Uganda's central bank raised its Central Bank Rate (CBR) by 100 basis points to "forestall a rise in core inflation over the medium term, above the BOU's policy target of 5 percent."
"The depreciation of the shilling's exchange rate and faster real GDP growth will exert upward pressure on inflation over the medium term," the Bank of Uganda (BOU) said in a statement by its governor, Emmanuel Tumusiime-Mutebile.
The BOU, which had maintained its rate since a cut in June 2014, expects core inflation to rise to around 5 percent by mid-2015 and without changes to the policy stance continue to rise to 7-9 percent by June 2016.
"Furthermore, the BOU judges that the balance of risks to the inflation forecast are on the upside, especially because of the potential pressure from the exchange rate," the statement added.
So far inflation in Uganda has remained subdued, with core inflation rising to 3.7 percent in March from 3.3 percent in February, partly driven by the pass-through effects of the fall in the shilling's exchange rate on the prices of imported goods.
Low rates of headline inflation - the annual rate rose to 1.9 percent in March from 1.6 percent in February - was due to a fall in food prices due to a good harvest.
The shilling has been depreciating since early 2014 and hit a low of 3,100 to the U.S. dollar on March 12 this year. Since then it has stabilized, helped by central bank intervention. Today the shilling was trading at 2,975 to the dollar, down 7.8 percent this year.
"The Bank of Uganda (BOU) will intervene in the foreign exchange market to curb disruptive volatility in the exchange rate, as was the case in March 2015, but will not try to impede the real exchange rate from adjusting smoothly where this is needed to maintain external balance," the BOU said.
The central bank has sold dollars at least nine times this year to bolster the shilling, which has been under pressure on worries that the government would boost spending before the 2016 election, leading to a repeat of the situation in 2011.
In October 2011 Uganda's inflation rate soared to 30.5 percent as the shilling fell to almost 2,900 to the dollar, forcing the central bank to push rates to a high of 23 percent in November that year.
Today's rate hike comes after the central bank on March 12 said it would use interest rates to keep inflation from exceeding its 5 percent target.
Uganda's economy is expanding, with the BOU estimating that real output is now slightly above its potential level and growth my accelerate even further, stimulated by higher public investment spending and private consumption, exerting upward pressure on prices.
Uganda's Gross Domestic Product expanded by 1.15 percent in third quarter of 2014 from the second quarter for annual growth of 3.01 percent, down from 3.92 percent and the lowest growth rate in four quarters.
"The balance of payments is a source of weakness for the economy and this has been reflected in the pressures on the exchange rate in the last three months," the BOU said, adding the current account deficit remains large and in the region of 8.5 percent of GDP in the 2014/15 fiscal year, which ends June 30, despite savings on imports from lower oil prices. The financial account has weakened over the last few months, the BOU added.
In the third quarter of 2014, Uganda's current account deficit rose to US$ 817.4 million, up from 551.8 million in the second quarter.