Analysis of Interest Rate Channel of Monetary Transmission Mechanism in Kenya

This study sought to investigate the impact of interest rate channel of monetary transmission mechanism in executing monetary policies in Kenya, during the period 2005-2013. The study employed a VAR methodology using impulse response graphs and variance decomposition to test the relative impact of the different variables tested being repo rate,NEER,M3, CPI, GDP and savings, which data sets were quarterly. The empirical analysis found two interesting results. First, all variables were stationary at level I(0) using KPSS. Second, with exception of innovation (M3), there exists significant influence of interest rate channel of monetary transmission shock to GDP and CPI, although weak and a strong significant influence on NEER. Abbreviations CBK : Central Bank of Kenya CPI : Consumer Price Index GDP : Gross Domestic Product IMF : International Monetary Fund IRF : Impulse Response Function LIC : Low Income Countries MPC : Monetary Policy Committee TB : Treasury Bills Rate VAR : Vector Auto Regression www.ijbcnet. com International Journal of Business and Commerce Vol. 4, No.04 [38-67] (ISSN: 2225-2436) Published by Asian Society of Business and Commerce Research 39 CHAPTER ONE INTRODUCTION 1.1 Background of the Study Monetary transmission is important to policy formulators, decision making and implementing authorities. The policies are used to enhance stability in key economic variables and promote social and political welfare in any country. In the USA, monetary policy is the responsibility of the Federal Reserve System. The policy goals are generally the same all over the world, with objectives of promoting stable prices, exchange rates, maximum employment and long term interest rates. Most studies have been done using Vector Autoregressive framework. Notable in the developed economies include, Karagiannis et al, (2010) in their study on the Euro-zone and the USA, Morsink and Bayoumi (2001) and Jean Boivin et al, (2008) used a factor Augmented Autoregressive model in his study on monetary transmission in the six largest European economies. Some authors in developing economies also support the same opinion on the importance of monetary transmission. For instance, Cheong and Boodoo (2008) used a VAR decomposition IRF and found weak pass through from interbank rate and Treasury bill rate to prime lending rate in Trinidad and Tobago. Kendall Patrick (2001) in his study on the Caribbean found that it was difficult to discern pattern of Tb rate in Barbados, Belize, Guyana and Jamaica. Davoodi et al, (2013) note that transmission channels differ in East African Countries (EAC) with exchange rate and credit channel being important to Kenya, credit channel in Rwanda and interest rate in Burundi. Morales and Raei (2013) concluded generally that there was evidence for existence of interest rate and exchange rate channels in EAC. Kenya is not exempted, notable studies include Mburu (2012), with findings suggesting that money supply changes is the predominant determinant of changes in inflation. Misati and Nyamongo (2011) found that instability in the stock market prices creates instability in Gdp and inflation and that the asset price channel of monetary transmission mechanism in Kenya is not compelling. But interesting study by Cheng (2006) who analyzed the interest rate channel with an objective of finding out whether a monetary shock affect output, prices exchange rate as well as other key economic variables. The author used monthly data running from 1997-2005 and the framework was a VAR model including Forecasting Error Variance Decomposition and an Impulse Response Function. Findings suggest that effects of monetary policy shock on output appear to be insignificant, has significant persistent impact on prices and that the nominal effective exchange rate respond strongly to monetary shock. The researcher noted that the reason for little impact of monetary policy on real output was because of structural weaknesses of the financial sector characterized by weak legal framework, poor governance and insufficient infrastructure. Since his study, lots of issues he raise have been addressed while others are work in progress. There has been the implementation of the new constitution advocating for minimum government intervention on regulatory authorities such as Central Bank (CBK), Capital Markets Authority (CMA) and Insurance Regulatory Board (IRB) and has promoted political stability with an independent and transparent judiciary. Financial innovation has taken root with OTC, demutualization, dematerialization and automation of the Nairobi Securities Exchange (NSE), a market capitalization of over one trillion shillings, M-pesa, Agent banking and SMEs has increased the levels of commercialization in the economy. The high level of globalization of the economy together with fast tracking of EAC integration www.ijbcnet. com International Journal of Business and Commerce Vol. 4, No.04 [38-67] (ISSN: 2225-2436) Published by Asian Society of Business and Commerce Research 40 to a Monetary Union, introduction of futures market, forward market, together with a minerals market in the near future. More so, the data used by the author was a short sample period and therefore never considered the explicit analysis of long run behavior of the economy. Further, since the author used a short term sample period, analysis by VAR which requires relatively long time series with consistent policy framework is likely unfruitful. A further diagrammatical representation of the relationship between Repo rate, Tb rate, Exchange rate and CPI until 2013 July is as under. Figure 1.1 suggests that the movement of the nominal exchange rate seem to be following the both the Tb rate and Repo rate, with an appreciation following an increase in nominal interest rate and vice versa. This kind of observation can be attributed by inflow of capital induced by interest rate movements since investors will channel their capital flow to areas where interest rate is highest as payment for the factor of production. 1.2 Problem Statement Cheng (2006) study found that monetary policy shock had little impact on real output suggesting the reason for this was structural weaknesses in the financial sector which was likely to hamper transmission of monetary policy. The endogenous variables he used were gross domestic product,consumer price index , money stock, short term interest rate and nominal effective exchange rate. However, a lot has happened in the financial sector since 2006 including increased levels of financial innovation, deregulation of financial regulatory authorities by the government and Economic integration. Misati et al (2010) results suggest that with financial innovation in Kenya, the effectiveness of the interest rate channel in monetary policy is weakened but at the same time, due to intensified financial innovation this has led to efficiency in access of finances to households, private firms and institutions therefore investing more and hence increased output bearing in mind that Cheng (2006) concluded that the interest rate shock has insignificant effect on real output which extent is subject to concern. www.ijbcnet. com International Journal of Business and Commerce Vol. 4, No.04 [38-67] (ISSN: 2225-2436) Published by Asian Society of Business and Commerce Research 41 Further, the author did not consider the explicit analysis of longrun behavior of the economy.Berg et al, (2013) note that analysis by VAR framework requires relatively long time series with consistent policy framework and so, a small sample period would be unfruitful. There is therefore a need to find out whether interest rate channel has become more effective or ineffective. 1.3 Objective of the Research General Objective The general objective of the study is to analyze the interest rate channel of monetary transmission mechanism in Kenya. Specifically the study sought: 1. To estimate the dynamic effects of interest rate channel on the exchange rate 2. To estimate the relative importance of interest rate channel on inflation 3. To determine the influence of financial innovation on interest rate channel 1.4 Research Questions The research paper sought to answer the following questions i. How does the exchange rate respond to interest rate dynamics? ii. How does inflation rate respond to variations in the interest rate? iii. How does financial innovation affect interest rate channel? 1.5 Justification of the Study It is the desire of every nation‟s government to achieve economic stability and growth. Because of this, in line with vision 2030‟s objective to have an average annual growth of 10% per annum every year, the interest channel of monetary transmission mechanism should be thoroughly studied and understood. The study therefore sought to be of great contribution to the government, international financial institutions, policy formulators, private sector, the society at large and future scholars and students. In other words, the study‟s result was highly relevant in the formulation and implementation of an effective interest rate channel that will promote growth and improve the welfare of the people. The study will be used by the government as a benchmark for comparison of past years monetary policies and review them basing on results found in the study and therefore enable them formulate and implement an interest rate considered to be optimal for economic growth and development of Kenya. Thirdly, the study sought to serve as a contributing foundation in guiding students who wish to further their research in this topic as they will use the work as a baseline study and subsequently work on them for better results. The study will also be important to forex dealers, securities markets dealers, the government and the public as a whole, to understand the degree of responsiveness of foreign exchange, financial securities and the economy at large to interest rate changes. 1.6 Scope of the Study Th