CBK should listen to IMF views on inflation and rates

Central Bank of Kenya governor Njuguna Ndung’u at a past press briefing on monetary policy. FILE 

By  Samora Kariuki

In a recent working paper entitled “Forecasting and Monetary Policy Analysis in Low Income Countries” the IMF’s view on food and non-food inflation in Kenya caused quite a stir in economic and financial circles.

Most analysts took it as a paper that condemned the CBK for the inappropriate policy decisions they made in 2011 — particularly the accommodative monetary policy stance that was partly to blame for the high inflation witnessed during the year.

In essence, the paper is really an attempt to understand the dynamics of the Kenyan economy from a central banking perspective, with a view of informing monetary policy in low income countries.

The opprobrium it has caused aside, the paper does raise a number of important issues that are important both for the Central Bank of Kenya (CBK) and private sector players.

This is particularly so for the latter due to the fact that the interest rate and inflation movements directly affect the bottom line. One key issue concerns the CBK’s policy instruments. Typically in Kenya and a number of other Sub-Saharan African countries, reserve money targeting has been the main policy instrument.

This is even enshrined in the CBK’s Monetary Policy statement. Reserve money targeting is implemented through open market operations particularly repos and reverse repos.

The thinking is that targeting reserve money enables the CBK to control money growth and thus inflation and to an extent output.

The IMF reckons that during the first half of 2011, the CBK’s focus on reserve money was misguided arguing that money market interest rates were too low despite the reserve money targets being met.

The IMF rightly argues that the CBK should have instead focused on interest rates rather than quantitative variables such as reserve money.

(Read: IMF faults Central Bank policy moves)

Had they done this, then low market interest rates would have signalled that the policy was too accommodative. On the same note, the issue of which interest rate to use is important. Since 2006, the CBK has used the Central Bank Rate (CBR) as its key interest rate tool.

The issue here is that the CBR prior to September 2011 was used mostly as a signal and did not have any real effects on market rates. Market rates particularly short-term rates such as the interbank rate, horizontal repo rates and 91-day T-bill rates tended to move independently of the CBR. 

I would argue that the CBK should use the repo rate as their key policy tool and communicate this to the market. Over the years the repo rate has moved in almost lock step with the interbank rate and to an extent Treasury bill rates.

Indeed if the CBK used the repo rate as their key policy variable, they would have significant traction over the money markets and therefore credit growth.

Towards the end of 2011, the CBK communicated that it would conduct repo transactions based on the CBR plus or minus a margin. This was a welcome step. However, the fact that the margin was never clear confused matters.

Nonetheless, I would advocate that the CBK communicates directly to the market that they will use the repo rate as their key policy variable.

The IMF also brings out the issue of the exact monetary policy transmission mechanism.

This simply means that we need to find out how exactly monetary policy affects the target variables particularly inflation and output. This problem is acute particularly when you consider that market players are always giving “post hoc ergo propter hoc” prognostications on their preferred monetary policy move.

Market players simply seek causality where it does not or has not been proved to exist. The direct channels through which monetary policy work need to be investigated further particularly as most studies on this matter have been conducted in countries where food price shocks don’t have significant effects.

The CBK staff have already done some good work to this end particularly with regards to how CBK rates work towards lending rates.

Finally, I would recommend that the CBK adopt market communication much like what is happening in the USA and other developed countries. 
In truth, the CBK has been communicating through its website on a number of issues pertaining to monetary policy.

The recent article penned by the governor on the CBK’s stand on exchange rates was a case in point. However, as was the case and as has been the case in the past, such communication is usually reactive rather than proactive.

Ultimately, it is important to recognise that central banking in Kenya and other developed countries is a learning process. Kenyans must firstly appreciate that the CBK is one of the best staffed central banks in Africa.

Indeed the recent agreement with the University of Nairobi will greatly improve the skill set available. Nonetheless the IMF paper has raised a number of important issues that the CBK need to consider.

Mr Kariuki is studying for a Master’s degree in finance at a UK university.