## sipea2025106

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---

### Overview and context
- Reviews Ethiopia’s transition to an interest-rate based monetary framework and the need for a functioning monetary transmission mechanism to make the framework effective.
- Modernizing the monetary policy framework is a key part of the Homegrown Economic Reform Agenda (HGER), launched in 2020, aiming to correct macroeconomic imbalances and support private sector led growth.
- Prior to July 2024, the NBE operated under a monetary targeting (MT) framework using reserve money as an operational target; MT proved problematic because money demand relationships (money multiplier and velocity) shifted over time.
- In July 2024, the NBE began using market-based interest rates to guide monetary conditions, shifting to an interest rate–based framework supported by OMOs, a policy rate corridor, and liquidity forecasting improvements.

### Inflation performance and recent developments
- Inflation has been persistently high compared with regional economies and has exceeded double digits since 2018.
- Both monetary and fiscal policy have been tightened to gradually reduce, and in FY2024/25 eliminate, the use of direct NBE advances to finance the budget.
- Since the new framework was put in place, interbank and Treasury bill rates have risen above inflation; Treasury bill yields also exceeded the policy rate and inflation.
- Some banks increased lending rates in March 2025, identified as the first sign of transmission through the bank lending channel.

### Operational features of the new framework
- Key operational changes introduced:
  - Full allotment liquidity absorbing open market operations (OMOs).
  - Standing lending and deposit facilities to form a policy corridor at ±300 basis points.
  - Overnight interbank lending rate set as the operational target.
  - Launch of a new interbank market (October) to support liquidity management.
  - Improvements to the T-bill market and introduction of an Emergency Liquidity Assistance framework.
  - Commitment to phase out quantitative restrictions on lending, including caps on private credit growth.
  - Launch of a Central Securities Depository (CSD) and move to fully dematerialize government securities.
- Rationale: fixed-rate full-allotment framework is robust to changes in banks’ demands for excess reserves and does not require short-term forecasts of autonomous factors.

### Monetary transmission channels and assessment for Ethiopia
- Interest rate channel:
  - Changes in policy rate transmit to interbank, T-bill, deposit, and lending rates, influencing opportunity costs of lending/saving and aggregate demand.
  - In Ethiopia, this channel is likely weak due to low private credit base and history of financial repression.
- Expectations channel:
  - Policy stance influences inflation expectations and price-setting behavior; anchoring expectations is critical as central bank credibility builds.
- Credit channel:
  - Policy affects aggregate credit via banks’ cost of funding and firms’ collateral values; less relevant in Ethiopia because banks do not borrow from capital markets and private borrowing options are limited.
- Exchange rate channel:
  - Despite a closed capital account, the exchange rate channel can operate via exchange rate expectations, price-setting, and the parallel market.
- General assessment:
  - Transmission in LICs tends to be weaker, more volatile, and less predictable where financial markets are shallow and institutional capacity is limited.

### Structural constraints that weaken transmission
- Shallow money and bond markets:
  - Need to develop a collateralized repo market, encourage interbank trading beyond overnight and 1-week maturities, and foster a yield curve.
  - Peer examples: Kenya, Uganda, Rwanda.
- Limited financial sector development:
  - Low and declining private sector lending reduces interest elasticity of consumption/investment.
  - Central bank can support market infrastructure, financial literacy, and access.
- Risk management and loan pricing:
  - Poor loan quality and practices like evergreening distort lending decisions.
  - NBE is updating asset classification and provisioning rules and aligning capital and regulatory standards with Basel II/III and IFRS.
- Banking sector competition:
  - Limited competition and dominance of some banks can weaken responsiveness of deposit and lending rates.
  - Reforms include ensuring state-owned banks operate commercially with explicit public service obligations where needed.
- Capital mobility and exchange rate adjustment:
  - Limited capital mobility and FX intervention can dampen exchange rate channel; greater exchange rate flexibility and smoother FX market functioning would strengthen transmission.
- Central bank fiscal financing/policy-based lending:
  - Monetary financing dilutes policy signals; NBE has eliminated monetary financing of fiscal deficits and is developing market-based debt issuance.
  - Publishing predictable government financing plans is essential.

