Given the market state, country could do with holding the interest rate constant.
Going by this week’s decision of the monetary policy committee (MPC) to cut its policy rate to nine per cent, monetary policy considerations, in my assessment, is increasingly being driven by the country’s fiscal sphere. Let’s go back to basics. Have you often wondered who spins the money supply engine in any economy?
Well, modern monetary system places deposit intermediaries led by commercial banks at the top of money supply engine. Deposit intermediaries take money from the public and use the same to create loans, in the process increasing cash supply. This critical function helps reallocate otherwise idle capital to productive enterprises through a variety of stakeholding structures.
Because deposit intermediaries are guided by profit objective, the extent to which they can create new money (or loans) can be unlimited, conceptually. Who then controls the money supply quantity? It’s the monetary authority—the Central Bank of Kenya in this case, and this is because it sits at the base of cash supply.
The monetary authority is guided, not by profit motive but by the need to achieve price stability.
Too much money supply can lead to rapid price increases while too little money can lead to reduced output and price declines.
This money supply control function is dispensed through a monetary policy. Depending on its front-view assessment(s) of the health of the economy, the authority can decide to reduce or increase money supply by either raising or cutting the cost of money—known as interest rates.
Note that the credit market is the main policy transmission channel. When the cost of money falls, borrowers are incentivised to take out or refinance loans, while a rise in cost is the perfect disincentive for new borrowing(s).
In Kenya, this signaling of a reduction or increase in money supply (or monetary policy) is achieved through a policy rate (central bank rate-or CBR).
At the heart of price stability is consumer prices, measured through inflation. The MPC is constantly watching out for either exogenous or endogenous factors that can destabilise price(s), and monitors a swathe of economic indicators periodically.
When it believes there are sufficient factors, exogenous, endogenous or both that can drive up prices, the last thing it wants is growth in money supply to be part of a potentially ruinous inflation cocktail. So, it decides to increase the cost of money. The converse applies.
So let’s contextualise the MPC’s July 2018 signaling.
The economy seems to be troughing out of the woods, albeit gradually. Inflation appears well anchored and, for now, remains below the government’s upper symmetric corridor.
The policy transmission channel (the credit market), most importantly, has been silted by the interest rate caps, and annual private sector credit growth momentum remains excruciatingly subdued.
I have read a number of reactions before and after the policy decision, including KBA’s pre-meeting note, and I just believe the monetary policy could as well do with a neutral path—that is, holding the policy rate constant.
Instead, there appears to be another submerged policy consideration which, in my view, is the fiscal space. In normal circumstances, a healthy monetary policy is focused on achieving the right price stability to drive sustainable economic growth.
However, when a country has a significant debt load and is unable to effectively pay it down using taxes, where Kenya currently finds itself, raising interest rates can make it difficult for the government to service debt and could easily trigger debt-related crises.
Resultantly monetary policy is forced to take into account the extreme happenings in the fiscal sphere. In industry jargon, this is referred to as fiscal dominance—and this, in my assessment, has been the case.
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Note: The results are not exact but very close to the actual.
