Monetary Policy
Overview
Price Stability and Economic Growth
The Central Bank’s monetary policy decisions are made to maintain a low and stable inflation rate over time, which is an indication of price stability.
Inflation is a general increase in price levels over time. It is based on the prices of various consumer goods and services, which are evaluated and statistically represented in the Consumer Price Index (CPI). The month-on-month (or year-on-year) inflation rate is determined by comparing the CPI for a particular month to the CPI of that same month in the previous year.
Inflation is caused by numerous factors, both locally and internationally. For example, during periods of drought or excessive rain, the prices of food could increase, leading to an increase in the inflation rate. International factors like increases or decreases in oil prices can also lead to changes in inflation reflecting movements in energy and transport costs. Depreciation in the exchange rate against the major currencies can also cause inflation since Kenya is a net importer of goods. Inflation can also be caused by factors that influence the demand for goods and services, like the amount of money ordinary people have available to spend.
High levels of inflation inhibit economic growth and cause the Kenya Shilling to lose value compared to international currencies, thereby discouraging the purchase of Kenyan goods and services. It also makes it difficult for people to make long-term financial decisions, as they cannot be sure about the future value of their investments and savings. If there is a general decrease of prices over time due to a collapse in demand or increased supply of goods and services, then there is deflation. Deflation inhibits economic growth by reducing profit and lowering investor incentives.
Inflation
As is the case the world over, a central bank exists in a country to safeguard the value of its currency in terms of what it can purchase. When prices of goods and services in an economy keep on rising, the value of these goods and services that the currency can purchase – or exchange for – diminishes. This leads to loss in value of the currency. Monetary policy is the main tool used in safeguarding the value of the currency in an economy. It involves the control of liquidity circulating in an economy to levels consistent with growth and price objectives set by the government. The volume of liquidity in circulation influences the levels of interest rates, and thus the relative value of the local currency against other currencies.
It is the responsibility of the Monetary Policy Committee to formulate the monetary policy of the Central Bank of Kenya. Maintaining price stability is crucial for a proper functioning of a market-based economy. It encourages long-term investments and stability in the economy. Low and stable inflation refers to a price level that does not adversely affect the decisions of consumers and producers. Price stability is a precondition for achieving a wider economic goal of a strong and sustainable growth and employment. High rates of inflation lead to inefficiency in a market economy and, in the medium to longer term, to a lower rate of economic growth. Movements in the general price level are influenced by the amount of money in circulation and productivity of the various economic sectors. The Central Bank of Kenya regulates the growth of money stock that is consistent with a predetermined economic growth target as specified by the Government and outlined in its Monetary Policy Statements.
Monetary Policy Decisions and Instruments
Monetary policy is guided by a monetary programme, which is premised on the economic growth and inflation targets provided by the National Treasury. Monetary policy decisions are made by the Monetary Policy Committee (MPC). The MPC meets at least once every two months and reviews data and analysis from various sources including the Central Bank Departments enabling it to decide on any action to maintain or vary its stance.
Monetary Policy Committee
Role and Legal Status
The Monetary Policy Committee is the organ of the Central Bank of Kenya responsible for formulating monetary policy. The Committee was formed vide Gazette Notice 3771 on April 30, 2008, replacing the hitherto Monetary Policy Advisory Committee (MPAC)
Membership
The membership of the MPC is as follows:
- The Governor, who is the chairman.
- The Deputy Governor.
- Two members appointed by the Governor from the Bank, one being a person with executive responsibility within the Bank for monetary policy analysis (Director of Research Department) and the other being a person with responsibility within the Bank for monetary policy operations (External Payments and Reserves Management).
- Four external members who have knowledge, experience and expertise in matters relating to finance, banking and fiscal and monetary policy, who are appointed by the Cabinet Secretary for the National Treasury.
- The Principal Secretary, National Treasury, or his designated alternate as representing the National Treasury. The National Treasury representative is a non-voting member of the committee.
- Each external member of the Committee serves for a term of three years, which is renewable once.
MPC Meetings
The Chairman of the MPC convenes a meeting of the Committee at least once every two months and will convene an additional meeting if requested in writing by at least four members. The quorum for meetings of the Committee is five members, one of whom must be the Chairman or Vice-Chairman. The decisions of the Committee in these meetings are communicated to the public through press releases from the Chairman.
Statutory Requirements
At least once every six months the Committee prepares and submits a report to the Cabinet Secretary for the National Treasury with respect to its activities. The Minister presents the Report to the National Assembly. In addition, the MPC is responsible for preparation of the bi-annual Monetary Policy Statement of the Bank. The Committee is supported by a Secretariat, responsible for the information flow between itself and the rest of the Departments of the Bank.
The daily monetary policy activities are undertaken by the Monetary Policy Management Committee, which meets at least three times a week.
