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 is a crucial part of the Homegrown Economic Reform Agenda (HGER) to address macroeconomic imbalances and support private sector-led growth.
The previous monetary targeting (MT) framework, which focused on managing the money supply, proved ineffective due to Ethiopia's unstable money demand relationship. The NBE shifted to a market-based interest rate framework in July 2024, using the overnight interbank lending rate as the operational target, complemented by open market operations (OMOs), a policy rate corridor, and liquidity forecasting.
Key transmission channels include the interest rate channel, expectations, credit channel, and exchange rate channel. While the first links in the transmission chain are developing, with interbank and Treasury bill rates rising above inflation, the strength of the credit and exchange rate channels remains uncertain.
Peer country experience suggests that building monetary transmission takes time and requires clarity, consistency, and predictability in the monetary policy framework. The NBE has taken steps in this direction by improving communication and establishing a Monetary Policy Committee (MPC).
To ensure effective transmission, further reforms are needed, including:
- Moving to a single operating target (the policy rate) and phasing out quantitative restrictions on lending.
- Strengthening analytical capacity for forward-looking policy, particularly in forecasting inflation and liquidity developments.
- Addressing structural features that weaken transmission, such as shallow money and bond markets, limited financial sector development, poor risk management and loan pricing, limited banking sector competition, and central bank fiscal financing.
Near-term priorities include developing a clear policy framework, moving to a single operating target, and strengthening analytical capacity. Enhancing the NBE's operational autonomy and supporting financial sector development will also be crucial for more effective and independent monetary policy in the long run.
