The Consequences of Imported Inflation on the Effectiveness of the Monetary Policy of the Bank of Central African States
By Dr. Jean Cédric Kouam (Download pdf version here)
The Consequences of Imported Inflation on the Effectiveness of the Monetary Policy of the Bank of Central African States
The countries of the Economic and Monetary Community of Central Africa (CEMAC) are all small, open economies. As such, they can only have a negligible impact on international markets, in particular on the global interest rate. They are also price takers and, therefore, cannot influence the general level of commodity prices by changing the number of products traded. By way of illustration, these countries, although they sell their oil internationally, are not in a position to move energy prices on the world markets.
This situation is not without consequences for economic growth and sustainable and inclusive development in these countries, which have remained highly dependent on international aid since independence. In addition, rising prices on international markets have direct repercussions on local prices, mainly due to the extroverted nature of these economies. This imported local inflation has profound implications for the definition and conduct of economic policy.
According to CentralCharts, imported inflation is defined as the general and sustained rise in prices due to an increase in the costs of imported products. This rise in prices concerns, in particular, the prices of raw materials and of all products or services purchased by companies abroad. Because of its long-lasting nature, this form of inflation poses enormous difficulties for the monetary authorities, whose task it is to ensure price stability. Controlling imported inflation is now a major concern for central banks but also a key factor in analyzing and assessing the contribution of monetary policy to strengthening the resilience of open economies to external shocks.
This article proposes to the monetary authorities of the CEMAC some measures to be taken to effectively counter the effects of imported inflation in the sub-region. It is structured into three main sections.
Section 1 identifies the transmission channels of imported inflation in CEMAC. Section 2 presents the impact of imported inflation on the effectiveness of the monetary policy. Section 3 highlights some measures that can be adopted by the monetary authorities in CEMAC to mitigate the effects of imported inflation on the economies of member states.
The Transmission Channels of Imported Inflation in the CEMAC
Since February 2022, inflation in the CEMAC zone has been at historic levels, well above the community threshold of 3%, which is defined by the criteria for multilateral surveillance by member countries. According to BEAC estimates, in September 2022, inflation will continue to rise, reaching 5.2% in December 2022 and peaking at 5.7% in March 2023. This inflationary pressure is explained in particular by the war in Ukraine, the intensity and duration of which is causing numerous disruptions in international supply circuits, with the unprecedented consequences of soaring world food prices and the depreciation of the euro against the US dollar.
As Russia and Ukraine are major world producers of wheat, oil, gas, etc., the drop in exports from these countries has led to a drop in world supply. At unchanged world demand, the drop in the supply of these raw materials, the rise in the cost of industrial and agricultural inputs, and the disruption of international supply chains inevitably cause import prices to rise. Moreover, as the CFA franc is anchored to the euro, the depreciation of the euro against the dollar increases the price of imported manufactured goods, which reinforces the effect of imported inflation.
As wages are not indexed to inflation in the CEMAC, this results in a decline in the purchasing power of consumers, particularly those in households with very low wages. Indeed, as production costs increase, companies pass on the rise in relative prices to the selling prices of the goods or services produced. Given the low average per capita income in CEMAC, the room for maneuver available to monetary authorities to counter rising prices remains limited. Bikai et al. (2016) show that about 6% of price fluctuations in CEMAC are due to foreign price increases (imported inflation).
The high extraversion of the CEMAC economies and the structural balance of payments deficit of the member states are, therefore, key determinants of imported inflation in CEMAC. As member countries are net oil exporters, any increase in the price of oil on international markets has a significant impact on local prices. Kenkouo (2015) shows that a 10% increase in oil prices would cause long-run inflation in CEMAC of between 1.5 and 4 percentage points, depending on the country.
Indeed, the increase in oil prices has a positive impact on member states’ budgets and the level of public expenditure. The massive public investments undertaken by the latter are likely to negatively affect aggregate demand, with the direct consequence of a fall in the production of consumer goods and a rise in the general price level. Due to the structure of the economies, imported inflation in the CEMAC is a major challenge, the magnitude, and duration of which are likely to lead to significant changes in the definition and conduct of monetary policy.
BEAC’s Response to the Persistent Imported Inflation in CEMAC
Monetary policy refers to all decisions and actions taken by the monetary authorities to regulate the quantity of money in circulation in the economy. In the CEMAC, it is defined and implemented by the Bank of Central African States (BEAC), the joint issuing institution of the six CEMAC states (Cameroon, Congo, Gabon, Chad, CAR, and Equatorial Guinea). According to Article 1 of its statutes, the ultimate objective of the BEAC’s monetary policy is to guarantee monetary stability, ensuring a low inflation rate and an adequate currency coverage rate (the minimum threshold is 20%). To achieve this, the BEAC closely monitors price developments and intervenes mainly when they exceed the Community threshold of 3% allowed by the multilateral surveillance criteria.
