So the National Bank of Ethiopia has got a new – in a way, a not-so-new – governor: Prime Minister Abiy Ahmed (PhD) has appointed Eyob Tekalign (PhD), formerly State Minister of Finance, as a successor to Mamo E. Mihretu. One can debate about the merits and demerits of this appointment, but what is certain is that the new governor has a fairly full in-tray. The NBE’s Strategic Plan for 2023-26 and the ongoing IMF-financed reform program will presumably be on the top of his agenda but they are not the only pressing issues. In fact, his unenviable and potentially thankless task is to adopt optimal and potent monetary policy at a time when the economic state does not give clear guidance. On the one hand, we have mass unemployment; on the other, high inflation. This creates a policy dilemma for any central banker: Should monetary policy be tightened to fight inflation or loosened to fight unemployment?
The answer turns out to depend on two things: the NBE’s mandate and its evaluation of the severity of the two problems. And it is now proclaimed that the NBE’s mandated mission is first and foremost the pursuit of price stability. This, however, does not imply that it can or should ignore employment objectives. As to how bad unemployment and inflation truly are, there is no doubt that both are unacceptably high, notwithstanding disagreements on specific estimates.
The Ethiopian economy appears to have been stuck with excessive unemployment, despite registering generally solid growth rates for over two decades. Granted, monitoring developments in our labor market is tricky for many reasons. One reason is that our society is predominantly agrarian and 45% of the workforce is employed in the informal sector; another is lack of sufficiently detailed and high-frequency data. Still, the Ethiopian Economics Association calculations show that about one-fifth of the labor force is unemployed in urban areas, where the formal sector claims 75% of jobs. In rural areas, where 60% of jobs are informal, disguised unemployment is prevalent.
Note, however, that overall unemployment rate, measuring the number of people being out of work and looking, does not tell the whole story. For example, not only do we have demand-deficient unemployment, but long-term unemployment, especially the number of prime-working-age people not in the labor force (neither working, nor actively seeking jobs), is observationally quite high. This is not surprising since extended periods without jobs cause more unemployed people to become alienated from the labor market.
The second part of the double blow – and one that has received a lot of attention in the news media over the last few years – is inflation. The annual inflation rate averaged 15% in the final thirteen years of the EPRDF regime and more than 24% in the last seven years. This is most plausibly explained by a combination of domestic factors and external shocks. Incidentally, some have put forward the narrative that the cause is “man-made” and thus the price hikes are unacceptable. Huh? Since when is inflation supposed to be caused by natural factors? Sophisticated though it may sound, the claim that the inflation surge is entirely a monetary phenomenon also does not hold water. Anyway, the official reading shows that inflation slowed rapidly in the last fiscal year. But this seems greatly at odds with what we see in everyday life. Even if inflation actually slowed, renewed cost-push inflation might be in the pipeline due to an inflationary fiscal action (phasing out fuel and other subsidies, levying new taxes like a VAT on fuel, etc.). Besides, what is the point of even hitting the single-digit inflation goal if the public continues to be preoccupied with a price surge?
Even more worrying from the NBE’s standpoint – and what is missing or ignored in inflation discourse far too often – is the serious danger that inflation has stayed high long enough to have become entrenched in public expectations. If so, the inflation process gets self-perpetuating. Yet our central bank cannot even accurately measure inflation expectations, let alone anchor them.
Clearly then, both unemployment and inflation are matters of great concern, with their well-known socio-economic and political costs. But the NBE can’t have its cake and eat it. At any one time, monetary policy action is designed to tackle one of the problems by risking invigoration of the other. It aims to effect a change initially in aggregate demand and output, which often means in employment, and then in the price level. So there are tradeoffs: monetary tightening is likely to involve job losses at least in the short term, and it can leave a permanent scar on the economy by increasing long-term unemployment. And it can get worse. The modern view on the unemployment-inflation tradeoff is that it depends on how hot the economy is running. This means that, in the Ethiopian economy that is most probably operating well below capacity, tight money would need to impose a costly loss of employment by contracting aggregate demand before achieving acceptable level of inflation, other things equal. It is also a good guess that the tradeoff has further tilted against us due to a rise in expected inflation.