### Institutional and analytical foundations needed
- Central bank independence:
  - End to NBE direct advances; NBE Proclamation; NBE internal organization changes; establishment of the Monetary Policy Committee (MPC).
- Clear commitment to price stability:
  - NBE mandate enhanced to prioritize price stability; exchange rate reform; strengthened communication policy.
- Strong financial sector:
  - Gradual reduction in financial repression (phasing out mandatory purchases of T-bonds, ensuring better functioning Treasury bill markets).
- Technical capacity:
  - Ongoing technical assistance (e.g., FPAS, liquidity forecasting) to develop inflation and liquidity forecasting.
- Effective implementation requires:
  - Effective monetary policy instruments (transparent market-based reference rate and OMOs).
  - Operational autonomy and a sound financial position for the central bank to maintain credibility.
  - Analytical capacity for forward-looking policy, including improving data compilation and quality to distinguish temporary supply shocks (drought, floods, food price volatility) from persistent inflationary pressures.

### Peer country experience and lessons
- Building monetary transmission is a multi-year process and often begins from a more advanced market-determined interest rate base.
- Communication improvements:
  - NBE has begun publishing MPC statements to enhance transparency, drawing on regional peers.
- Credible and consistent implementation across instrument use, operational targets, and communication has been critical in peer successes.
- Examples of peer reforms:
  - Strengthening central bank capital, institutionalizing FPAS, and conducting FX market diagnostics to limit FX interventions to preventing disorderly adjustments.
- Operational choice highlighted:
  - Starting with a wide policy corridor and narrowing it gradually provides flexibility and avoids frequent rate adjustments that could complicate communication of policy stance.

### Near-term priorities and policy recommendations (Going forward)
- Continue to develop a clear, well-communicated policy framework.
- Move to a single operating target (the policy rate), including phasing out the cap on private credit.
- Strengthen analytical capacity for policy making (FPAS and higher-frequency indicators).
- Strengthen the National Bank of Ethiopia’s (NBE) operational autonomy by:
  - Strengthening NBE’s financial position.
  - Further efforts to support NBE independence (e.g., appointing Board members in accordance with the reformed law).
- Complementary reforms to support transmission:
  - Develop money and bond markets.
  - Expand financial inclusion.
  - Implement financial regulations aimed at reducing financial repression and ensuring a market-oriented financial sector.
- Expected outcome:
  - Over time, these reforms will lay the foundation for more effective and independent monetary policy, though strengthening the monetary transmission mechanism will take time.

### Structural reform actions and technical measures (Going forward)
- Money and bond markets:
  - Improve primary market practices.
  - Issue benchmark bonds to support pricing and liquidity.
  - Diversify the investor base.
  - Strengthen legal framework to support repo transactions with greater certainty.
- Financial sector development:
  - Increase private credit and deepen the financial system.
  - Source charts indicate Private Credit to GDP 2024, Ethiopia vs SSA Peers with axis labels 0, 5, 10, 15, 20, 25, 30, 35 (percent GDP).
  - Total Deposits and Credit 2009/10-23/24 shown with axis labels 0, 5, 10, 15, 20, 25, 30, 35 (percent of GDP) for Total Deposits and Total Credit.
- Banking sector concentration and policy-based lending:
  - Reduce state-bank dominance and policy lending; examples from peers show similar measures support transmission.
- Exchange rate flexibility:
  - Allowing more exchange rate flexibility cited as important for managing passthrough to inflation where passthrough is high.

