During the global food crisis, Ethiopia experienced an unprecedented increase in inflation, among the highest in Africa. Using monthly data over the past decade, we estimate models of inflation to identify the importance of the factors contributing to CPI inflation and three of its major components: cereal prices, food prices, and nonfood prices. Our main finding is that movements in international food and goods prices, measured in domestic currency, determined the long-run evolution of domestic prices. In the short run, agricultural supply shocks affected food inflation, causing large deviations from long-run price trends. Monetary policy seems to have accommodated price shocks, but money supply growth affected short-run non-food price inflation. Our results suggest that when analyzing inflation in developing economies with a large food share in consumer prices, world food prices and domestic agricultural production should be considered. Omitting these factors can lead to biased results and misguided policy decisions.

Ethiopia has experienced a historically unprecedented increase in inflation, mainly driven by cereal price inflation, which is among the highest in Sub-Saharan Africa. Using monthly data over the past decade, we estimate error correction models to identify the relative importance of several factors contributing to overall inflation and its three major components, cereal prices, food prices and non-food prices. Our main finding is that, in the long run, domestic food and non-food prices are determined by the exchange rate and international food and goods prices. In the short to medium run, agricultural supply shocks and inflation inertia strongly affect domestic inflation, causing large deviations from long-run price trends. Money supply growth affects food price inflation in the short run, though excess money supply does not seem to drive inflation in the long run. Our results suggest a challenging time ahead for Ethiopia, with the need for a multipronged approach to fight inflation. Forecast scenarios suggest monetary and exchange rate policies need to take into account the cereal sector, as food staple growth is among the key determinants of inflation, assuming a decline in global commodity prices. Implementation of successful policies will be contingent on the availability of foreign exchange and the performance of agriculture.

Financial sector development has played a key role in Ethiopia’s economic development, particularly since the launching of the first Five-year Growth and Transformation Plan in 2010. The gradualist approach that Ethiopia followed in reforming its financial sector seems to have borne fruit as no single commercial bank has gone bust so far, unlike the case in neighbouring countries. Though Ethiopia’s financial sector growth was following output growth in the first two phases, government has started to play a key role in accelerating the sector’s growth through active interventions, such as encouraging branch expansion, and introduction of new financial instruments such as the Grand Ethiopian Renaissance Dam Bond, a housing saving scheme, and the private pension fund. Consequently, the number of bank branches expanded from 681 to 4,257 between 2010 and 2017 while the deposit-to-GDP ratio went up from 25.9 per cent to 31.4 per cent in the same period.