Is Monetary Policy Too Tight?
Category: Monetary Policy
By: Kwame Owino, Maureen Barasa, Peter Doyle,
We recommended (“And then, Floods”) that the Central Bank of Kenya policy rate should be lowered by 300 basis points, from 13 to 10 percent, from August 6.
Instead, a reduction of just 25 basis points, from 13 to 12¾, was made on that date.
Someone is wrong.
Who?
In explaining the 25bp decision, it was noted that “there was scope for a gradual easing of the monetary policy stance. while ensuring continued exchange rate stability” given that “global inflation has moderated, with central banks in some major economies lowering interest rates. Food inflation has continued to decline with improved supply of key food items, particularly sugar and cereals. International oil prices have moderated … [and] … Kenya’s overall inflation declined to 4.3 percent in July 2024 from 4.6 percent in June, thereby remaining below the mid-point of the target range.”
This argument appears comforting. But all is not well.
In particular, if the monthly rate of inflation of non-food prices—our preferred measure of core prices given food price shocks—continues at the same rate as registered on average over the last six months from February to July, then as a matter of simple numerical mechanics, by December the 12-month rate of non-food inflation will be 1.6 percent, and by July 2025 it will be 1.1 percent.
Those last numbers compare with the Central Bank of Kenya’s target for headline inflation including food prices of 5 percent, with a band of 2½ percentage points on either side.
And as, under the IMF program, the Central Bank of Kenya is required to conduct an official consultation with the IMF when the 12-month rate of inflation falls outside the target band for three months consecutively—in either direction—the mechanical exercise just outlined anticipates such a consultation being triggered around the turn of the year, absent a significant unanticipated acceleration in food prices.
Thus, what is missing from the explanation for the 25bp cut is any elaboration of the factors which will raise the underlying momentum of non-food prices to get inflation back up into the target band and to the center of that band over the coming year or other relevant policy horizon.
In particular, there is no suggestion of a prospective rise in imported inflation, in domestic wages, in domestic demand, in growth of credit or monetary aggregates, or in indirect taxation, or in the Kenyan fiscal impulse, nor subsequent accelerated policy rate cuts. Nor is there reference to further monthly food price inflation—which despite being negative in July, might raise the headline measure of inflation even if non-food price inflation remains subdued.
Nor in the absence of any of those, is there an account of why monetary policy should now be set deliberately to far undershoot the center of the target range over that year-out horizon or beyond, nor given the inflation targeting framework for the emphasis in the key concluding policy sentence on “continued exchange rate stability”.
Of course, further unanticipated shocks could arise. But given that those might in principle have implications in either direction for core and headline inflation, policy should aim at the center of the target band. In that context, monetary policy should respond promptly only to the second-round effects of such shocks when those occur, rather than systematically aiming below target in one-sided anticipation. And policy should certainly not be anchored in the exchange rate.
Worse still, not only do we see no account in the statement indicating why the momentum of non-food prices established over the last six months is expected to rise but, to the contrary, we see factors which may slow that momentum further, taking non-food inflation even further below the target band by end year and July 2025 than is indicated by the mechanical exercise.
In particular, the Central Bank of Kenya policy rate was raised in steps from 9½ to 13 percent in the year to February 2024, the last 300 bps of which were specifically in response to market concerns of a possible default on the then imminent bullet maturity of the US$2 billion Eurobond. Those interest rate hikes offset the inflationary impulse from the sharp depreciation of the Kenya Shilling (Chart 1, from early 2023 to the blue line peak in February 2024).
Chart 1. Central Bank Policy Rate and US$ Exchange Rate, 2019-2024.
But since that bullet maturity was refinanced in February 2024, the Kenya Shilling began strongly appreciating, reversing its prior strong inflationary impulse. Whereas monetary policy rightly combatted the inflationary implications from exchange rate depreciation by policy rate increases of some 300 basis points up to that point, it has not done the reverse as the Shilling reversed.
That has opened up a sizeable gap now between the trajectories of the policy rate and the exchange rate (Chart 1, after the blue line peak).
That visual gap is indicative of a sharp tightening in the overall monetary stance, yielding a severe deceleration in non-food prices since February. Accordingly, their average monthly annualized inflation over the last six months has plummeted to just 1.1 percent (Chart 2, red line below the target band in 2024).