### Select peer-country transition experiences and transmission status
- Kenya:
  - Moved away from a monetary aggregate targeting framework in 2008.
  - Forward-looking inflation targeting framework using the policy rate (central bank rate).
  - Transmission: Weak but improving with removal of interest rate controls and introduction/narrowing of interest rate corridor (IMF, 2024a).
- Rwanda:
  - Announced transition to an interest-rate based framework as of 2019; policy rate and interest rate corridor introduced in 2008 and 2012, respectively.
  - Medium-term inflation target of 5 percent with an inflation target band of +/- 3 percent.
  - Operational target: keep interbank rate close to policy rate.
  - Transmission: Improved through the interest rate corridor but remains limited in the exchange rate channel (IMF, 2023a).
- Tanzania:
  - Formally adopted interest-rate based policy framework in January 2024, after a gradual transition.
  - Medium-term inflation target of 5 percent.
  - Operational target: keep the 7-day cash rate within a ±200 bps corridor with the policy rate.
  - Pre-transition study found evidence of active transmission particularly via overnight interbank and T-bill rates (IMF, 2023b).
- Uganda:
  - Shifted to an inflation targeting regime in 2011.
  - Policy rate set in response to deviations of the medium-term forecast from the target.
  - Study over 2011–23 found transmission to lending rates only in the long run, with stronger transmission through T-bill and exchange rate channels (IMF, 2024b).
- Uzbekistan:
  - Transition to inflation targeting began in January 2020 with an inflation target of 5 percent and the policy rate as key instrument.
  - Operational objective: ensure short-term overnight rates remain close to policy rate (within interest rate corridor).
  - Transmission: constrained with limited changes to bank lending and deposit rates but improving as reforms have progressed (Al Rasasi and Cabezon, 2022).

*Source: sipea2025106 - 1. Inflation versus Sub-Saharan African Peers, June 2016–February 2025; 14. Going forward, advancing modernization of the monetary policy framework will help*

### 1. Inflation versus Sub-Saharan African Peers, June 2016–February 2025 _________________ 2

### 1. Inflation versus Sub-Saharan African Peers, June 2016–February 2025

### Overview and context
- The Selected Issues Paper reviews Ethiopia’s transition to an interest-rate based monetary framework and the need for a functioning monetary transmission mechanism to make the framework effective.
- Modernizing the monetary policy framework is a key part of the Homegrown Economic Reform Agenda (HGER), launched in 2020, aiming to correct macroeconomic imbalances and support private sector led growth.
- Prior to July 2024, the NBE operated under a monetary targeting (MT) framework using reserve money as an operational target; MT proved problematic because money demand relationships (money multiplier and velocity) shifted over time.
- In July 2024, the NBE began using market-based interest rates to guide monetary conditions, shifting to an interest rate–based framework supported by OMOs, a policy rate corridor, and liquidity forecasting improvements.

### Inflation performance and recent developments
- Inflation has been persistently high compared with regional economies and has exceeded double digits since 2018.
- Both monetary and fiscal policy have been tightened to gradually reduce, and in FY2024/25 eliminate, the use of direct NBE advances to finance the budget.
- Since the new framework was put in place, interbank and Treasury bill rates have risen above inflation; Treasury bill yields also exceeded the policy rate and inflation.
- Some banks increased lending rates in March 2025, identified as the first sign of transmission through the bank lending channel.

### Operational features of the new framework
- Key operational changes introduced:
  - Full allotment liquidity absorbing open market operations (OMOs).
  - Standing lending and deposit facilities to form a policy corridor at ±300 basis points.
  - Overnight interbank lending rate set as the operational target.
  - Launch of a new interbank market (October) to support liquidity management.
  - Improvements to the T-bill market and introduction of an Emergency Liquidity Assistance framework.
  - Commitment to phase out quantitative restrictions on lending, including caps on private credit growth.
  - Launch of a Central Securities Depository (CSD) and move to fully dematerialize government securities.
- Rationale: fixed-rate full-allotment framework is robust to changes in banks’ demands for excess reserves and does not require short-term forecasts of autonomous factors.

### Monetary transmission channels and assessment for Ethiopia
- Main channels described:
  - Interest rate channel: changes in policy rate transmit to interbank, T-bill, deposit, and lending rates, influencing opportunity costs of lending/saving and aggregate demand. In Ethiopia, this channel is likely weak due to low private credit base and history of financial repression.
  - Expectations channel: policy stance influences inflation expectations and price-setting behavior; anchoring expectations is critical as central bank credibility builds.
  - Credit channel: policy affects aggregate credit via banks’ cost of funding and firms’ collateral values; less relevant in Ethiopia because banks do not borrow from capital markets and private borrowing options are limited.
  - Exchange rate channel: despite a closed capital account, the exchange rate channel can operate via exchange rate expectations, price-setting, and the parallel market.
- Challenges in LICs: transmission tends to be weaker, more volatile, and less predictable where financial markets are shallow and institutional capacity is limited.

