After a regular Monetary Policy Committee meeting in July 2026, the National Bank of Ethiopia (NBE) issued a press release to announce its “successful transition” from money-focused to interest rate-based monetary policy regime – Action Plan #1 in its Strategic Plan for 2023-26. “Full implementation” of indirect monetary instruments was also declared. And as this means retiring direct control via credit policy, the credit ceiling imposed on commercial banks since August 2023 in an attempt to reduce inflationary pressures was lifted. But since the NBE wanted to retain a tight policy stance and “restore inflation to single-digit levels over the medium term,” it raised its target for the policy rate, aka the national bank rate, by 100 basis points from 15 to 16% – notwithstanding the question mark over whether this rate was initially set to be consistent with inflation and growth goals. Nonetheless, while the policy regime change is undoubtedly historic, important questions are left unsettled, especially that of whether monetary policy shocks can now percolate quickly and effectively throughout the financial system and the economy.
First of all, what exactly is the NBE’s new operational framework? The short-term interest rate in the interbank money market is the NBE’s operating target. In other words, the so-called national bank rate is just a target for the interbank rate. And having exited its habitual accommodative policy stance, the central bank has now adopted a corridor-type system for conducting monetary policy. To this end, the NBE has set up standing lending (discount) and deposit facilities. And so, it stands ready to lend overnight any amount banks want at 300 basis points above the announced target policy rate, while it is willing to hold their deposits of excess reserves at 300 basis points below the said target. Then the implied penalty-and-incentive mechanism, combined with banks’ rational behavior, is expected – or rather hoped – to stabilize the average, overnight interbank rate near its target set in the middle of the “corridor” formed by the two standing facilities. If not, the NBE would adjust the supply of reserves primarily through market operations so as to steer the interbank rate toward the chosen target.
As is well known, there are pros and cons of a corridor operational system. The potential benefits include enabling the NBE to set overnight, interbank interest rates irrespective of the demand for reserves and encouraging tight liquidity management on the part of banks as well as greater interbank market activity. But the newly adopted system has two important disadvantages. First, because a match between the NBE’s supply of reserves and a demand that becomes increasingly volatile and difficult to predict with expansion of nonbank finance and electronic/digital payment systems is unlikely, the interbank rate is bound to fluctuate around its target, probably requiring more frequent market operations. Second, a corridor system – in which central banks create a “structural shortage” of bank reserves to a level where the target policy rate clears the overnight interbank market (thus eliminating the excess reserves that rendered our interbank market inactive during the monetary targeting regime) – raises the risk of intermittent liquidity shortages in the banking system, which may obstruct monetary transmission.
Additionally, whether the NBE has chosen an optimal width for the interest rate corridor is up for debate. Major central banks have traditionally had a corridor 200 basis points wide. By contrast, the NBE has preferred a much wider corridor with 600 basis points. Clearly, this allows too large a deviation from the target overnight policy rate, meaning less precise implementation of a desired monetary policy stance.
Turning to the announced shift from direct to indirect policy instruments, which should be used with a view to achieving the NBE’s operational target, it naturally follows a move to implement a basic interbank money market free from interest rate controls, an organized securities exchange, and regular open market operations. However, what constitutes an indirect instrument is sometimes in the eye of the beholder, and the NBE’s take is as yet unknown. For example, does the NBE envisage it to comprise statutory liquid asset requirements of commercial banks? If it does, and that were to force banks to hold more Treasury bills as part of their liquid asset holdings, what we would get in effect is not a monetary instrument but rather a selective credit instrument that is used to channel credit to the government, distorting the pattern of credit allocation and determination of interest rates.
In addition, a transition from direct to indirect control of monetary policy is supposed to denote increased reliance on market forces, and away from directives. And whether the NBE can and will indeed rely on market-based indirect instruments, rather than on statutory indirect instruments (such as reserve requirements), is an open question. The scope for conventional open market operations remains limited until there is a sufficiently deep secondary market. Still, the NBE can and does, in fact, conduct “open market-type operations” in the primary market, using an auction system. But what is expected here under a corridor system is that the NBE sells more or less government securities (Treasury bills) than those maturing so as to effect the liquidity provision change necessary to hit the target interest rate. The practical question is: Can the NBE realistically set the volume of government-bill sales and determine the allocation of proceeds based solely on monetary criteria when the federal government, weighing in with its deficit financing needs, actually has a constitutional right to “formulate and execute” monetary policy?