Chart 2. Non-Food Inflation, 2019-2024.
The 25 bp reduction from August 6 leaves the tight monetary stance fundamentally unchanged.
Furthermore, when announcing that reduction, the Governor also referred to additional fiscal consolidation as negotiated with the IMF through August, both for 2024/25 and beyond. That prospect, contrary to our counsel, will slow monthly non-food inflation even more.
Accordingly, the balance of evidence with just a 25 bp cut strongly indicates that annualized monthly overall inflation will continue to undershoot the headline inflation target band—absent further food price or other exogenous shocks. That could trigger the IMF consultation clause for 12-month inflation below the target band in three consecutive months as soon as the end year.
And if indeed inflation substantially undershoots the target going into 2025, that will compound budget revenue shortfalls from systematic IMF over-prediction of real GDP growth with a hit to indirect tax receipts from lower-than-target inflation. Following protests in 2024, that unwelcome combination heralds further difficulties with missed fiscal targets and even more stressed budget negotiations with the IMF going into 2025.
So who is responsible for the monetary policy decision on August 6?
Formally, it was made by the Kenyan Monetary Policy Committee (MPC) and announced by the Central Bank Governor.
But that was done under formal constraints. As noted, Kenya’s ongoing IMF program sets conditionality on monetary policy. As recently as June the IMF staff formally endorsed the monetary policy stance, and the Governor in his August press conference drew specific attention again to the fact that monetary policy is in accord with IMF requirements.
President Ruto has similarly made herculean efforts on the fiscal side to continue conforming with IMF demands since protests erupted two months ago—including after withdrawal of the 2024/25 Finance Bill and reshuffling his cabinet. So were the Central Bank to deviate from IMF monetary advice now, even on the grounds we have reiterated here, that step would undermine his efforts to secure IMF disbursements. That would leave the Central Bank highly exposed.
The implication is that whatever the unconstrained monetary judgment of the MPC might or might not be, the monetary policy action announced on August 6 reflects the IMF view.
That turn implies that our dispute in the first instance is not with the MPC; it is with the IMF.
And our dispute with the IMF goes beyond the specific contention that it should have endorsed a decisive relaxation in the Central Bank of Kenya policy rate after the Eurobond was refinanced in February. We also argue, even more fundamentally but to the same effect in “And then, Floods”, that if an economy with a floating exchange rate has its fiscal stance at best practice with a monetary stance calibrated assuming that the currency is at fair value despite it being significantly overvalued, then a key symptom of that disorder would be monthly core inflation below target on a sustained basis. That exactly describes Kenya since early 2024.
Nothing is certain in applied macroeconomics, in Kenya or elsewhere. But at least our framing relative to the Eurobond and to Shilling overvaluation has the merit of congruence with what is actually being observed with non-food prices and other key macro trends. By contrast, the IMF framing which asserts that inflation is on track for the 5 percent target with the Central Bank of Kenya policy rate set on August 6 and that the shilling is at fair value cannot account for the observed well-below-target-band trajectory of non-food prices sustained since early 2024.
In conclusion, our concern with IMF-mandated monetary policy is not only that it is liable to yield a below-target-band rate of core inflation and thus further impair prospects for realization of nominal budget revenue targets for 2024/25, but, far more seriously for the long-run, that it impedes the necessary correction in the real exchange rate and outward orientation of the economy that is essential to boosting job growth—the immediate primary concern of protesters.
Accordingly, the IMF should recommend an immediate cut in the Central Bank of Kenya policy rate of a further 275 basis points to 10 percent, belatedly fully reversing the policy rate increases directly associated with the market-anticipated-but-not-realized Eurobond default. That would get non-food inflation back up to target and help secure necessary real exchange rate correction.
If the IMF finally does so, the Central Bank of Kenya should implement that step immediately.
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Is Monetary Policy Too Tight?
| Post date: Thu, Aug 15, 2024 |
| Category: Monetary Policy |
| By: Kwame Owino, Maureen Barasa, Peter Doyle, |
We recommended (“And then, Floods”) that the Central Bank of Kenya policy rate should be lowered by 300 basis points, from 13 to 10 percent, from August 6.
Instead, a reduction of just 25 basis points, from 13 to 12¾, was made on that date.