The Central Bank has several tools that it can use to counter changes in the market and influence price stability:
Commercial banks in Kenya are required by law to keep a specified proportion of their total deposits at the Central Bank. This proportion of deposits is called the Cash Reserve Ratio (CRR), and when the Central Bank needs to significantly adjust the amount of money in the market, it can increase or decrease the ratio.
The CRR deposits are held in the CBK at no interest. The CRR is currently set at 5.25 percent of the total of a bank’s domestic and foreign currency deposit liabilities. To facilitate commercial banks’ liquidity management, commercial banks are currently required to maintain their CRR based on a daily average level from the 15th of the previous month to the 14th of the current month and not to fall below a CRR of 3 percent on any day.
The CBK, as lender of last resort, provides secured loans to commercial banks on an overnight basis at a penal rate that is over the CBR. This facility is referred to as the Discount Window or Standing Facility. The penal rate restrict banks to seek funding in the market only resorting to Central Bank funds as a last solution.
The CBK does not have automatic standing facilities with respect to overnight lending. Access to the Window is governed by rules and guidelines which are reviewed from time to time by the CBK. Banks making use of this facility more than twice in a week are scrutinised closely, and supervisory action taken
Open Market Operations (OMO) refers to actions by the CBK involving purchases and sales of eligible Government securities to regulate the money supply and the credit conditions in the economy. OMO can also be used to stabilise short-term interest rates. When the Central Bank buys securities on the open market, it increases the reserves of commercial banks, making it possible for them to expand their loans and hence increase the money supply. Specifically the Central Bank conducts open market operations using:
- Repurchase Agreements (Repos) which entail the sale of eligible Government securities by the CBK to commercial banks through an auction system to reduce the level of commercial banks deposits held at CBK. Repos thus reduce the commercial banks’ capacity to make loans and advances to customers. The Central Bank undertakes to repurchase the security after three or seven days depending on the mutual agreement. The Late Repo, sold in the afternoon, has a 4-day tenor and is issued at an interest rate 100 basis points below the Repo on that day. When a weekend or public holiday coincide with the maturity date of the Repo, the tenor is extended to the next working day.
- Reverse Repos are purchases by CBK of eligible Government securities from commercial banks. They enhance the liquidity of the money market during periods of tighter than desired liquidity level thereby dampening upward pressure on interest rate. The current tenors for Reverse Repos are 7, 14, 21, and 28 days.
- Term Auction Deposit (TAD) is used when the securities held by the CBK for Repo purposes are exhausted or when CBK considers it desirable to offer longer tenor options. The CBK seeks to acquire deposits through a transfer agreement from commercial banks at an auction price but with no exchange of security guarantee. Currently, the tenors for such deposits at CBK are 14, 21, or 28 day periods. At maturity, the proceeds revert to the respective commercial banks.
- Horizontal Repos are modes of improving liquidity distribution between commercial banks under CBK supervision. They are transacted between commercial banks on the basis of signed agreements using government securities as collateral, and have negotiated tenors and yields. Horizontal Repos help banks overcome the problem of limits to lines of credit, thus promoting more efficient management of interbank liquidity.
Other Monetary Policy Tools
Central Bank Rate (CBR): The CBR is reviewed and announced by the Monetary Policy Committee (MPC) at least every two months. Movements in the CBR, both in direction and magnitude, signal the monetary policy stance. In order to enhance clarity and certainty in monetary policy implementation, the CBR is the base for all monetary policy operations.
Whenever the Central Bank is injecting liquidity through a Reverse Repo, the CBR is the lowest acceptable rate by law. Likewise, whenever the Bank wishes to withdraw liquidity through a Vertical Repo, the CBR is the highest rate that the CBK will pay on any bid received. However, to ensure flexibility and effectiveness of monetary policy operations in periods of volatility in the market, the CBK can raise the maximum acceptable interest rates on Term Auction Deposit to above the CBR. Movements in the CBR are transmitted to changes in short-term interest rates. A reduction of the CBR signals an easing of monetary policy and a desire for market interest rates to move downwards. Lower interest rates encourage economic activity and thus growth. When interest rates decline, the quantity of credit demanded should increase.
Foreign Exchange Market Operations: The CBK can also inject or withdraw liquidity from the banking system by engaging in foreign exchange transactions. A sale of foreign exchange to banks withdraws liquidity from the system while the purchase of foreign exchange injects liquidity into the system. Participation by the CBK in the foreign exchange market is usually motivated by the need to acquire foreign exchange to service official debt, and to build-up its foreign exchange reserves in line with the statutory requirement.
The CBK uses its best endeavours to maintain foreign reserves equivalent to four months’ imports as recorded and averaged for the last three preceding years. The CBK does not participate in the foreign exchange market to defend a particular value of the Kenya shilling but may intervene in the exchange market to stabilise the market in the event of excess volatility.