So it is important to acknowledge that, until markets are fully developed, statutory measures might indeed be required to absorb or inject liquidity and thereby achieve monetary control. But in that case the NBE should stay away from pretence or equivocation, and instead provide a transparent explanation.
Speaking of which, the NBE has announced that it will implement extra, selective reserve requirements based on individual banks’ loan-to-deposit ratio. But nobody knows when and how this will be administered. And banks are understandably hysterical at the prospect of applying this tool as it may require substantial portfolio adjustments for them. The stated trigger clause “in case credit expansion poses pressure on inflation path” is too vague and open-ended to stimulate confidence in the instrument. Beyond this, non-interest-bearing reserve requirements are known to increase banks’ effective cost of funds, and the required reserve ratio is currently high at 10%. If the NBE is really intending to raise them further, it should surely consider remunerating them, or they will have distortive effects à la direct controls, and even more so when applied unequally.
Most importantly, perhaps, the idea that the NBE can tweak the money supply and interest rates by varying reserve requirements across banks is far-fetched. So why create a gratuitous liquidity management problem for banks, against the very advantage of a corridor-style framework, which is strengthening banks’ liquidity management? In fact, tinkering and trial-and-error fiddling with reserve requirements can also inflame interest rate volatility in the interbank market.
Ultimately, of course, the effectiveness of the NBE’s interest rate policy and its instruments will be measured by the strength and speed of the transmission of monetary policy to economic activity and inflation. And the medium-term prospects here are bleak. First, there is little chance that setting a target for the NBE’s policy rate affects interest rates “throughout” the economy. Even at a conceptual level, the transmission of policy rates to bank rates under a corridor system is far from assured. The transmission to interbank and loan rates can be weak when the interbank market is not very efficient. And our banks have typically been unconcerned about the policy rate while setting their lending rates. As for the transmission to bank deposit rates, it may well depend on banks’ liquidity positions. But the average savings-deposit rate remains stuck at around 8%, in a way reminiscent of collusion in the banking industry. Add in the fact that the real deposit rate is almost always negative, and the link with financial savings is effectively broken.
Let us suppose for the sake of argument that the NBE really does manage to hit the target interest rate and thereby affect the availability and cost of credit within the banking sector. The pass-through to the volume of bank lending is still uncertain, not least because it depends on banks’ own risk appetite. And the pass-through of borrowing costs onto aggregate demand is even more uncertain, partly because our consumption spending is less credit-dependent and thus less interest rate-sensitive. For example, few of our households take out mortgage, car or credit card loans. As far as business is concerned, a percentage point rise in bank lending rate is highly unlikely to restrain a largely interest-unresponsive credit demand from the private sector, which has become accustomed to borrowing at a staggering average rate of 15.8% and even much higher in effective terms. Besides, other asset price channels for monetary policy effects such as foreign exchange and equities (stocks) are not yet active.
In short, even though the NBE has raised its target policy rate from 15 to 16% in a supposedly counterbalancing act, expecting disinflation through weaker demand for goods and services, and thereby increased unemployment, is patently unrealistic. This, in turn, means that if and when disinflation occurs (I mean, no inflation lasts forever, right?), there will be non-monetary factors to take most of the credit.
So the moral of this story is that the NBE’s maiden corridor operational framework, for all its symbolism of modernity, will not be substantively relevant to the real economy for years at best. For the truth is that the employed corridor system means less precise control over the interbank interest rate, and robust or widespread transmission of the signals provided by changes in the target policy rate requires many years of financial, economic and institutional transformation.
But make no mistake: nobody can really begrudge the NBE revising its policy framework in the right direction and developing its institutional standing – because it needs it for the day when, at long last, monetary policy really matters for ultimate economic outcomes.
