I. Recent Inflation in Ethiopia and Policy Responses1
1. Inflation in Ethiopia has been on the rise for nearly three years. Notwithstanding past policy measures to address the phenomenon, it reached about 40 percent in May 2008, far exceeding the authorities’ policy target of single-digit inflation.2 At this level, and similar to other countries, Ethiopia faces a significant risk of inflation escalating further as inflation expectations may become ingrained unless appropriate adjustment policies are implemented.
Consumer Price Index
2. Inflation has been attributed to several factors. The Ethiopian Development and Research Institute (EDRI, 2007) and FAO (2008) point out that both domestic and external factors account for the recent inflation, among them (i) increasing money supply; (ii) rising world commodity prices; (iii) continued good economic performance, (iv) housing shortages in urban areas; (v) changes in farmers’ behavior to supply products more uniformly over the year (improvements in access to credit, storage facilities, marketing information, etc.,); and (vi) increased local purchases by governmental food security institutions, agricultural cooperatives, and relief agencies.
3. While each of these factors—structural, external, and domestic—may be important, a debate on their relative contribution to recent inflation has emerged. In addition to these factors, once inflation has reached the level of 20–30 percent, the role of past inflation—which likely drives inflation expectation—also warrants attention.
4. This paper examines the causes of recent inflation and discusses possible policy responses. Section II provides an overview of recent inflation developments. Section III explores the factors contributing to recent inflation, based on recent studies and the review of recent monetary and external developments. Section IV lays out cross-country analysis with countries experiencing high inflation. Section V presents the main conclusions.
B. Recent Inflation Developments
5. Inflation in Ethiopia has reached a historical peak. Following a drought-related surge of food prices in 2003, it receded to single digits but soon turned back up in 2004 and gradually increased, reaching about 40 percent on a 12-month basis in May 2008.
6. Compared with previous periods, recent inflation has some unique characteristics:
- It has coincided with high economic growth. In the past, inflation was largely associated with supply shocks, such as conflicts or droughts. This pattern was particularly apparent for agricultural production and food prices. Thus, the recent surge in food prices despite good harvests is unusual.3 Some supply-side factors help explain this phenomenon4: (i) farmers have recently been equipped with better access to credit, storage facilities, marketing information and income, leading to better negotiation powers for higher prices, and (ii) the total supply of cereals has apparently not kept up with the increase in demand, also because some donors have switched from food to cash aid.
- In recent years inflation has been rising faster in Ethiopia than in its neighbors. On closer comparison with other countries, two different dynamics can be recognized (Appendix I). Recent inflation was initiated by sharp increases in nonfood prices in mid-2006, part of which reflected upward price adjustments in retail petroleum products and the construction boom in Addis Ababa. Though nonfood inflation subsided through 2007, food inflation has escalated, while in other countries price rises for non-food items have been lower.
- Nonfood inflation has also been on the rise. Previously, food prices drove inflation trends; nonfood prices were relatively stable. The recent increases in nonfood prices, partly reflecting the hikes in world nonfood commodity prices, especially oil, have contributed to overall inflation.5
Ethiopia: Real GDP and CPI (Total)
CPI in Ethiopia’s Neighboring Countries
C. Factors Contributing to Recent Inflation
7. This section examines possible factors contributing to recent inflation. The analysis shows that, at least to date, the role of external factors is relatively limited, although future upward adjustments of retail fuel prices would add some pressures on prices. By contrast, the role of money appears to be larger, following the rise in money growth since 2005. The monetary factor alone, however, cannot explain the recent food inflation. Here, structural factors play a role, including the convergence of prices of some exported agricultural products to international prices.
8. Two recent studies have attempted to empirically identify the relative importance of each factor contributing to inflation. Such exercises, however, face serious technical difficulties, due to the scarcity of data and frequent structural changes and external shocks. The studies took two different empirical approaches to address the structural breaks:
- Netsere (2007) estimated a structural vector auto regression model with two variables (real output and CPI) using annual data for three periods: 1965–98, 1965–2002, and 1965-2005. Comparing impulse responses and variance decompositions of output and prices to demand and supply shocks, he found that, when the sample included the most recent period, demand factors became important.
