Kenya’s monetary policymaking is way behind the curve

George Bodo
By George Bodo

A Sub-Saharan Africa focused thought leader and the founder of Callstreet Research and Analytics.

Posted on Thursday, 15 December 2022 09:53

Kenya Central Bank Governor Patrick Njoroge displays the newly designed Kenyan shilling bank notes during a news conference at the Central Bank in Nairobi, Kenya, June 3, 2019. REUTERS/Baz Ratner

The Monetary Policy Committee (MPC) of the Central Bank of Kenya (CBK) met on 27 November 2022 to, inter alia, review the outcomes of its previous rate decisions.

The committee then voted to increase the policy rate, the central bank rate, by 50bps to 8.75%. Despite the hike in the policy rate, the committee is way behind the curve, given developments in the global economy.

Strictly speaking, monetary transmission mechanisms describe how policy-induced changes in short-term interest rates, or the nominal money stock (and its components), impact on variables, such as output, prices, lending rates, the exchange rate and stock market prices.

In Kenya, previous empirical literature has identified four money policy transmission channels: interest rate, credit, exchange rate and asset prices.

All these four channels have been subjected to empirical tests to determine their impacts on output and prices, and the results have shown that the exchange rate channel bears statistical significance (which is appropriate for a small, open economy such as Kenya).

Essentially, tight monetary policy makes domestic assets more profitable vis-a-vis foreign assets, resulting in capital inflows, thereby appreciating the exchange rate. This makes imports cheaper, thus easing inflation.

‘Trade balances don’t determine exchange rates’

This inference reinforces the view that trade balances don’t determine exchange rates. Instead, exchange rates are determined by capital flows and this is evident in currency unions. For instance, Germany runs a trade surplus while Spain has a deficit, yet they both share a common currency.

Consequently, an appropriate monetary policy needs to counter Fed, ECB and BOE risks. Most of the capital is domiciled in Europe and the US. Interest rates in these markets have been on an upward trajectory.

  • Specifically, the US Federal Reserve (the Fed) recently raised its base rate on the US Dollar to between 3.75%-4%, and is projected at around 4.75%.
  • Similarly, the Bank of England (BOE) has raised its base rate on the Sterling Pound to 3.00% (and is expected to rise to 3.5% by the end of 2022).
  • The European Central Bank (ECB) raised the interest rate, in November 2022, on the main Euro refinancing operations and the interest rates on the marginal lending facility to 2% and 2.25% respectively, effective 2 November  2022.

At these steep levels, achieving stickiness in capital flows into emerging and frontier markets calls for counterbalancing these rate rises in the US and Europe. As a result, emerging and frontier markets, such as Kenya, must now put more premium on returns on domestic assets, which means raising rates to even higher levels.

A simple interest rate parity calculation between Kenya and the US drives the point home. Using a forward rate of KSh130 per USD, which is the level at which commercial banks have been executing foreign exchange trades, I calculated the interest rate differential between the Kenyan Shilling and USD, based on the current Fed funds rate of 3.75%. The calculation results in an interest rate differential of 6.4%.

This means that an investor holding USD, currently yielding a base rate of 3.75%, and looking to invest in KSh denominated assets should earn an interest rate premium (or differential) of 6.4% over current KSh interest rates. Essentially, Kenya’s policy rate should be around 15.15%.

There is also the argument that the MPC’s policy rate at 15% levels would tighten private sector financing conditions by way of slowing down credit growth.

This argument doesn’t hold

First, empirical evidence suggests that increases in lending rates are not strongly translated to lower credit to the private sector.

Additionally, given the oligopolistic market structure in the banking sector in Kenya, banks have, over time, shown reluctance to respond to any innovations in the policy rate. Hence changes in the policy rate may have little impact on credit conditions due to banks practise of keeping spreads constant, as well as inelastic demand for credit.

Beyond being caught behind the curve, policy signalisation also needs enhancement. In an inflation targeting (IT) monetary policy regime (which the MPC has, through a white paper, sought to adopt), language and communication are core policy tools, which offer a platform for any central bank to reinforce credibility in financial markets.

Broadly, monetary policy in Kenya has been rather subdued and cannot provide sufficient counterbalance measures against the Fed rate shocks.

Understand Africa's tomorrow... today

We believe that Africa is poorly represented, and badly under-estimated. Beyond the vast opportunity manifest in African markets, we highlight people who make a difference; leaders turning the tide, youth driving change, and an indefatigable business community. That is what we believe will change the continent, and that is what we report on. With hard-hitting investigations, innovative analysis and deep dives into countries and sectors, The Africa Report delivers the insight you need.

View subscription options