Someone is wrong.
Who?
In explaining the 25bp decision, it was noted that “there was scope for a gradual easing of the monetary policy stance. while ensuring continued exchange rate stability” given that “global inflation has moderated, with central banks in some major economies lowering interest rates. Food inflation has continued to decline with improved supply of key food items, particularly sugar and cereals. International oil prices have moderated … [and] … Kenya’s overall inflation declined to 4.3 percent in July 2024 from 4.6 percent in June, thereby remaining below the mid-point of the target range.”
This argument appears comforting. But all is not well.
In particular, if the monthly rate of inflation of non-food prices—our preferred measure of core prices given food price shocks—continues at the same rate as registered on average over the last six months from February to July, then as a matter of simple numerical mechanics, by December the 12-month rate of non-food inflation will be 1.6 percent, and by July 2025 it will be 1.1 percent.
Those last numbers compare with the Central Bank of Kenya’s target for headline inflation including food prices of 5 percent, with a band of 2½ percentage points on either side.
And as, under the IMF program, the Central Bank of Kenya is required to conduct an official consultation with the IMF when the 12-month rate of inflation falls outside the target band for three months consecutively—in either direction—the mechanical exercise just outlined anticipates such a consultation being triggered around the turn of the year, absent a significant unanticipated acceleration in food prices.
Thus, what is missing from the explanation for the 25bp cut is any elaboration of the factors which will raise the underlying momentum of non-food prices to get inflation back up into the target band and to the center of that band over the coming year or other relevant policy horizon.
In particular, there is no suggestion of a prospective rise in imported inflation, in domestic wages, in domestic demand, in growth of credit or monetary aggregates, or in indirect taxation, or in the Kenyan fiscal impulse, nor subsequent accelerated policy rate cuts. Nor is there reference to further monthly food price inflation—which despite being negative in July, might raise the headline measure of inflation even if non-food price inflation remains subdued.
Nor in the absence of any of those, is there an account of why monetary policy should now be set deliberately to far undershoot the center of the target range over that year-out horizon or beyond, nor given the inflation targeting framework for the emphasis in the key concluding policy sentence on “continued exchange rate stability”.
Of course, further unanticipated shocks could arise. But given that those might in principle have implications in either direction for core and headline inflation, policy should aim at the center of the target band. In that context, monetary policy should respond promptly only to the second-round effects of such shocks when those occur, rather than systematically aiming below target in one-sided anticipation. And policy should certainly not be anchored in the exchange rate.
Worse still, not only do we see no account in the statement indicating why the momentum of non-food prices established over the last six months is expected to rise but, to the contrary, we see factors which may slow that momentum further, taking non-food inflation even further below the target band by end year and July 2025 than is indicated by the mechanical exercise.
In particular, the Central Bank of Kenya policy rate was raised in steps from 9½ to 13 percent in the year to February 2024, the last 300 bps of which were specifically in response to market concerns of a possible default on the then imminent bullet maturity of the US$2 billion Eurobond. Those interest rate hikes offset the inflationary impulse from the sharp depreciation of the Kenya Shilling (Chart 1, from early 2023 to the blue line peak in February 2024).
Chart 1. Central Bank Policy Rate and US$ Exchange Rate, 2019-2024.
But since that bullet maturity was refinanced in February 2024, the Kenya Shilling began strongly appreciating, reversing its prior strong inflationary impulse. Whereas monetary policy rightly combatted the inflationary implications from exchange rate depreciation by policy rate increases of some 300 basis points up to that point, it has not done the reverse as the Shilling reversed.
That has opened up a sizeable gap now between the trajectories of the policy rate and the exchange rate (Chart 1, after the blue line peak).
That visual gap is indicative of a sharp tightening in the overall monetary stance, yielding a severe deceleration in non-food prices since February. Accordingly, their average monthly annualized inflation over the last six months has plummeted to just 1.1 percent (Chart 2, red line below the target band in 2024).
Chart 2. Non-Food Inflation, 2019-2024.
The 25 bp reduction from August 6 leaves the tight monetary stance fundamentally unchanged.
Furthermore, when announcing that reduction, the Governor also referred to additional fiscal consolidation as negotiated with the IMF through August, both for 2024/25 and beyond. That prospect, contrary to our counsel, will slow monthly non-food inflation even more.