- Ayalew (2007) employed a general equilibrium model using annual data during 1970-2005. To account for structural and policy shifts during the estimation period, many dummy variables were used, including for market reform, rural transformation, price controls under the Derg. While acknowledging the drawbacks of excessive use of dummy variables, he found that supply shocks and the consumer prices of major trading partners were among the most important determinants of inflation in Ethiopia.
9. EDRI (2007) argues that past trends cannot be expected to explain current developments in light of on-going structural changes in the economy (Box 1). For instance, the import-to-GDP ratio has steadily increased since 1993, following the lifting of quantitative import restrictions under the Derg. Furthermore, there have been a number of structural changes during the period, including (i) the devaluation of exchange rate (1992),6 (ii) Substantial reduction in tariffs (through the 1990s),7 (iii) liberalization of most price regulations (toward mid–1990s).8 More recently, the unprecedented economic performance in recent years (with double-digit economic growth for four consecutive years) suggests that the economy is going through further structural changes.
Box 1:Implications of Possible Structural Changes in Recent Years
To explore the implications of possible structural changes in recent years, a basic inflation model is estimated using annual data for three periods: 1970–2001, 1970–2004, and 1970-2007. The initial model includes the two lags of inflation, money, income, and import price. Then, a parsimonious inflation model is derived using a general-to-specific model selection procedure.
The results indicate some structural changes after 2004. The estimated coefficients are generally stable for the two periods 1970–2001 and 1970–2004. For the period 1970–2007, however, there are some changes; money has a more important role for inflation, while GDP and import price coefficients decline. The coefficient for a lagged CPI is generally stable across the sample periods; past inflation is likely driving inflation expectations and has an increasingly larger impact when inflation is rising. Despite the recent increases in international commodity prices, import prices are less significant, possibly reflecting the administered retail petroleum prices.
|Δln Currency (t-1)||0.31||2.9||***||0.33||2.6||***||0.33||2.5||***|
|Δln Broad money||0.48||5.9||***||0.49||5.0||***||0.54||5.5||***|
|Δln Import price||0.11||2.2||**||0.12||1.9||*||0.09||1.4|
Inflation after 2002 and 2005 are estimated using the coefficients based on the samples of 1970-2001 and 1970-2004, respectively. The estimates are both far lower than actual inflation, which also suggest the existence of structural changes in recent years.
Estimated Errors of Annual Inflation
Estimates of the GDP coefficient need careful interpretation in light of recent developments. The coefficient is negative and statistically significant, reflecting repeated supply shocks in the past, but does not explain the coincidence of recent inflation with high growth. When including more recent data, it became slightly less negative, consistent with the idea of recent demand pressures diluting the past influences of supply effects.
Import to GDP Ratio
D. Recent External and Monetary Developments
10. External factors influence domestic prices through three channels: (i) the exchange rate, (ii) import and export prices, and (iii) changes in import volumes (supply). Among these channels, some pressures are recently emanating from the price adjustment of exportable agricultural products to international prices and the recent depreciation of the exchange rate. However, import prices—despite the recent surges in international food and petroleum prices—have played a relatively limited role to date.
- Exchange rate: It has long remained stable vis-à-vis the U.S. dollar, moving by less than 5 percent in the last five years. With the recent modest depreciation against the U.S. dollar, which, in turn, has weakened against other major currencies, Ethiopia’s nominal effective exchange rate has depreciated somewhat faster since mid–2007 (about 10 percent annually) than in other countries in the region (Appendix II). This may have put some upward pressures on prices of imported items since mid-2007 but had no significant impact before then. .
- International commodity price: EDRI (2007) suggests that recent increases in international commodity prices are contributing to nonfood inflation, as evidenced by the high correlation between nonfood CPI and world industrial commodity prices.9 Most prominently, large fluctuations in nonfood CPI for the last three years have been closely associated with changes in retail petroleum prices, although the fuel price controls have helped mitigate the impact of the hike in surging world oil prices (Box 2). There is, however, a clear upward trend of other nonfood items since early 2006, which suggests a role in domestic factors.
