The monetary policy framework is described in terms of the monetary policy goals, intermediate targets used to signal policy action, and the associated monetary policy strategy. The following description concentrates on the current framework; users interested in the history of monetary policy in Botswana are referred to, among other sources, the theme sections of the Bank's Annual Reports for 2007 and 2008.
Prior to 2008, the Bank's price stability was specified principally in terms of a range to be achieved over the coming year. However, commencing with the 2008 Monetary Policy Statement (MPS), it is defined as a range to be achieved over a medium-term horizon, and is currently set at 3 - 6 percent. (This refers to the annual rate of change in consumer prices as measured by the Consumer Price Index (CPI)). In this framework, the policy horizon is up to 3 years, which is considered appropriate given the considerable lags in the transmission of monetary policy to affect price developments, with both current inflation and short term developments already determined by past developments, including policy decisions. Furthermore, the current framework defines the medium-term as a three-year rolling period in recognition of the need for continuous review of the inflation outlook together with a corresponding proactive policy review. Thus, the Bank applies a forward-looking monetary policy strategy in order to achieve medium-term price stability. The medium-term horizon satisfies three conditions for the effectiveness of monetary policy: first, it anchors the setting of the inflation objective; second, it is consistent with the period covered by the inflation forecast; and, third, it is a reasonable period for policy action to take effect.
Indicators for Policy Action
Since 2008, this framework has been forecast-based, where the forecast for inflation serves as a signal for policy action. In particular, the Bank adjusts its monetary policy stance when there is an indication of a significant divergence over the policy horizon between the 3 - 6 percent range of price stability and the inflation forecast over the medium-term. In other words, the medium-term inflation forecast serves as the intermediate target for monetary policy. (Previously, while the forecasting capability of the Bank was still at an early stage, the growth of commercial bank credit served as the intermediate target.) Although other factors influence the level of inflation, in the final analysis inflationary trends are associated with sustained (over the medium term) developments of aggregate demand for goods and services not in line with the production/supply capacity of the economy. In the circumstances, the Bank's forward-looking and forecast-based monetary policy strategy aims to provide appropriate monetary conditions necessary to influence aggregate demand towards the supply capacity of the economy. The factors that influence the discrepancy between demand and supply include: interest rates; the exchange rate; administered prices; indirect taxes; import prices; inflation expectations; government expenditure; wages and salaries; and external demand.
However, while the inflation forecast forms the basis of the Bank's policy analysis, it is not the only input. The forecast is both supplemented by additional information that is not formally incorporated in the modelling process (the results of the twice yearly business expectations survey, for example) as well as expert judgement.
Monetary policy operates in an uncertain environment, hence the need to regularly assess the state of the economy and prospective medium-term developments regarding the determinants of inflation. Uncertainty emanates from delays in the availability of some key information about the state of the economy (e.g., GDP data), as well as difficulties relating to the origin, effects, length and magnitude of impacts affecting the economy. As economic circumstances change, the outlook for the determinants of inflation and, of necessity, the inflation outlook will change, with a possibility for a change in the monetary policy stance. In this regard, the policy framework entails regular meetings of the Monetary Policy Committee (MPC).
Current Framework and Inflation Targeting (IT)
It is important to appreciate that, although there are clear similarities, the current framework does not amount to inflation targeting (IT); for this reason, the Bank is careful to described the policy range as an ‘objective' rather than a ‘target'. IT would require a clear legal mandate regarding price stability and policy independence, supported by appropriate institutional arrangements. The current framework is developed within the Bank of Botswana's existing mandate, and is deemed as appropriate to the current situation in the country. (See basics of monetary policy and the 2008 Annual Report for a fuller discussion of this issue.)
Since the inflation objective (initially in the form of an annual objective) was first introduced in 2002, headline inflation in Botswana has generally been outside the desired range, sometimes to a significant extent. However, in many instances, these deviations are largely attributable to significant price shocks, both domestic (e.g., the introduction of value added tax and currency devaluations) and external (volatile commodity prices). Without these, inflation would have been much closer to, if not within, the objective range.