Corti Paul LakumaSome of the most challenging problems in the conduct of monetary policy in developing countries such as Uganda are the exchange rate pass-through effects (ERPT hereafter).

Generally, ERPT refers to the change in domestic prices in response to a change in the exchange rate. In this case, the larger the ERPT, the larger the response in domestic price volatility.

In Uganda, the ERPT is largely a reflection of the scarcity of dollars in the economy, which can be explained by the reduction in exports, an increase in imports, reduced Foreign Direct Investments (FDI), reduced remittances, reduced donor aid, fluctuations in compounding factors (such as in oil prices, trade openness, global food prices and domestic interest rates) and grants from the developed world.

To some extent, the recent financial turmoil in Europe and the effects of the Ukraine-Russia dispute have affected European financial markets and as a result reduced the off-shore investments in the developing world, Uganda inclusive. One likely effect of ERPT is the increase in the general price levels, inflation, spurred by not only imported consumer goods, but also industrial products that are produced from imported intermediary inputs.

Even though, in the short-run, price changes in response to exchange rate movements may not be immediately apparent, the long-run inflationary pressures, especially due to over-depreciation of the domestic currency, may be counter-productive to the economy, if not counteracted by prudent monetary policy measures.

Therefore, there is a need to be cautious over the recent weakening of the Uganda shilling against the dollar. In percentage terms, the Uganda shilling has depreciated by 12 per cent in the first three quarters of 2014. This rate is high when compared to an annual increase of 5.2 per cent between 1996 and 2007.

The Uganda shilling has moved from Shs 2,500 per dollar in the first quarter of 2014 to Shs 2,800 per dollar by the end of the third quarter of 2014.

There is a strong relationship between the inflation rate and exchange rate movements. For instance, the depreciation of the Uganda shilling to Shs 2,700 in the second quarter of 2011 coincides with the increase in inflation to 28 per cent during that period.

This evidence suggests a positive long-run co-movement between exchange rate and inflation. And, such changes, if not contained, may lead to higher inflationary pressures that could hurt the economy. Given such past evidence, it suffices to say that the current depreciation of the Uganda shilling could have a long run ramification on inflation and by extension on the economy.

Nevertheless, Uganda could take advantage of the depreciation of the shilling to boost industrial and agricultural exports, which would see a much-desired inflow of dollars and a strengthening of the shilling in the long-run.

However, the growth of Uganda's exports is constrained by limited value-addition and low investment in the industrial and agricultural sectors, and thus the economy cannot benefit from the easing of the exchange rate.

To stabilize the exchange rate within acceptable bounds, Bank of Uganda will have to intervene in the exchange rate market to mop out the excess liquidity. Therefore, we urge the central bank to pursue such precautionary measures (open market operation, asset market etc.) that stabilize the exchange rate to support economic activity.

However, such measures should be pursued in respect of the minimum exchange rate bound so as not to constrain demand for Uganda's exports.