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Monetary Conditions Index for Kenya: Monetary Policy Framework in Kenya

Monetary Conditions Index for Kenya: Monetary Policy Framework in KenyaKenya is a small open economy with a liberalized capital market and a floating exchange rate. The exchange rate against other major currencies is market driven. A floating exchange rate policy was adopted in Kenya in 1993, allowing the Central Bank to conduct an independent monetary policy to fight inflation. The National Treasury specifies a price target to be pursued by the CBK, which then coordinates monetary policy and expectations towards the achievement of the target.
The direction of monetary policy in Kenya is signaled by movements in the Central Bank Rate (CBR), which indicates the monetary policy stance being pursued by the CBK. External shocks that affect the demand and supply of foreign exchange are reflected through the automatic adjustments on the exchange rate. Banking sector

In formulating monetary policy, the CBK has at its disposal several policy instruments. These include the Open Market Operations, the discount window, reserve requirements among others. According to CBK, the purchase and sale of foreign exchange from and to the market is an indirect tool of monetary policy. The CBR indicates the direction of monetary policy as set by the Monetary Policy Committee (MPC), and then the Central Bank applies appropriate tools to manage liquidity in the direction required by the monetary policy stance. Mainly, the CBK tries to control the monetary base or high powered money to determine the desired money stock in the economy.
The conduct of monetary policy in Kenya has gone through a raft of policy changes and reforms. In the 1960s after independence, there was a passive role of monetary policy since inflation was low (at 2 percent) and GDP growth was high (at 8 percent). The need for monetary policy intervention arose in the second decade when inflation became high -fluctuating between 10 and 20 percent annually from the 1970s to the mid-1980s, and accelerated further to 47.7 percent in 1993. Policy intervention was needed after the 1973 oil crisis, the coffee boom of 1977/78 and the second oil crisis of 1979 which was accompanied by drought. The exchange rate regime was changed from a fixed to a crawling peg to deal with the appreciation of the real exchange rate. This was complemented with fiscal stabilization and interest rate adjustments.
This cocktail of measures brought inflation down from 22 percent to 11 percent in 1982/83. It stayed below 20 percent up to the early 1990s when it recorded an annual average of 45 percent. Policy reforms were then implemented where the exchange rate regime was changed to a floating exchange rate among other measures. By 1995, all the foreign exchange restrictions had been eliminated, foreign exchange bureaus permitted and the Exchange Control Act repealed.
These changes in the policy regime laid the foundation for a decade of good performance in inflation management and output gains lasting until the end of 2007. The bedrock of this was a monetary framework which was successful in bringing inflation under control. This regime was organized around a broad-money anchor, with reserve money functioning as the operational target. Despite the efforts and gains described above, CBK’S objective of maintaining the inflation rate below the 5% target has for most years remained elusive as shown in figure 1. Figure 1 shows the nominal inflation rate and the target rate for Kenya between the year 2000 and June 2011. It shows that not only has the inflation rate stayed above the target for most of the time, but it also shows some volatility. Inflation in Kenya is driven by food prices (occasioned by drought, which affects agricultural output and necessitates food imports) and high crude oil prices. Therefore, a monetary policy that concentrates on interest rate movements and ignores the exchange rate is bound to be ineffective.

Figure-1

Figure 1: Trend of Inflation in Kenya

This post was written by , posted on January 23, 2014 Thursday at 4:48 pm