1. Governor, Central Bank of Kenya
INTERNATIONAL CONFERENCE ON MONETARY POLICY FRAMEWORKS IN DEVELOPING COUNTRIES: PRACTICE AND CHALLENGES
KENYA’S EXPERIENCE By
Prof. Njuguna Ndung’u
Governor, Central Bank of Kenya
July 20, 2012

2. Outline Monetary Policy Framework Transmission Mechanism
Impact of Financial Innovations
Recent Experience and Challenges
Policy Responses and Implications

3. 1. Monetary Policy Framework
Historical characteristics and the CBK’s ability to implement monetary policy:
The open capital account and floating exchange rate dating from the 1990s.
The dominance of exogenous supply shocks relating to domestic events such as droughts.
External events such as the sub-prime mortgage crisis of 2008 and the more recent instability in the eurozone in the face of the Greek sovereign debt default.
The Central Bank of Kenya (CBK) Act requires the government to provide an inflation target to the CBK at the beginning of the fiscal year. The CBK formulates and conducts monetary policy with the aim of attaining the specified target.
The CBK Act also requires the CBK to support the government’s desired growth objectives. Specifically, it must ensure the stability of the Kenyan currency and health of the financial sector.

4. 1. Monetary Policy Framework…
Consequently, monetary policy is conducted based on a modified monetary aggregate framework where:
Net Domestic Assets of the CBK/Reserve money are the operational targets. The Central Bank Rate (CBR) signals the monetary policy stance. Broad money supply (M3) is the intermediate target.
The current monetary programme is based on targets outlined of Net International Reserves (NIR) and Net Domestic Assets (NDA) as the quantitative performance criteria measures.
Kenya has a floating exchange rate regime: therefore the CBK’s formulation of monetary policy incorporates an awareness of the implications of the open accounts in the balance of payments and their likely impact on money supply.
Monetary policy instruments include Open Market Operations (Repos including Reverse Repos, and Term Auction Deposits), Cash Reserve Ratio, Foreign Exchange Market operations, and Standing Facilities at CBK.

5. 1. Monetary Policy Framework…
The CBK issues Prudential Guidelines from time to time to ensure the efficacy of the monetary policy instruments.
The CBR forms the base for all monetary policy operations; this has enhanced clarity and certainty in monetary policy operations.
Introduction of a Monetary Policy Committee (MPC) in 2008 has enhanced the transparency and legitimacy of monetary policy decisions, as well as information processing and the decision process – But more importantly coordinate expectations around Monetary Policy direction and actions.

6. 2. Transmission Mechanism
There are five inter-linked channels whereby monetary policy is transmitted to the real economy: these are interest rate, exchange rate, asset prices, credit, and expectations channels.
Well developed financial markets, institutions and instruments are key ingredients in enhancing the transmission of monetary policy signals. Institutional constraints and policy failures inhibit the monetary policy transmission mechanism in most developing countries.
Most transmission mechanisms depend on the stability of the money demand function.
Expanding financial inclusion in Kenya has resulted in unstable money multiplier and velocity of money both of which have detrimental effects of undermining predictability of demand for money leading to adverse expectations.

7. 2. Transmission Mechanism…
The MPC’s communications strategy has ensured a wider dissemination of monetary policy decisions, and enhanced the efficiency of information transmission.
Recent empirical studies (CBK/IMF) show that interest rate and exchange rate channels are the main channels of monetary policy transmission in Kenya. But expectations channel also becoming significant with increasing Central Bank communications and transparency.
The latest CBK study shows that an increase in the policy rate is followed by an appreciation in the exchange rate, and a decline in inflation with the full impact being felt after 9-12 months.
Recent empirical estimates of the pass-through of oil and food prices show that shocks on oil prices are propagated more strongly to core inflation than the shocks on food prices.

8. 2. Transmission Mechanism… Operationalising the Net Domestic Assets Ceiling
NDA ceiling provides room for judgment calls while protecting external position.
Policy can be adjusted without target revisions.
Bias towards reserve accumulation when demand for money increases (building up buffers to protect external vulnerability).
Allows liquidity injection/absorption through foreign exchange operations (exploiting exchange rate channel).
In the face of unstable demand for money, exceeding NDA ceilings can be addressed by injecting liquidity through Net Foreign Assets (NFA).

9. 3. Impact of Financial Innovations: Velocity Movements Imply Unstable Money Demand
Velocity of Money in Kenya has been declining which is an indication of greater financial depth.
Financial developments including mobile money innovations have played a significant role in the decline in the velocity of money since 2007.
The fall in velocity implies less cash being used in the economy, therefore, money is mostly “inside money” which can support the improvements in the transmission mechanism for monetary policy.

10. 3. Impact of Financial Innovations: An Increasing Money Multiplier Reflects Financial Innovation
The money multiplier has been rising since 2007 with the introduction of mobile money transfer services which has led to a decline in currency outside banks.
Declining velocity and unstable money multiplier imply that the money demand function is unstable which has implications for monetary policy instruments.

