Just about three weeks ago, the IMF issued a press release to announce the conclusion of the fifth review of Ethiopia’s four-year economic stabilization program, agreed upon by the IMF staff and the Ethiopian authorities. The release mostly contained the usual stuff – praising authorities’ efforts to execute the program, highlighting downside risks, and making some recommendations. But there was one real head-scratcher among the latter. Namely, the IMF urged the authorities to maintain “a tight monetary policy stance to anchor inflation expectations.” It turns out that anchoring inflation expectations using monetary policy in the existing economy is, well, an inflated expectation which cannot be met. And there emerges a microcosm of the IMF’s general reluctance to tailor its policy advice to the realities on the ground in recipient countries.
To those readers who may be less versed on the issue, expectations of future inflation are a key determinant of actual inflation today, since they affect current spending and price setting behavior. Moreover, they take center stage in the transmission of monetary policy through the real economy. In fact, many of the transmission mechanisms depend on them. And so, in central bankers’ shop talk, inflation expectations are said to be “anchored” when the public has been accustomed to expect low inflation, being largely indifferent to temporary fluctuations. They lose their anchor when the public has grown accustomed to anticipate chronic inflation, the latter getting embedded in the economy.
And there are different ways of evaluating expected inflation. One way is to approximate it from what is happening to those goods- and services-prices that are less volatile in nature. Another alternative is to consult what financial markets have to say. Yet another, more direct method is to conduct surveys of consumers and businesses (e.g., purchasing managers) on how much inflation they expect in the short to medium term.
Now, the common worry of policymakers is that if inflation stays high for a lengthy period, it may get entrenched in public expectations, ushering in a cycle of rising prices, whose stopping probably requires a sustained economic downturn. So modern monetary authorities, in particular, consider stabilizing or “managing” expectations as an important task. Critical to this end, however, is the behavior of monetary policy. In particular, system, credibility, transparency, and effective communication in central bank policy actions/plans are considered as decisive factors. The degree of development of financial and economic systems also matters.
Given these, what does the situation of inflation expectations in Ethiopia look like? The relevance of expectations is undeniable. In fact, it is not unreasonable for one to worry that fear of high future inflation has gotten entrenched in private-sector expectations. For our troubling inflation has lasted for so long even while being juxtaposed with high unemployment. There have been anecdotes, too, about some domestic businesses raising their prices and workers demanding higher wages anticipating increased cost/price pressures. Yet expectations have been glaringly missing from inflation discourse among media pundits, economic commentators and public officials alike.
However, it is one thing to be cognizant of a problem and another to be able to do something about it. And the Ethiopian monetary authority encounters numerous obstructions as it sets about influencing expectations. The first one arises from the central bank itself. That’s to say, the National Bank of Ethiopia (NBE) does not have a longstanding acquaintance with timely, systematic, and well-articulated policymaking. In fact, until very recently, monetary policymaking in Ethiopia has been shrouded in secrecy, while exhibiting defective monetary policy framework, weak commitment to fight inflation and the NBE’s subservience to the Treasury (not to mention its politicized pasts). But an established track record as successful and sufficiently independent central bank is a sine qua non for guiding expectations.
Headwinds are not confined to the NBE, though. Monetary policy never functions in a vacuum, but rather within given financial, institutional and economic structures. And Ethiopia has long been characterized by underdeveloped financial system, inferior quality of institutions, relatively large size of the informal financial sector, and primary goods-inclined production structure. As a result, the link between monetary policy tools and either economic activity or price level has been somewhere between loose and nonexistent, forestalling monetary transmission. And this fact alone makes anchoring expectations a nonstarter.
Most of the general public, too, perceives the NBE just as regulator of commercial banks at best, or as a bank with the large vault to store cash at worst, and therefore does not really understand how monetary policy responds to economic conditions. Thus it would be too ambitious a task to shape the public’s policy and inflation expectations today.
Leaving aside for a moment the aforesaid constraints on the conduct of monetary policy, how would the IMF know whether inflation expectations are anchored or unanchored when there is little hard data to begin with? (Incidentally, it would be great if institutions like the Ethiopian Economics Association and the Policy Studies Institute fill the gap by regularly conducting surveys on expectations and publishing the results, so that any interested party can know the true extent and duration of the problem.) Trying to produce a change in a latent variable is akin to shooting at a hidden enemy combatant in a war. Neither hits nor misses make sense.
To be sure, the authorities have already started taking measures to enhance the relevance of monetary policy to ultimate economic outcomes. For instance, the NBE has revised its monetary policy framework, setting price stability as a primary policy goal. And monetary policy committee meetings and proposals are now being publicized. The government is also taking various steps to reform the financial industry, expand the formal sector, and bring about structural change in the economy. But until such efforts come to full fruition and at least a fairly predictable relationship is empirically established between central bank tools and economic growth/inflation, it remains extremely difficult for the NBE to be legitimately credited for low inflation (or indeed be blamed for high inflation), let alone correlated with (un)anchored expectations.
Of course, the IMF of all institutions should know all this. After all, it is a place where some of the most rigorous empirical analyses on economic issues are performed. So why its staff team finds it fitting to dispense a policy prescription that has little chance of yielding the desired result is anyone’s guess. But whatever one’s explanation, making a public statement that will not survive contact with reality risks calling into question the whole policy advice.
For the truth is that anchoring inflation expectations is at the pinnacle of central banking. I mean, if the NBE were already in that stage, it would not need the kinds of reforms it is undertaking today. The ability to guide expectations is rather something the central bank must continually strive to acquire in the future. And what will the IMF’s superfluous recommendation add to this endeavor? If anything, by giving a wrong impression of the development stage the economy is at, it can potentially distract the policymakers from focusing on laying the required groundwork (including developing the NBE as a truly technocratic institution it is supposed to be).
In short, the IMF’s counsel notwithstanding, at this stage of our monetary, financial and economic development, we can tighten monetary policy as much as we like, but anchoring expectations remains nothing more than pie in the sky.