### Structural constraints and reforms needed
- Identified structural features that weaken transmission and policy responses:
  - Shallow money and bond markets: need to develop a collateralized repo market, encourage interbank trading beyond overnight and 1-week maturities, and foster a yield curve. Peer examples: Kenya, Uganda, Rwanda.
  - Limited financial sector development: low and declining private sector lending reduces interest elasticity of consumption/investment; central bank can support market infrastructure, financial literacy, and access.
  - Risk management and loan pricing: poor loan quality and practices like evergreening distort lending decisions; NBE is updating asset classification and provisioning rules and aligning capital and regulatory standards with Basel II/III and IFRS.
  - Banking sector competition: limited competition and dominance of some banks can weaken responsiveness of deposit and lending rates; reforms include ensuring state-owned banks operate commercially with explicit public service obligations where needed.
  - Capital mobility and exchange rate adjustment: limited capital mobility and FX intervention can dampen exchange rate channel; greater exchange rate flexibility and smoother FX market functioning would strengthen transmission.
  - Central bank fiscal financing/policy-based lending: monetary financing dilutes policy signals; NBE has eliminated monetary financing of fiscal deficits and is developing market-based debt issuance; publishing predictable government financing plans is essential.

### Institutional and analytical foundations
- Key institutional reforms and capacity needs (components adapted from IMF (2015)):
  - Central bank independence: end to NBE direct advances; NBE Proclamation; NBE internal organization changes; establishment of the Monetary Policy Committee (MPC).
  - Clear commitment to price stability: NBE mandate enhanced to prioritize price stability; exchange rate reform; strengthened communication policy.
  - Strong financial sector: gradual reduction in financial repression (phasing out mandatory purchases of T-bonds, ensuring better functioning Treasury bill markets).
  - Technical capacity: ongoing technical assistance (e.g., FPAS, liquidity forecasting) to develop inflation and liquidity forecasting.
- Effective implementation requires:
  - Effective monetary policy instruments (transparent market-based reference rate and OMOs).
  - Operational autonomy and a sound financial position for the central bank to maintain credibility.
  - Analytical capacity for forward-looking policy, including improving data compilation and quality to distinguish temporary supply shocks (drought, floods, food price volatility) from persistent inflationary pressures.

### Peer country experience and lessons
- Peer cases (Kenya, Tanzania, Rwanda, Uganda, Uzbekistan) illustrate that building monetary transmission is a multi-year process and often begins from a more advanced market-determined interest rate base.
- Communication improvements: NBE has begun publishing MPC statements to enhance transparency, drawing on regional peers.
- Credible and consistent implementation across instrument use, operational targets, and communication has been critical in peer successes.
- Examples of peer reforms include strengthening central bank capital, institutionalizing FPAS, and FX market diagnostics to limit FX interventions to preventing disorderly adjustments.

- Key operational choice highlighted:
  - Starting with a wide policy corridor and narrowing it gradually provides flexibility and avoids frequent rate adjustments that could complicate communication of policy stance.

*Source: sipea2025106 - 1. Inflation versus Sub-Saharan African Peers, June 2016–February 2025*

### 14.      Going forward, advancing modernization of the monetary policy framework will help

### 14.      Going forward, advancing modernization of the monetary policy framework will help

### Near-term priorities and policy recommendations
- Continue to develop a clear, well-communicated policy framework.
- Move to a single operating target (the policy rate), including phasing out the cap on private credit.
- Strengthen analytical capacity for policy making (FPAS and higher-frequency indicators).
- Strengthen the National Bank of Ethiopia’s (NBE) operational autonomy by:
  - Strengthening NBE’s financial position.
  - Further efforts to support NBE independence (e.g., appointing Board members in accordance with the reformed law).
- Complementary reforms to support transmission:
  - Develop money and bond markets.
  - Expand financial inclusion.
  - Implement financial regulations aimed at reducing financial repression and ensuring a market-oriented financial sector.
- Expected outcome: Over time, these reforms will lay the foundation for more effective and independent monetary policy, though strengthening the monetary transmission mechanism will take time.

