Kenya passes policy rate test as Tanzania flops

A study by the International Monetary Fund (IMF) staff shows that decisions of central banks of Kenya and Uganda take one to three months to be felt in the economy.

The findings of a paper titled The Monetary Transmission Mechanism in the Tropics: A Narrative Approach comes amid market skepticism about policy rates’ efficacy.

IMF says the Central Bank of Kenya (CBK) and the Bank of Uganda have effectively managed to contain inflation through the Central Bank Rate (CBR).

The two banks have better transmission of monetary policy signals than Tanzania and Rwanda, where it was sometimes impossible to determine the exact market reaction to a particular decision, the study dated September 2013 says.

“The transmission was the clearest in Kenya and Uganda, where the regimes most resembled inflation targeting in that the authorities prioritised inflation, emphasised the role of the policy rate, allowed the exchange rate a large degree of flexibility and broadly avoided multiple objectives,” said the research.

The IMF gave a caveat saying the study was not the official position of the institution but represents views of its staff.

Clear evidence

“We find clear evidence of a working transmission mechanism: after a large policy-induced rise in the short-term interest rate, lending and other interest rates rise, the exchange rate tends to appreciate, output growth tends to fall, and inflation declines,” says the IMF paper.

In a separate presentation, during a conference organised by the IMF and the Treasury last week, CBK governor Njuguna Ndung’u said the monetary transmission in Kenya had been effective and delivered expected outputs.

For years, questions have persisted as to whether Kenya’s real economy, interest and exchange rates respond to signals of the Monetary Policy Committee (MPC).

Prof Ndung’u showed how CBR, the signal rate now at 8.5 per cent, as a market prompter is transmitted through the interest rates, exchange rate, bank credit and expectations to affect supply and demand, inflation and other forecasts.

“Interest rate and exchange rate channels are the main channels of monetary policy transmission in Kenya — but the expectations channel is also becoming significant with increasing CBK communications and transparency,” said Prof Ndung’u.

The IMF study shows that when the exchange rate became unstable towards the end of 2011, CBK tightened the monetary policy stance which in turn raised interest rates which also stabilised the shilling.

Credit to the private sector also fell drastically from a growth of 31 per cent to less than 20 per cent towards the middle of last year as the tight monetary policy stance took root. Only after mid-2012 did inflation and interest rates start coming down significantly.

Users of the policy signals, such as bond traders, agreed with the findings that the changes in the policy rate have had impact even though with a lag.

“I think the policy rate works. It brings about some gradual change in the market, rather than immediate. It has had some impact all the same,” said Alexander Muiruri, a bond trader at African Alliance Investment Bank.

In Tanzania, the IMF paper noted that lending rates did not respond to policy signals.

“It was less clear in Tanzania, where the effects on some interest rates, activity, the exchange rate, and inflation are still broadly evident, but lending rates failed to respond, perhaps reflecting the fact that the money targeting regime led to highly volatile short-term interest rates and hence a less clear signalling of the policy stance,” said the IMF paper.

With regard to Rwanda, the IMF study concluded that the “regime did not provide a clear signal... And in the event, the results of the tightening were less evident.”