Ethiopia has struggled with high inflation over the past decade despite price stability being a key objective of the National Bank of Ethiopia (NBE). The transition to an interest-rate based monetary framework, part of the Homegrown Economic Reform Agenda (HGER), aims to address this issue. The shift away from the previous monetary targeting (MT) framework, which proved ineffective due to unstable money demand relationships, marks a significant change. The new framework, implemented in July 2024, uses market-based interest rates and includes open market operations (OMOs), a policy rate corridor, and improved liquidity forecasting. The overnight interbank lending rate is set as the operational target, with a fixed-rate full-allotment operational framework chosen for its appropriateness given Ethiopia's developing financial markets and institutional capacity.
Effective monetary transmission is crucial for the success of the new framework. Key transmission channels include the interest rate channel, expectations, credit channel, and exchange rate channel. However, transmission mechanisms tend to be weaker in low-income countries like Ethiopia due to shallow financial markets and evolving monetary frameworks. Since the new framework's implementation, interbank and Treasury bill rates have risen above inflation, indicating development in the first links of the transmission chain. However, the strength of the exchange rate channel remains uncertain due to ongoing exchange rate reforms and inflation uncertainties.
The experience of peer countries provides valuable lessons for Ethiopia. Clarity, consistency, and predictability in the monetary policy framework are essential. The NBE has taken steps in this direction by improving communication, such as publishing Monetary Policy Committee (MPC) statements. Ensuring credible and consistent implementation requires progress in three core areas: effective monetary policy instruments, operational autonomy and a sound financial position, and analytical capacity for forward-looking policy. Addressing structural features that weaken transmission is also important, including shallow money and bond markets, limited financial sector development, risk management and loan pricing issues, banking sector competition, capital mobility and exchange rate adjustment, and central bank fiscal financing.
Near-term priorities include developing a clear policy framework, moving to a single operating target (the policy rate), and strengthening analytical capacity. Strengthening the NBE's operational autonomy and supporting its independence are also key. Complementary efforts to develop money and bond markets, expand financial inclusion, and implement regulations aimed at reducing financial repression will help address structural weaknesses. Over time, these reforms will lay the foundation for more effective and independent monetary policy in Ethiopia.