### Structural constraints and areas for reform
- Shallow money and bond markets weaken transmission; reforms should focus on:
  - Improving primary market practices.
  - Issuing benchmark bonds to support pricing and liquidity.
  - Diversifying the investor base.
  - Strengthening the legal framework to support repo transactions with greater certainty.
- Financial sector development is needed to increase private credit and deepen the financial system:
  - Charts in the source show Private Credit to GDP 2024, Ethiopia vs SSA Peers with axis labels 0, 5, 10, 15, 20, 25, 30, 35 (percent GDP).
  - Total Deposits and Credit 2009/10-23/24 are shown with axis labels 0, 5, 10, 15, 20, 25, 30, 35 (percent of GDP) for Total Deposits and Total Credit.
- Banking sector concentration and policy-based lending can constrain transmission; measures to reduce state-bank dominance and policy lending are examples from peers.
- Exchange rate flexibility can matter where passthrough is high; allowing more exchange rate flexibility was cited as important for managing passthrough to inflation.

### Lessons from peer-country experience (select findings)
- Communication:
  - Uganda: Clear policy statements helped strengthen transmission (Berg and Portillo., 2018).
  - Tanzania: Published a communication strategy in 2023, including an annual MPC calendar and monetary policy and MPC meeting statements (Bank of Tanzania, 2023).
- Consistency and predictability:
  - Uganda: Committed to a single operating target (the policy rate) while experimenting with implementation tools (e.g., different repo operations) (Berg and Portillo, 2018).
- Market-based reference rates and monetary instruments:
  - Uganda: Introduced a Central Bank Rate (CBR) in 2011 and used a policy corridor and liquidity operations to guide the overnight interbank rate.
  - Rwanda and Kenya: Policy rates are supported by observable interbank rates; Kenya introduced an interest rate corridor around the policy rate in 2023, lowering the discount window rate in tandem.
- Central bank autonomy and financial position:
  - Uzbekistan: Central bank underwent a major capital injection in 2019 to support sterilization and reinforce independence; authorized capital of the Central Bank to increase by 500 times.
  - Rwanda: 2017 central bank law stipulates a clear legal framework for raising National Bank of Rwanda capital.
- Analytical capacity:
  - Kenya: Adopted an FPAS in 2013; outputs are a key input to MPC meetings and are supplemented by market expectation surveys.

### Country transition experiences and transmission status (selected examples)
- Kenya:
  - Moved away from a monetary aggregate targeting framework in 2008.
  - Forward-looking inflation targeting framework using the policy rate (central bank rate).
  - Transmission: Weak but improving with removal of interest rate controls and introduction/narrowing of interest rate corridor (IMF, 2024a).
- Rwanda:
  - Announced transition to an interest-rate based framework as of 2019; policy rate and interest rate corridor introduced in 2008 and 2012, respectively.
  - Medium-term inflation target of 5 percent with an inflation target band of +/- 3 percent.
  - Operational target: keep interbank rate close to policy rate.
  - Transmission: Improved through the interest rate corridor but remains limited in the exchange rate channel (IMF, 2023a).
- Tanzania:
  - Formally adopted interest-rate based policy framework in January 2024, after a gradual transition.
  - Medium-term inflation target of 5 percent.
  - Operational target: keep the 7-day cash rate within a ±200 bps corridor with the policy rate.
  - Pre-transition study found evidence of active transmission particularly via overnight interbank and T-bill rates (IMF, 2023b).
- Uganda:
  - Shifted to an inflation targeting regime in 2011.
  - Policy rate set in response to deviations of the medium-term forecast from the target.
  - Study over 2011–23 found transmission to lending rates only in the long run, with stronger transmission through T-bill and exchange rate channels (IMF, 2024b).
- Uzbekistan:
  - Transition to inflation targeting began in January 2020 with an inflation target of 5 percent and the policy rate as key instrument.
  - Operational objective: ensure short-term overnight rates remain close to policy rate (within interest rate corridor).
  - Transmission: constrained with limited changes to bank lending and deposit rates but improving as reforms have progressed (Al Rasasi and Cabezon, 2022).

*Source: sipea2025106 - 14.      Going forward, advancing modernization of the monetary policy framework will help*

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_Source: https://www.imf.org/-/media/files/publications/selected-issues-papers/2025/english/sipea2025106.pdf_