability significantly led to the economic depression. The realization that money supply affected economic activity prompted governments to attempt to influence money supply through monetary policy. This led to the creation of central banks to establish monetary authority, in order to influence the amount of money in circulation. This would in turn influence credit creation and the overall level of economic activity. In this regard, the Bank of Uganda (BOU)’s mandate is to regulate the amount of money and credit in the domestic economy in order to influence price stability and the overall level of macroeconomic stability. In addition, the Bank of Uganda also ensures that it maintains the purchasing power of the Uganda shilling and its comparative worth to other foreign currencies. The above can only be achieved in a well developed and functioning financial sector. This work might sound easy, but it is a complex task, especially in this era of economic liberalization and globalization. 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 a target of an average annual core inflation of about 5 percent or less is set by the Ministry of Finance, Planning and economic development (MFPED). b) What are the benefits of Price stability or low and stable inflation?  Preserves the purchasing power of people’s money and savings Research Department; November 2009 Page 1  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.  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.  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 costs of High inflation?  Inflation erodes the value of money, inducing fear that the agents’ future purchasing power will decline and erode their standard of living.  Inflation encourages investments that are speculative (rent seeking) rather than those that are viewed to be productive activities.  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.  Inflation can hurt those whose incomes do not keep pace with the rising level of prices, especially for salary and pension earners.  Loss of business confidence due to uncertainty 3. What is Uganda’s Monetary Policy Framework and who is in charge? Since 1993, the Reserve Money Program (RMP) has guided the conduct of monetary policy in Uganda. The Reserve Money Program is quantity based, focusing on the growth of the central bank’s balance sheet. The Constitution of the Republic of Uganda (1995) and the Bank of Uganda’s Act of 1993 empower the Bank of Uganda to formulate and implement monetary policy directed at the economic objectives of achieving and maintaining economic stability. Before 1988, the financial sector was highly regulated. The government controlled all categories of credit, interest rates and exchange rate policy. Since then, key reforms have been implemented:  All interest rates and exchange rates were fully liberalized, meaning that these rates are now fully determined by the market forces of demand and supply (The government no longer fixes interest and exchange rates). Also it allows financial institutions freedom to manage their balance sheets.  The BOU adopted indirect-market based monetary policy, shifting away from direct monetary control.  The government divested its interest in the banking system. Research Department; November 2009 Page 2  The financial sector’s legal and regulatory frameworks were improved based on international best practice (Basel standards).  The Constitution of the Republic of Uganda assigned the responsibility for monetary policy formulation to the BOU.  Legal framework reformed, with the passing of the new BOU Act, the Financial Institutions Act, the Micro-deposit taking institutions Act (MDI), and other enabling laws and regulations.  Current and capital accounts of the balance of payments were fully liberalized in 1993 and 1997, respectively. This meant that both Ugandans and non-residents could engage in transactions of goods, income, services and capital with the rest of the world without any restrictions.  BOU attained operational independence through the 1995 constitution Article 162(2) which in part states that “In performing its functions, the BOU shall conform to the Constitution, but shall not be subject to the direction or control of any person or authority”. Overall, the reform measures have led to significant improvements in the efficiency of resource allocation, which in turn has stimulated economic growth. 4. How does the Bank of Uganda influence the amount of money in circulation to be able to meet the target on inflation? Bank of Uganda uses the RMP as an operating framework in order to influence the supply of money in the economy. The Bank of Uganda uses the following instruments to implement monetary policy:  Open market operations,  Reserve requirements,  Foreign exchange operations for liquidity sterilization and market stabilization, and  Standing Facilities Open market operations involve the issuing and/or redeeming of Government securities such as treasury bills and treasury bonds in the primary market in order to decrease or increase money supply. That is to say, if the Bank of Uganda issues bonds and/or bills in amounts larger than the maturities, the effect would be to decrease money supply, while the opposite is true if it were to redeem bonds and/or bills. Open market operations is the most widely used instrument in the regulation of money supply due to its ease of use and the relatively smooth interface it has with the economy as a whole. Reserve requirements are set as a percentage of commercial banks' total deposit liabilities that are kept as deposits at the Bank of Uganda. Though rarely used, this percentage may be changed by the Central Bank at any time, thereby affecting the money supply and credit conditions. That is