Escalation of cost of living is a policy choice

Central Bank of Kenya offices in Nairobi.

Central Bank of Kenya headquarters in Nairobi. Since central banks have no say over drought and oil prices, they focus on exchange rates and control of the money supply, their main tool being interest rates.

Photo credit: Pool I Nation Media Group

With populations restive in many countries over the escalating cost of living, monetary authorities in the region are hoping that the bitter pill of high-interest rates works faster in taming inflation.

Price stability is one of the key aims of all central banks. It seems reasonable, therefore, to target a low and stable inflation rate over time. In the lingo of economists — inflation targeting. The US Fed and most central banks in the West aim for two per cent. But get this; the target itself is rather arbitrary! 

Inflation targeting was first introduced in New Zealand in 1989. Parliament enacted the Reserve Bank Act, 1989, to shield the central bank from political processes. The act required the finance minister and head of the central bank to arrive at a formal inflation target, leaving the bank to achieve it. 

But what would the target be? Zero per cent? Three per cent? What escalation in the cost of living would be acceptable? A chance remark settled it. The finance minister, pressed in a TV interview, stated that he aimed for zero to one per cent inflation. And so, it became one per cent, which they stated as a range, zero to two per cent, to give themselves some flexibility. 

Announcing the goal, and with the central bank now independent to pursue it, made it a reality. Labour unions and businesses started using two per cent as the inflation in their wage negotiations and price increase decisions. 

Within a year, New Zealand’s inflation had fallen from 7.6 per cent to two per cent and a new economic gospel had been born. It soon became popular with most countries, thanks to convention and New Zealand’s quick success. 

Flexible margin

So, what is happening in our neighbourhood? Set annually by the Treasury CS, Kenya’s target for this financial year is “five per cent with a flexible margin of 2.5 per cent on either side in the event of adverse events”.

The target is five per cent in Uganda, 5.4 per cent for mainland Tanzania, and seven per cent in DRC. The general convention is for the treasury to set it, and for central banks to control the money supply (I should say set monetary policy, to sound learned!) to achieve those targets.

As can be expected, the actual inflation rates vary across countries. In January, inflation was 4.9 per cent in Tanzania, nine per cent in Kenya and 10.4 per cent in Uganda. Drought, oil prices, exchange depreciation and the amount of money people have to spend can all cause inflation.

I think we can safely discount the last one in our case. But drought and war in Ukraine have driven food prices up. As a net importer, a weakening shilling has made things worse. CBK’s indicative rate is Sh127 to the US dollar, but you will be lucky to buy it for less than Sh137.

Since central banks have no say over drought and oil prices, they focus on exchange rates and control of the money supply, their main tool being interest rates. But there are many other ideas governments are pursuing. India, for instance, has hiked interest rates, reduced exercise tax on petroleum, reduced import duties on critical raw materials, removed duty on sunflower imports and capped sugar and wheat exports.

@NdirituMuriithi is an economist


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