Ethiopia has transitioned from a monetary targeting (MT) framework to an interest-rate based monetary framework to improve policy effectiveness and achieve price stability. The MT framework, which focused on managing the money supply, proved ineffective due to Ethiopia's unstable money demand relationship. The new framework, initiated in July 2024, uses market-based interest rates and key instruments like open market operations (OMOs) and a policy rate corridor to guide monetary conditions.
The transition faces challenges, including weak transmission channels, shallow financial markets, and structural issues. Key transmission channels—interest rate, expectations, credit, and exchange rate—are generally weaker in low-income countries like Ethiopia. While the interest rate channel is the most effective, its strength in Ethiopia is limited due to low private credit and financial repression. The exchange rate channel remains relevant but is uncertain following recent exchange rate reforms.
To strengthen transmission, Ethiopia needs to:
- Enhance communication and consistency in policy framework, as seen in peer countries like Uganda and Tanzania.
- Improve monetary policy instruments, including establishing a transparent, market-based reference rate.
- Strengthen central bank autonomy and financial position, as in Uzbekistan and Rwanda.
- Boost analytical capacity for forward-looking policy, using tools like the Forecasting and Policy Analysis System (FPAS).
- Address structural features: deepen money and bond markets, expand financial inclusion, improve risk management and loan pricing, enhance banking sector competition, allow greater exchange rate flexibility, and eliminate policy-based lending.
Ethiopia's transition will take time, but continued reforms and learning from peer country experiences will enhance monetary policy effectiveness and support price stability.
