A "Balanced Argument" on Interest Rates

A superficial look at Robert Bunyi's commentary in the Business Daily gives the impression of a well-reasoned and balanced argument on the emotive subject of interest rates. It will take a trained eye to note that the commentary hides as much as it reveals on the general understanding on the determination and importance of the price of money in the broader dynamic of financial intermediation and the interplay between policy and market outcome.

Let me start with what it hides. One is the fact that there is no perfect correlation between the adjustment of the monetary policy signalling rate - the Central Bank Rate (CBR) - and the market interest rates. Even when such correlation exists, it comes with a time lag that depends on - among other factors - the level of depth of the financial system generally and the banking industry particularly. In our case, even the mechanism through which such policy is transmitted is not understood. As I recently argued in an essay in the Business Daily, even those seeking to support the Central Bank of Kenya (CBK) understand the monetary policy transmission mechanism are speaking from both sides of their mouths.

Two, is the fact that the effective demand for credit function is not a two-variable model with the sole determinant being interest rate. There is more at play here such that even if interest rates were to decline, credit demand will not necessarily respond. Real GDP growth numbers are interesting only on account of their outlook being continuously revised downwards. If the thinking is that credit expansion alone will spur sustained recovery then clearly there is need to give hard thinking a chance as a substitute for armchair economics practice.

For one, the slower than expected real GDP growth can only mean that the economy still has some substantial output gap - the difference between actual growth and potential growth. Under the circumstances therefore you can't expect a robust credit demand on the back of an economy whose performance is anything but robust.

Furthermore, it cannot be only the monetary policy to do the heavy lifting while the fiscal policy is actually seen as a drag to growth. As a recent World Bank report indicates, low government expenditure on account of absorption challenges is one of the key factors for the output growth not meeting the forecasted target.

Let me now turn to what it reveals. One, it reveals that there is little appreciation of the fact that the likely effect of the decision by the CBK's Monetary Policy Committee (MPC) in its January 14, 2014  will depend on the prevailing market liquidity conditions. If liquidity is tight - and this may be the case given that the inter-bank rate that has largely been below CBR when the CBK was pursuing an increasingly accommodative monetary policy are now showing signs of keeping ahead of the CBR (see Figure) - then any attempt to play activist through a reduction will not yield the anticipated results of increased credit.

Two, there is a misguided notion that the role of monetary policy is to support growth more than to promote stability. When I last checked, the CBK - unlike the Fed or the Reserve Bank of India - does not have a dual mandate; its forte is stability. That is not to say that sometimes it doesn't act as if it has a dual mandate.

So, Robert Bunyi's essay may well be balanced - on what it reveals being as much as what it hides, and on both accounts reflecting how sometimes even with good intentions analysts do not deeply reflect on issues they tackle.