This being the case, at this juncture the NBE is pursuing an anti-inflation policy, and has announced its intention to do so until single-digit inflation goal is achieved. Credibility issues notwithstanding, the central bank has indeed imposed a lending cap on commercial banks since August 2023. To be sure, the NBE has good reason to be trying to tame inflation, not least because of the palpable public discontent over the rising cost of living. Still, unemployment is an equally major worry, and actions meant to bring inflation down could only worsen it. Furthermore, there are scholars who point out that the economic harm from unemployment is measurably higher than that from inflation. So can the NBE tell whether the cost of more unemployment is worth the benefits of reduced inflation?
Suppose instead that the central bank is actually afraid of unemployment and thus decides to accommodate the inflationary pressure through a higher money growth. In that case there could be less unemployment but prices could also rise even more. Furthermore, if the central bank develops the habit of accommodating, an inflationary bias may take root in the economy. Alas, this policy decision too cannot be made free of risks.
But of course, making a policy choice is one thing; producing the desired outcomes is another. The NBE in fact faces a more basic, yet serious problem than balancing unemployment and inflation risks – namely, it lacks tools that can meaningfully and predictably affect real economic variables. The Ethiopian monetary policy has long been hobbled by weak transmission mechanisms (for reasons that we need not belabor here). Yes, if the policy could affect domestic credit, it is at least arguable that it could also affect output and price level. The trouble in practice is that there is no systematic link between the NBE’s primary policy indicator – the national bank rate (NBR), adopted in July 2024 – and the goal variables.
How, after all, is the interest rate-based policy supposed to work? First, changes in the NBR would alter real short- and longer-term rates, such as mortgage rates, thereby affecting housing construction, business investment and consumer durable spending. But no such transmission process exists in our economy. Second, the policy rate would also affect the foreign exchange value of the birr and thus exports. Here again, the link between the first two variables is virtually absent thanks to Ethiopia’s capital controls and exchange-rate policy; that between the last two variables is weakened by the exchange rate-unresponsive nature of the foreign prices of our main exports and by the sluggish response of export supply. Under these conditions, expecting the interest rate-based monetary policy regime to deliver price stability is like expecting a blindfolded man to ferry you across the river. In short, direct or statutory monetary controls remain the monetary authority’s best hope for influencing the level of economic activity.
Now here arises an interesting question: How much substance is there to the claim that the NBE has caused disinflation in the last fiscal year? Well, as noted above, adoption of tight monetary stance is necessary but not sufficient for containing inflation. Unless substantiated by visible slowdown in the economy and, with it, a rise in unemployment, that claim remains nothing more than speculative. This should not be misinterpreted to mean that output-inflation tradeoffs are eternal, however. To the NBE, the tradeoffs may be relevant only in the course of implementing the IMF-backed reforms. But even in the applicable time period, it is not too difficult to imagine a scenario in which our economy can make its escape from the harsh medicine. For example, improved productivity and aggregate supply may come to the rescue – except the credit belongs not to demand management policies, but rather in the supply side of the economy (e.g. spending on public infrastructure, relaxation in supply-chain constraints).
One last point: It is widely believed that independence of a central bank is of great importance when dealing with policy dilemmas, weighing the risks and assessing the public’s real interests. And while the NBE is recognized by the reformed NBE Proclamation as an “autonomous institution,” it does report to the Prime Minister. More to the point, the final arbiter on monetary policy is the Board of Directors, composed entirely of members appointed by the premier. But this should not be surprising: the current constitution – the supreme law of the land – grants the federal government statutory authority over the NBE as well as monetary policy. Needless to say, there is much room for the NBE to become an independent, technocratic institution.
To sum up, the Ethiopian economy is experiencing the twin problems of inflation and unemployment. And if the NBE walks the talk on its single-digit inflation objective and pursues a vigorous anti-inflation policy, the policy could inflict substantial unemployment. But this probably does not matter very much. For our economy is not blessed with powerful transmission mechanisms of monetary policy anyway. Even if it were, the supply side of it may render the NBE’s restrictive actions irrelevant tradeoff-wise.
So for now, keeping the economy on an even keel is too ambitious a task for the NBE. And this has more to do with the nature of our economy than with the central bank.
Matias Assefa is an Economic and Business Analyst based in Addis Ababa. He can be reached at matias.assefa@gmail.com