- Other than petroleum products, the impact of international commodity prices has been relatively small, in light of the limited size of their imports. Based on customs data, nonfuel commodities represent only about 5 percent of Ethiopia’s imports. Food prices were not strongly correlated with world food prices, at least until recently (Appendix III). This is attributed to the fact that Ethiopia’s domestic prices for food items have historically been well below world market prices. Therefore, imports of food items are very limited.10 From late 2007, however, there are some indications that local food prices may be converging to high (and rising) world prices as exports for some agricultural products, taking advantage of rising world prices, have been increasingly rapidly.11
- Changes in imports The rapid growth in imports in recent years—doubling the import share of GDP in the last ten years—should have expanded available supply and alleviated inflation pressures. Nevertheless, shifts in food imports may have dampened this effect, especially given the high weight of food in the CPI. For example, food imports were significantly reduced in 2006, following an increase by 160 percent in 2005, and stayed low compared with the average for the last five years.
Nonfood CPI and InternationalCommodity Prices
Estimated Noncommodity Nonfood CPI
Box 2:Retail Oil Prices
Retail prices of petroleum products are regulated in Ethiopia. Although they were adjusted in mid-2006, early 2007, and early 2008, they are increasingly isolated from world prices. Price controls may have helped mitigate the impact of the hike in surging world oil prices on domestic prices, but at the cost of increases in implicit subsidies.
Non-Food CPI and Retail Gasoline Prices
Retail Gasoline Price and World Oil Price
11. In recent years, broad money growth has accelerated, mainly driven by domestic credit to the public sectors. In the past, money growth remained typically at around 10 percent. Since 2005, however, money growth has soared, reflecting, above all, demand for credit from the public sector (Box 3). Significant increases in NBE advances to government in 2005–2006 pushed up currency in circulation and enabled high growth in public credit without crowding out private sector, which also played an important role until recently (Appendix IV). Relatively loose monetary conditions were evident from the existence of excess reserves in the banking system for a prolonged period.12
Contribution to Broad Money Growth
Contribution to Net Dometic Credit Growth
12. In addition to the high money growth, inflation expectations are likely becoming ingrained, as evidenced in the recent rising trend of money velocity. In this context, Section II (“Income Velocity of Money in Ethiopia”) argues that inflation not only reduced the transaction demand for money, but, more importantly, it eroded the credibility of using money as a store of value. Because the real interest rate on deposit accounts was becoming increasingly negative, people have been switching to consumption or alternative investments to protect their wealth, which, in turn, is adding further pressures on prices. In view of further escalation of inflation in recent months, Ethiopia would likely be exposed to a risk of inflation expectations becoming ingrained unless appropriate policy measures are implemented swiftly.
E. Experiences in Other Countries
13. This section provides an overview of inflation experiences in other developing countries and policy responses, focusing on the periods of two years after inflation reached 20 percent. Among 152 developing countries, about 50 countries have experienced high inflation, above 20 percent, in the last fifteen years (Appendix V). According to Fischer et al. (2002), their experience shows that as inflation reached high levels, the probability increases that inflation continues to go up as inflationary expectations begin to build. With this in mind, the following looks at how countries responded to inflation rates of 20–40 percent.13
- Most countries tightened their fiscal stance for a period of two years after reaching inflation rates of 20–40 percent, through reducing the fiscal deficits by 0–5 percent of GDP. Most of these countries achieved lower inflation. Some countries experienced an increase of their fiscal imbalances, with several of them experiencing much higher inflation.
Fiscal Tightening and Changes in Iinflation
Note 1: Fiscal tightening is measured by the difference in fiscal balances in terms of GDP between time t (when inflation reached 20–40 percent) and time t+2 (after two years).
Note 2: Changes in inflation are measured by the difference in a 12-month inflation between the two periods; t and t+2.
Box 3.Public Sector Borrowing
To examine the role of the public sector in recent inflation, public sector borrowing is estimated based on annual changes in credit outstanding to the public sector from the NBE and commercial banks. According to this estimate, domestic public sector borrowing is highly correlated with inflation, likely reflecting the dominant role of the sector in the economy. While this fact alone would not rule out other factors causing inflation, it does suggest that public sector imbalances have played a significant role in Ethiopia’s price developments.