However, it is not enough just to intervene; the decisions that are taken should also be conducive to the recovery of economic activity and price stabilization. To assess the risks to monetary stability and decide on an action, the BEAC generally opts for a pragmatic approach based on the analysis of the evolution of monetary aggregates, the international economic environment, and the supply and demand conditions on the goods and factor markets. The question is whether the decisions taken are appropriate to strengthen the resilience of economies to the various economic shocks they face, notably imported inflation.
The export restriction measures taken by some countries to compensate for the slowdown in production during COVID-19 on the one hand and the Russian invasion of Ukraine (the consequence of which is a surge in the price of raw materials and agricultural inputs such as fertilizers on the international market, the explosion in the cost of maritime freight and the rise in the world price of crude oil) on the other has caused the price of goods and services in CEMAC to skyrocket over the past few months.
According to BEAC estimates, the year-on-year imported inflation rate in CEMAC stood at 5.1% in June 2022, compared with 2.2% three months earlier and -0.2% a year earlier (BEAC, 2022). Given the current global situation, there is no doubt that the average level of inflation in the sub-region will remain above 3% for several months.
To counter this general rise in prices, the monetary policy committee at its session on September 26, 2022, decided for the second consecutive time in two quarters to raise the interest rate on tenders (TIAO), the main tool available to the BEAC to influence the granting of credit to commercial banks, from 4% to 4.5%. Furthermore, the marginal lending facility rate, which is the cost at which the central bank provides liquidity to commercial banks for a period not exceeding 24 hours, was increased from 5.75% to 6.25%.
By adopting such measures, the monetary authorities are making it more expensive for commercial banks to refinance with the central bank. The purpose of this tightening of monetary conditions is to increase the cost of bank credit in order to restrict access to it by economic agents.
Unfortunately, this decision is not sufficient to counter the rise in prices in the sub-region, particularly because of the excess liquidity of commercial banks on the one hand and the low rate of bank penetration among economic agents on the other. These two factors seriously complicate the effectiveness of monetary policy and require the central bank to take appropriate measures if it is to achieve its objective of price stabilization.
Policy Proposals to Effectively Address Imported Inflation in the CEMAC
The effects of imported inflation in the CEMAC can only be countered by strengthening the effectiveness of monetary policy transmission channels. The BEAC’s monetary policy committee, since the beginning of the COVID-19 pandemic, has certainly made coherent decisions to stabilize prices in the sub-region, but these are not always adapted to the structural characteristics of the different countries. It would therefore be unwise to follow the world’s other central banks in tightening monetary conditions without first ensuring that this decision is in line with the economic realities of the states.
In this context, taking measures to curb the excess liquidity of commercial banks would have the merit of improving the rate of banking and strengthening the effectiveness of monetary policy transmission channels (interest rate channel, credit channel, price channel, etc.). This is a prerequisite today for monetary policy to play an effective role in economic stabilization. The central bank should refocus on finding mechanisms that would allow commercial banks to be more rational.
This approach relies on coordinated monetary and fiscal measures to encourage commercial banks to extend more credit to the economy and to strengthen the institutional and judicial framework so that it is capable of resolving contractual disputes between commercial banks and customers who default on their debts (Kauffmann, 2005).
In the shorter term, the implementation of a certain number of financial instruments (public guarantee funds, credit against stocks, factoring) are instruments to be considered in order to reassure commercial banks on their perception of the risk linked to the financing of investment projects (Lucotte, 2013).
The issuance of Treasury bills is also proving to be an effective way of recycling some of the excess bank liquidity while allowing governments to limit recourse to external debt. All these measures inevitably require better coordination between national fiscal policies and the common monetary policy.
BEAC’s decision to raise interest rates to combat inflation is more likely to be detrimental to economic activity. Commercial banks in various countries are mostly unresponsive to the decisions taken, even though they are consistent with the current economic situation. This is due to the fact that commercial banks are mostly over-liquid, the transmission channels for monetary policy are practically inoperative, and the rate of bank penetration is still very low.
Any monetary policy measure aimed at countering the effects of imported inflation, whether in the short or long term, is fundamentally based on coordinated action between the monetary and fiscal authorities to encourage credit institutions to use their idle cash reserves to finance bankable investment projects.
Such a decision has the merit of improving the rate of bancarization, making the transmission channels of monetary policy a little more operational, and reinforcing the effectiveness of the decisions taken by the monetary policy committee of the central bank to stabilize prices.