to say, if the reserve requirement were increased (reduced), the effect would be to reduce (increase) money supply by Research Department; November 2009 Page 3 requiring a larger (smaller) percentage of the banks’ deposits to be held by the Bank of Uganda. The reserve requirement currently stands at 9.5 percent. Foreign exchange operations for liquidity sterilization: Since April 2002, the Bank of Uganda began selling on a daily basis, small and steady amounts of foreign exchange to sterilize excess liquidity. The use of this instrument was aimed at reducing pressures on domestic interest rates. Standing Facilities take two forms: Rediscount and borrowing windows, to enable commercial banks meet their short-term liquidity shortages. At the Rediscount window, commercial banks have the option of selling back to the Bank of Uganda securities with less than 91 days to maturity in exchange for cash. The borrowing Window is where commercial banks are able to access short-term credit from the Bank of Uganda at the Bank Rate. The Bank Rate is usually set at 1% above the rediscount rate, as per the BOU Act of 1993. The Rediscount Rate is set at a margin above the average of the 91-day Treasury bill rates from the most recent three Treasury bill auctions. 5. What are the recent modifications in the implementation of the Reserve money program? Although the monetary policy framework continues to comprise a quantitative target for reserve money and an intermediate target for broad money, the Bank of Uganda recently revised the operating procedures for monetary policy. The revisions included de-linking structural liquidity management (based on regular primary securities auctions and regular daily sales of foreign exchange) from daily liquidity management (implemented through repos and reverse-repos). The aim of this change was threefold; a) to dampen volatility in the interbank rates which hitherto frequently characterized the money markets; b) to allow the targets for reserve money to be adjusted to accommodate any unanticipated shocks to money demand; and c) to review the stance of monetary policy by taking into account, the recent macroeconomic developments and outlook. The introduction of this flexible reserve money program is intended to be a step towards the eventual adoption of a fully fledged inflation targeting monetary policy framework. 6. 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 condusive environment that facilitates savings’ mobilization 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 Research Department; November 2009 Page 4 inflation persists for about six quarters and, the impact on the exchange rate is immediate but wanes after about eight quarters. 7. How is the impact of Monetary Policy monitored? Monitoring of the impact of monetary policy is done to ensure that the Bank of Uganda is achieving the overall macroeconomic stability objectives. It involves obtaining information on a regular basis on the evolution and forecasts of a wide array of variables, including inflation, interest rates, exchange rates, monetary and credit aggregates, real GDP, and fiscal operations. Such information and feedback on monetary policy performance is received through the numerous surveys carried out by Uganda Bureau of Statistics (UBOS) and other agencies. In addition, the BOU conducts regular data collection exercises and surveys such as the quarterly Business confidence index survey, the Private foreign capitals survey, the Bi-annual Bank lending survey, the Domestic resource costs and Index of agricultural production survey. There are also primary sources of data like the financial institutions that are required by law to regularly report to the Bank of Uganda. Monitoring allows for reviews in the projections and revisions to incorporate new developments and for making new assumptions. 8. What are the current challenges to monetary policy and response? The recent two years were very challenging for macroeconomic management in Uganda. The Ugandan economy was hit by successive external shocks. The very steep rise in international fuel and food prices, which had begun in the second half of 2007 and peaked in mid 2008, drove up inflation to double digits in Uganda, as it did elsewhere in the world. Shortly after international commodity prices peaked, the financial crisis in the advanced economies drove the world economy into the most severe recession for more than 50 years. The global recession affected the Ugandan economy mainly through the balance of payments. The Bank’s primary policy goal remains price and financial sector stability. Monetary policy therefore shall remain focused on reducing core inflation towards its long term target of 5 percent in support of long-term output growth. The Ugandan economy has already proved remarkably resilient in the face of the global economic crisis, demonstrating both its underlying strength and the importance of the country’s macroeconomic policy framework which has ensured macroeconomic stability. For example, Uganda’s flexible exchange rate policy played a vital role in enabling the economy to adjust to the large external shock it faced, while the international reserves built up since the 1990s provided a large buffer of resources to support the balance of payments 9. What is BOU’s foreign exchange rate policy? Research Department; November 2009 Page 5 In line with a liberalized 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. BOU’s 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. 