For much of the past few decades, public enterprise borrowing from commercial banks was low, possibly because they were financed through other sources, including the government. In recent years, however, public enterprises have borrowed substantially from commercial banks.
During previous disinflation periods (late 1980s and mid 1990s), inflation was lowered by 8–18 percentage points, following the reduction of the public sector borrowing by 1½–4½ percent of GDP. This is broadly equivalent with empirical results from cross-country analysis.14
Public Sector Borrowing and Inflation
Public Sector Borrowing
The nature of spending by government and public enterprises would need to be examined further to assess its impact on prices. For example, if credit is used for capital spending with a high import content, higher borrowing should put more pressures on international reserves, rather than domestic prices. If, however, more resources are spent on recurrent outlays (including nontradables), inflation pressures may heighten.
- There is a clear correlation between monetary tightening and lower inflation. Those countries which lowered money growth achieved low inflation. Some countries experienced significantly higher money growth, and all of them faced even higher inflation within the following two years.
Monetary Tightening and Changes in Iinflation
Note 1: Monetary tightening is measured by the difference in broad money growth per annum between time t (when inflation reached 20–40 percent) and time t+2 (after two years).
Note 2: Changes in inflation are measured by the difference in a 12–month inflation between the two periods; t and t+2.
- Decisive disinflation tends to lead to a quick rebound in growth. Countries that were experiencing low growth and high inflation tended to experience higher growth when they reduced inflation. For other cases, growth was either unaffected or reduced somewhat, but there is no indication that the impact of anti-inflation policies on growth was strong. However, countries which failed to reduce inflation tended to see lower growth after some time.
Changes in Real Growth and Inflation
Note 1: Changes in real growth are measured by the difference in a GDP growth between time t (when inflation reached 20–40 percent) and time t+2 (two years after).
Note 2: Changes in inflation is measured by the difference in a 12–month inflation between the two periods; t and t+2.
- For most countries, the exchange rate was not explicitly used to anchor domestic prices. The nominal exchange rate was allowed to depreciate significantly, and may even allow depreciation in real terms. However, the pace of depreciation slowed down significantly for most countries two years after inflation reached 20–40 percent, which often reinforce the move to lower inflation.15
Changes in Effective Exchange Rates
Note 1: REER is measured at the end of year t+1 assuming the rate =100 at the end of year t-1.
Note 2: NEER is measured at the end of year t+1 assuming the rate =100 at the end of year t-1.
Changes in Pace of Nominal Depreciation and Inflation
Note 1: Changes in nominal depreciation are measured by the difference in annual changes (in percent) in NEER between time t (when inflation reached 20-40 percent) and time t+2 (two years after).
Note 2: Changes in inflation is measured by the difference in a 12-month inflation (in percent) between the two periods; t and t+2.
14. Ethiopia’s recent rise of inflation is unusual because it does not coincide, as in the past, with a negative supply shock but, instead, high growth. While Ethiopia has often been affected by domestic supply shocks, it has rarely experienced high inflation driven by demand factors.
15. Both domestic and external factors explain recent inflation. While estimating the precise impact of each factor is technically difficult, given data constraints and continuing structural changes, inflation rates in excess of those experienced by trading partners and in the region point to some Ethiopia-specific factors.
16. High money and credit growth in recent years has likely played a key role in increasing demand and prices. More recently, inflation expectations seem to play an increasing role as prices are steadily accelerating. By contrast, the prices of imported goods have played a limited role as (i) the bulk of Ethiopia’s imports are manufactured and intermediate goods, whose prices in world markets have increased only modestly; (ii) the share of imported commodities (for which world prices accelerated in recent years) is small; and (iii) the impact of rising oil prices has been mitigated through lags in adjusting domestic retail prices.
17. The prices of exportable agricultural products have played a significant role in driving up domestic prices of some food items as they have been converging to higher (and rising) world prices. This process is in principle desirable as it raises incomes of rural households through trade of their outputs, and price rises stemming from it should come to an end when international prices are reached. However, policy-makers need to pay careful attention if prices for these products begin to exceed their international level as this would indicate that domestic factors push prices beyond their competitive levels.