Accordingly, the balance of evidence with just a 25 bp cut strongly indicates that annualized monthly overall inflation will continue to undershoot the headline inflation target band—absent further food price or other exogenous shocks. That could trigger the IMF consultation clause for 12-month inflation below the target band in three consecutive months as soon as the end year.
And if indeed inflation substantially undershoots the target going into 2025, that will compound budget revenue shortfalls from systematic IMF over-prediction of real GDP growth with a hit to indirect tax receipts from lower-than-target inflation. Following protests in 2024, that unwelcome combination heralds further difficulties with missed fiscal targets and even more stressed budget negotiations with the IMF going into 2025.
So who is responsible for the monetary policy decision on August 6?
Formally, it was made by the Kenyan Monetary Policy Committee (MPC) and announced by the Central Bank Governor.
But that was done under formal constraints. As noted, Kenya’s ongoing IMF program sets conditionality on monetary policy. As recently as June the IMF staff formally endorsed the monetary policy stance, and the Governor in his August press conference drew specific attention again to the fact that monetary policy is in accord with IMF requirements.
President Ruto has similarly made herculean efforts on the fiscal side to continue conforming with IMF demands since protests erupted two months ago—including after withdrawal of the 2024/25 Finance Bill and reshuffling his cabinet. So were the Central Bank to deviate from IMF monetary advice now, even on the grounds we have reiterated here, that step would undermine his efforts to secure IMF disbursements. That would leave the Central Bank highly exposed.
The implication is that whatever the unconstrained monetary judgment of the MPC might or might not be, the monetary policy action announced on August 6 reflects the IMF view.
That turn implies that our dispute in the first instance is not with the MPC; it is with the IMF.
And our dispute with the IMF goes beyond the specific contention that it should have endorsed a decisive relaxation in the Central Bank of Kenya policy rate after the Eurobond was refinanced in February. We also argue, even more fundamentally but to the same effect in “And then, Floods”, that if an economy with a floating exchange rate has its fiscal stance at best practice with a monetary stance calibrated assuming that the currency is at fair value despite it being significantly overvalued, then a key symptom of that disorder would be monthly core inflation below target on a sustained basis. That exactly describes Kenya since early 2024.
Nothing is certain in applied macroeconomics, in Kenya or elsewhere. But at least our framing relative to the Eurobond and to Shilling overvaluation has the merit of congruence with what is actually being observed with non-food prices and other key macro trends. By contrast, the IMF framing which asserts that inflation is on track for the 5 percent target with the Central Bank of Kenya policy rate set on August 6 and that the shilling is at fair value cannot account for the observed well-below-target-band trajectory of non-food prices sustained since early 2024.
In conclusion, our concern with IMF-mandated monetary policy is not only that it is liable to yield a below-target-band rate of core inflation and thus further impair prospects for realization of nominal budget revenue targets for 2024/25, but, far more seriously for the long-run, that it impedes the necessary correction in the real exchange rate and outward orientation of the economy that is essential to boosting job growth—the immediate primary concern of protesters.
Accordingly, the IMF should recommend an immediate cut in the Central Bank of Kenya policy rate of a further 275 basis points to 10 percent, belatedly fully reversing the policy rate increases directly associated with the market-anticipated-but-not-realized Eurobond default. That would get non-food inflation back up to target and help secure necessary real exchange rate correction.
If the IMF finally does so, the Central Bank of Kenya should implement that step immediately.
More Blogs
Mr. Trump and Kenya’s Macro
It has always been difficult to tie Mr. Trump’s statements to his subsequent policy actions. That fact qualifies any certainty in discerning his implications for Kenya’s macro now. But in three areas, the Kenyan macroeconomic authorities should be on high alert. The Kenya Shilling For much of 2024, the Central Bank of Kenya (CBK)has been […]
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Two Immediate Monetary-Framework Imperatives for Mr. Mbadi
The credibility of Monetary Policy in Kenya is compromised at present by two factors: As we anticipated mid-year, inflation is headed below the target range for the first time; The 7-member Monetary Policy Committee (MPC) has four vacancies. In light of the former prospect, the MPC reduced the Central Bank of Kenya (CBK) Policy Rate, […]
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