Markets & Finance

IMF faults Central Bank policy moves


CBK Governor Njuguna Ndung’u accompanied by Mr Terry Ryan, a member of the Monetary Policy Committee, address the media after a policy meeting in August, 2011. IMF has faulted CBK’s policy decisions. Photo/File

The International Monetary Fund (IMF) has faulted the Central Bank of Kenya’s (CBK) policy decisions, saying they contributed to high inflation and the near collapse of the shilling in late 2011.

In a research paper focused on the inflation and exchange rate movements in the months before November 2011 when CBK raised its policy rate, the IMF says earlier action by the regulator would have helped to stabilise the shilling and cool down commodity prices.

The IMF states that even though Kenya’s inflation rate is largely driven by food supply shortages, the level of interest rates and supply of money also has a major impact on price stability in the economy.

“We find that, while imported food price shocks have accounted for some of the inflation dynamics in Kenya, both in 2008 but also recently, an accommodative monetary policy also played an important role. Our out–of–sample exercise indicated that policy needed to be tightened,” says the IMF in the report released on Friday.

The inflation rate surged to a peak of 19.72 per cent in November 2011 driven mainly by a rally in international oil prices, while the shilling depreciated rapidly to a record low exchange rate of 107 units to the dollar in mid October of the same year.

The CBK mainly blamed the high volatility on “external shocks,” which it argued were beyond its control.

The IMF acknowledged the unique constraints faced by CBK and other developing economy Central Banks while implementing monetary policy, which impedes effectiveness of their policy actions.

“We have much to learn about important features of these economies, including: the (micro) structure of the food sector and its exposure to domestic and international shocks, the importance of other supply shocks, the degree of price and wage stickiness, the implications of limited financial participation and imperfect capital mobility for the transmission mechanism, and the role of alternative instruments such as sterilised foreign exchange interventions.”

IMF says the CBK was managing inflation and exchange rate on the basis of highly optimistic assumptions that did not tally with reality.

Though the paper is prepared by the Fund’s staff and is still subject to further refinement, it is the first insight into the thinking of IMF insiders on the turbulent developments in the financial markets towards the end of 2011 and what the CBK needs to improve.

The CBK’s optimism was shown in the failure to raise interest rates promptly in the time preceding the drastic fall in the value of the local currency in October 2011.

“In hindsight, the targets for broad money and credit were based on an optimistically low assumption for broad money velocity and optimistic assumptions about the credit growth rates consistent with stable inflation,” said the paper titled ‘Forecasting and Monetary Policy Analysis in Low-Income Countries: Food and non-Food Inflation in Kenya.’

The CBK appeared keen to increase credit uptake, which grew rapidly and peaked at 36 per cent in September 2011, creating excessive money supply.

“More generally, had the policy regime placed more emphasis on interest rates as indicating the stance of policy and less emphasis on credit growth and other quantitative targets, a clearer picture about the stance of policy may have emerged,” said the IMF paper.

The document notes that the CBK has had challenges in predicting inflation, partly because of lack of information on the velocity of money, or the number of times a unit of currency changes hands within a given period. The higher the velocity the higher the potential to cause inflation, but the CBK is usually at a loss on this measure.

In their analysis of the IMF exposition, Standard Investment Bank said that it amounted to an indictment of the CBK policy decisions.

“In the paper, the IMF indicts the policy decisions made by the Central Bank of Kenya. It proposes that by using the new [Forecasting and Policy Analysis System] model, Central Banks in low-income countries can now correctly apply the correct magnitude in interventions, and make decisions at the right time,” said the SIB analysts.

The IMF was convinced that the CBK needs to deal decisively with a number of issues including exchange rate management and transmission of monetary policy signals.

“A number of practical issues will need to be confronted, such as the definition of the policy instrument, the functioning of the interbank market, the role of money and exchange rate management in policy making, and scarce high-frequency data,” said the paper.

The document added that “efforts to think and act more systematically about monetary policy can complement and even promote the development of better functioning financial markets and, over time, improve the functioning and understanding of the transmission mechanism.”

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