11. 4. Recent Experience and Challenges
The rapid increase in food and fuel prices since 2010 exerted pressure on inflation and created a build-up of the current account deficit to an estimated 11.3 percent of GDP by May This has implications on exchange rate stability in Kenya.
Food and fuel prices in Kenya account for over 60 percent of the overall inflation. Food related items account for 40 percent of the surveyed items in the computation of the Consumer Price Index. Transport and other oil related items account for a further 27 percent of the items.
Non-food-non-fuel inflation which is the relevant measure to monetary policy is determined by 32 percent of the CPI basket. Food prices are mainly affected by the predominantly rain-dependent agriculture while international events which affect crude oil prices have a strong pass- through effect to domestic fuel prices. Both, in the end, feed back into costs affecting non-food-non-fuel items.
Price stability is therefore anchored on the stability of commodity prices and the institutions that support the supply side of the market. These are outside the influence of monetary policy instruments.

12. 4. Recent Experience and Challenges: Inflation has been largely driven by factors which are exogenous to the Tools of Monetary Policy…
Short-term inflation target of 9%
Medium-term inflation target of 5%
Overall inflation peaked at 19.7 percent in November 2011 as fuel prices remained high with world oil prices remaining persistently above USD100 per barrel.
The CBK tightened monetary policy to prevent the supply shocks that affected domestic prices being ratified thereby creating a higher plateau of prices.
This has paid off at the expense of high interest rates.

13. 4. Recent Experience and Challenges: Balance of Payments Pressures and International Developments Driving the Exchange Rate
The current account deficit as a proportion of GDP increased from -7.3 percent in October 2010 to -9.1 percent in October 2011 and further to an estimated percent in May 2012.
Pressure on the exchange rate in 2011 was exacerbated by instability in the eurozone which resulted in strengthening of the US Dollar globally. The expansion of financial trading derivatives and increased usage of Electronic Brokerage Systems in the foreign exchange market exerted further pressure on the exchange rate in 2011.
This implies that if the exchange rate channel is dominant in the transmission mechanism of monetary policy, it can be hazardous during speculative attacks.

14. 4. Recent Experience and Challenges: Exports have been Financing Less Imports – Exchange Rate has to Weaken
There is a mismatch between foreign exchange earnings and utilisation. Heavy public investments involving heavy foreign exchange expenditures in the short to medium term have been factored in the government budget to secure the growth capacity for the future and support export diversification in the long-run.
The monthly oil import bill rose from an average of 22 percent of the total cost of imports experienced throughout 2010 to 31 percent in August 2011 and remains high at 26 percent in May 2012.
This is a structural problem in the economy which requires a long-term policy to support the export sector to boost foreign exchange inflows and reverse this trend.

15. 5. Policy Responses and Implications
A tighter monetary policy stance and regulatory measures in the foreign exchange market were adopted by the CBK in the second half of 2011 to dampen the persistent inflationary pressures and stabilise the exchange rate. The CBR was raised from 6.25 percent to percent between September and December 2011.
Inflation dynamics in Kenya largely driven by exogenous factors (food and energy prices). This is where monetary policy instruments have been inadequate.
Monetary policy actions will work to tame inflation and stabilize the exchange rates with short-term interest rates rising. But this will work against the economic growth objectives in the short-term.
Initiatives to facilitate building of foreign exchange reserves necessary to cushion the exchange rate against exogenous shocks.
A floating exchange rate regime ensures that the exchange rate is an automatic stabiliser. It absorbs external shocks and adjusts for imbalances arising in the current account of the balance of payments.

16. 5. Policy Responses and Implications…
Coordination between fiscal and monetary policies is critical in ensuring that growth and inflation objectives of the government are harmonised.
The relationship between reserve money and broad money is unstable and unpredictable. Targeting broad money via reserve money as an intermediate target is inadequate:
NDA of the CBK has been suggested as a suitable replacement for Reserve Money.
However, the NFA objectives conflict with exchange rate flexibility while NDA ceilings are not explicitly related to inflation targets.
NDA ceilings are seen as a transitional stage leading to explicit inflation targeting due to bias towards reserve accumulation:
A higher stock of NFA over time allows for increasing exchange rate flexibility.
Injection of permanent liquidity through foreign exchange operations can help minimize undesirable interest rate swings.

17. 5. Policy Responses and Implications…
Adoption of an explicit inflation targeting framework for Kenya may not be feasible at the moment given that a large proportion of the inflation process is supply driven. However, it could help to focus on a particular level of inflation that has to be hit in the event of tightening monetary policy.
To support the transmission mechanism and efficacy of monetary policy, there is need to develop various instruments:
Interest rate instruments should help drive NDA changes – policy rates should be the reference for Open Market Operations and should guide interbank interest rates.
Inflation forecasts and formal identification of links between instruments and inflation should increasingly be used as inputs for policy decisions.
Assess inflation expectations through surveys and similar means of information gathering so that CBR anchors these expectations properly.