Understanding Ethiopia's Inflation Challenge

Inflation is the overall rise in prices for goods and services over a period of time. It tells that a currency is losing its purchasing power, which in turns lowers the value of money. This process is often calculated using an inflation rate.

Ethiopia is facing a persistent inflation challenge, with the average inflation rate reaching 34% in 2022, following an already high 27% in 2021. While recent trends show a slight improvement, the sustainability of this downward shift remains uncertain. This analysis delves into the key factors influencing Ethiopia's inflation, explores potential policy implications, and provides insights into the future outlook

Ethiopia's inflation trends can be examined through year-on-year and month-on-month measures, shedding light on various aspects of the situation.

• Year-on-year Inflation: In December 2022, the year-on-year inflation rate stood at 33.8%, showing a slight improvement from the peak of 37.2% in May 2022.

• Month-on-month Price Increases: In the fourth quarter of 2022, the average month-on-month price increase was 1.1%, indicating a positive direction. This figure represents an improvement from the higher rates observed in the second and third quarters.

Examining the factors that contribute to inflation helps identify the driving forces behind its fluctuations.

• Food and Non-food Inflation: Non-food prices, particularly fuel, transport, alcoholic beverages, furnishings, and housing, have become dominant contributors to overall inflation(up 35% y-o-y). Meanwhile, food inflation has seen a decline of 10 percentage points since early 2022 (now at 33% vs 44% then) and showed negative month-on-month inflation rates for two of the past three months following recent kiremt harvests.

• Splitting the inflation data into its various components shows that domestically offered services are showing lower inflation rates (of near 27%), presumably reflecting more elastic local supplies and competitive conditions in this space. By contrast, mostly imported commodities are showing 50% y-o-y inflation, which is similar to the percentage change in the parallel exchange rate (and suggests many consumer goods are actually being secured in that market).

Addressing Ethiopia's inflation challenge requires a careful examination of policy implications and their potential impact on inflation dynamics.

• Administrative Measures: Recent administrative measures, such as fuel price increases, excise/tariff adjustments, and import bans, have contributed to higher monthly inflation rates, particularly in non-food items. The impact of these measures on inflation dynamics needs to be assessed.

• Expansionary Fiscal and Monetary Policies: Over the past six months, fiscal and monetary policies in Ethiopia have become more expansionary. This expansion reflected in M2 growth and the use of central bank advances, calls for a more restrained policy stance to achieve meaningful declines in inflation.

Considering both the offsetting and opposing factors influencing inflation, the future outlook becomes clearer. A set of offsetting factors, including the already high base, declining global commodity prices, and the recent decline in the month-on-month trajectory, have the potential to reduce inflation. However, assumptions of depreciation under the reform scenario may contribute an immediate 5 to 7 percentage points to inflation. The net effect of these factors is expected to take inflation to the high 30s in the second half of 2023. However, a firm downward trend is anticipated afterward as central bank financing to the government decreases and reform policies address supply-side reforms. Based on these assumptions, inflation is expected to fall to just below 20 percent by June 2024.

Ethiopia's inflation challenge requires a comprehensive understanding of the underlying trends, contributing factors, and policy implications. Monitoring inflation dynamics and implementing appropriate policies are crucial to achieving sustainable and stable inflation levels. Striking a balance between fiscal and monetary measures, while carefully managing administrative actions, will be essential in navigating Ethiopia's inflation landscape and ensuring long-term economic stability.