18. International experience suggests that, as soon as inflationary expectations begin to emerge, a significant tightening of macroeconomic policies is essential. In doing this, a proper policy mix between fiscal and monetary policies is key to avoid crowding out the private sector and affecting long-term growth potential.
Food CPI in Ethiopia’s Neighboring Countries
Nonfood CPI in Ethiopia’s Neighboring Countries
Nominal Exchange Rate
Nominal Effective Exchange Rate in the Region
Share of Commodity Imports
Food CPI and International Commodity Prices
1. International coffee price index, including other mild arabicas and robusta
1. International cereals price Index, including wheat, maize (Corn), rice, and barley
Oils and Fats
1. International vegetable oil index, including soybean, soybean meal, soybean oil, coconut oil, palm oil, sunflower oil, olive oil, fishmeal, and groundnut price indices
1. International meat price index, including beef, lamb, swine (pork), and poultry price indices
Currency in Circulation
Government Domestic Debt
Excess Reserves of Commercial Banks
|(Year of time t)||T-1||T||T+1||T+2|
|Afghanistan, I.R. of||2003||5.1||24.1||13.2||12.3|
|Central African Rep.||1994||(2.9)||24.5||19.2||3.7|
|China, P.R.: Mainland||1994||14.7||24.1||17.1||8.3|
|Iran, I.R. of||1999||18.1||20.1||12.6||11.4|
|Lao People’s Dem. Rep||1997||19.1||19.5||90.1||128.4|
|Serbia, Republic of||1998||18.3||30.0||41.1||70.0|
|Venezuela, Rep. Bol.||1993||31.4||38.1||60.8||59.9|
Ayalew, Yohhanes,2007, “Explaining the Current Sources of Inflation in Ethiopia”, The National Bank of Ethiopia.
Ethiopian Development Research Institute, 2007, “Determinants of Inflation in Ethiopia”, EDRI.
FAO Special Report, “Integrating the Crop and Food Supply and the Emergency Food Security Assessments”, March2008, FAO/WFP Crop and Food Security Assessment Mission to Ethiopia, http://www.fao.org/docrep/010/ah883e/ah883e00.htm
Fischer, Stanley, RatnaSahay and CarlosA,2002. “Modern Hyper-and High Inflations”, IMF Working Papers 02/197, International Monetary Fund.
Netsere, Muche,2007, “Macro Policies, Output and Inflation in Ethiopia”, The Resident Representative Office of the International Monetary Fund, Unpublished.
The main contributor to this chapter is Jiro Honda.
These efforts include tripling of minimum reserve requirements on commercial bank deposits from 5 to 15 percent and increases in the minimum time and saving deposit rate.
As the Ethiopian Development Research Institute (EDRI) points out, “What makes recent food price developments puzzling is that the food inflation surge is accompanied by four years of successive bumper harvests and unprecedented economic growth.”
See also IMF (2007) and EDRI (2007).
Retail fuel prices have been administered; adjustments were made in May and August 2006, January 2007, and January 2008.
Maximum tariffs were reduced from 230 percent under the Derg to 35 percent by 2003; average tariffs were reduced from 41.6 percent in mid–1990s to 17.5 percent.
Most price regulations were liberalized toward mid–1990s; only petroleum prices remain regulated.
Prices of industrial commodity inputs, including some agricultural raw materials and metals.
Import data include food aid at international prices. Food aid is not sold commercially in Ethiopia, so it has no impact on domestic prices.
For instance, the local price of oilseeds is increasingly correlated to international prices.
In late 2004, bank reserves exceeded the required level by 35 percent. Since then, excess reserves have been gradually reduced through (i) more use of treasury bills to finance the fiscal deficit; (ii) increases in reserve requirements (July 2007 and April 2008); and (iii) increases in commercial bank credit to the private sector. As a result, excess reserves have fallen below 10 percent, close to the minimum by historical standards.
Those which had experienced high inflation in early 1990s but already trended down inflation were excluded from the sample (e.g., some CIS countries).
Fischer et al. (2002), using fixed effects in panel of 94 developing countries, estimate that, for high inflation countries, a 1 percentage point improvement (deterioration) in the ratio of the fiscal balance-to-GDP typically leads to a 4.2 percent decline (rise) in inflation, all else constant.