A strong case for dropping CBR as monetary policy tool

Central Bank Governor Patrick Njoroge. FILE PHOTO | NMG 

By GEORGE BODO
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Summary

• Advent of loan capping has rendered the rate ineffective.

British economist John Maynard Keynes, in his book General Theory of Employment, Interest and
Money, remarkably joked that in bad economic times, a government might as well bury banknotes in jars then employ thousands of people to dig them up (you recall the kazi-kwa-vijana initiative?).

According to Keynes, paying the workers may be a waste in conventional terms, but it wouldn’t matter as the overall effect—which is full employment that then jumpstarts aggregate demand back to normal levels—outweighs the cost.

Essentially, in periods of slack, a government must do everything possible to jumpstart an economy. With this theory, Keynes gave birth to macroeconomics.

He went on to postulate a number of things. Specifically, he prescribed how a government could deal with uncertainties. Spending decisions by households and enterprises are subject to future expectations of economic performance.

Fear of uncertainty can make people hoard cash, or make bankers hesitant to lend and borrowers afraid to take credit. For instance, suspending spending and investments on the expectations of a rise in interest rates can slacken output growth.

Consequently, uncertainties and expectations create a natural path for interest rates. But Keynes advanced the idea of government taking over this natural path of interest rates in order to keep the economy roaring.

He invented monetary policymaking. Simply put, monetary policy are actions aimed at controlling money supply in an economy and interest rates, as a tool, is at the heart of it.

When there is too much money supply, which can be inflationary in most cases, central banks simply raise the (interest) rate at which commercial banks borrow from wholesale market.

Banks in turn raise the rates at which they lend, and, voila, borrowers become hesitant; and the converse applies.

This is the disruption Keynes postulated. In Kenya, econometric studies have established and lent credence to the strong link between inflation and money supply.

Consequently, a core mandate of the Central Bank of Kenya (CBK) remains that of maintaining price stability through monetary policy, which, as the late Prof Francis Mwega showed in a paper, is transmitted through four channels, namely interest rate, credit, exchange rate and asset price channels.

In Kenya, the CBK’s monetary policy toolkit, adjudicated by a monetary policy committee (MPC), is composed of open market operations (OMOs); mandatory commercial bank reserves; the famous lender-of-last-resort function and the monetary policy rate, known as the Central Bank Rate (CBR).

The CBR, which was added into the toolkit in June 2008, remains the main policy tool.

But as Ben Bernanke, former chairman of the US Federal Reserve, illustrated in his autobiography, The Courage to Act, there are no limits as to how the policy toolkit can be renovated and flexed.

Talking of the toolkit, it may be time to withdraw the CBR as a policy tool, for two reasons: first, because the CBR’s main transmission mechanism has been through the interest rate and credit channels, the advent of rate caps has rendered it ineffective. Its efficacy has been compromised.

Second, a key success point lies in its communication (and the art of signalisation). Bernanke, in his memoir, talks about going on a mission to improve the Fed’s communication by breaking from his predecessor Alan Greenspan’s personality cult.

In fact, he talks of embarking on a journey to reduce the identification of the Fed with the chairman by “summarising committee members’ thoughts on the economic outlook before giving mine”.

He goes on to say that central bankers’ speeches (including public engagements) aren’t just about policy, they are monetary policy tools.

Here at home, the lack of signalisation has contributed to the impairment of CBR’s efficacy (look at the last 25 policy communiques) which then lays sufficient ground for the abandonment of the tool.