10. How can the Public judge Bank of Uganda’s performance? The objective of monetary policy is “price stability in form of low and stable inflation, and stability in both domestic and foreign exchange markets. The annual core inflation target is set by the government and announced during the budget speech pronouncements by the Minister of finance, planning and economic development. The current medium to long-term target is five percent. Therefore, the public can congratulate BOU on a job well done if the Annual core inflation rate is about 5 percent, the exchange and interest rates are stable; and the banking sector is profitable, savings’ mobilization and credit extension is good and there are no or few bad loans. During the period 1993/94 to 2007/08, inflation was kept at an average of about 5.5 percent and this facilitated robust economic performance for the country. Uganda’s real economic growth averaged about 8 percent during that period. 11. What is Base money (Reserve money/High powered money/Monetary base)? 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. Other name of base money is “the monetary base”. 12. What is Broad money? Broad money consists of claims of the general public on the financial system as a whole. They include: currency in circulation and deposits of the non-bank public held with Commercial banks. The distinction of various monetary aggregates is meant to capture the degree of liquidity. The various categories of broad money are: M1 = currency in circulation + Private sector’s Demand deposits. M2 = currency in circulation + Private sector’s Demand deposits + Private sector’s Time and savings deposits or (M1 + Private sector’s time and savings deposits). M3 = currency in circulation + Private sector’s Demand deposits + Private sector’s Time and savings deposits + Private sector’s Foreign currency deposit or (M2 + Private sector’s foreign currency deposits). Research Department; November 2009 Page 6 13. 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. The value of a shilling is observed in terms of purchasing power, which are the real, tangible goods that money can buy. When inflation rises, there is a decline in the purchasing power of money. For example, if the Annual inflation rate is 30%, then theoretically a Sh. 100 pack of pancakes a year ago costs Shs. 130 now. It is thus that BOU’s desire is to keep inflation at low single digit levels to ensure that every shilling owned, maintains its purchasing power over a longer period of time. This is meant to encourage savings mobilization and investment, which are critical ingredients for robust economic growth and poverty reduction. 14. What are the various categories of inflation?    15. Deflation is when the general level of prices is falling. This is the opposite of inflation. Hyperinflation is unusually rapid inflation. In extreme cases, this can lead to the breakdown of a nation's monetary system. Stagflation is the combination of high unemployment and economic stagnation with inflation. This happened in industrialized countries during the 1970s, when a bad economy was combined with raising oil prices. How is inflation measured in Uganda? In Uganda, inflation is measured by the annual and monthly percentage changes in Consumer Price Index (CPI), based on a basket of goods and services consumed at the household. The CPI is compiled by the Uganda Bureau of Statistics (UBOS) on a monthly basis from the eight selected centers of Kampala high income, Kampala low and middle income, Jinja, Mbale, Masaka, Mbarara, Gulu and Arua. Uganda’s Consumer Price Index is computed and published on a monthly basis. The reference date of the index is the 15th day of each month. This means that any price change after the 15th is reflected in the CPI of the following month. The current base year or reference period of the index is the 2005/06 financial year (July 2005 to June 2006) = 100. This implies that the fixed basket of goods and services used to monitor inflation refer to the consumption habits of Ugandans as observed during the period July 2005 to June 2006. Research Department; November 2009 Page 7  Headline inflation is the percentage change of the weighted composite price index of all selected goods and services.  Core inflation is the Headline inflation excluding prices of food crops (whose seasonality tends to distort prices) and EFU  Food crops’ inflation includes only prices of food crops, like staple foods, and fruits and vegetables.  Energy, Fuel and Utilities (EFU) Inflation includes only prices of electricity, fuel including firewood, and utilities like water whose prices are either exogenously or administratively determined and could bring about sharp changes in prices. 16. How is the CPI (Inflation) data used?  Monitoring Price stability and the performance of the economy by indicating changes in inflation and its trends.  CPI could also be used to Index salaries, wages and contracts in both government and the private sector. This is however not done currently in Uganda.  The CPI can also be used to calculate changes in the purchasing power of money. A common use of the CPI is to determine the amount of money that would be needed at the present time to have the same purchasing power as a nominal amount that was promised or received in the past.  Sometimes the CPI may be referred to in an agreement or contract so that the sum of money under consideration is automatically adjusted each month by changes in the CPI. Such an instruction would be referred to as an “escalation clause”.  Deflating time series values. When the CPI is used as a deflator, the aim is to alter a series of money values, so that the effect of price changes over the period is eliminated or adjusted for. Deflated values are referred to as “constant prices values”. For instance, the CPI is used in the computation of the GDP deflator applied to arrive at GDP at constant prices from GDP at current prices. Research Department; November 2009 Page 8