Effect Of Monetary Policy On Retail Interest Rates In Kenya

ABSTRACT

Kenya’s economic policy stance since 1966 has been to keep interest rates under control so as to promote monetary stability. Economic growth and inflation averaged 4.4 per cent and 10.2 per cent, respectively, in the period 1963 to 2016. However, despite the growth rate of the economy and moderate inflation rates, managing interest rates remained a major macroeconomic policy concern. The lending rates and deposit rate responded to interbank and treasury bill rates changes but with some level of rigidity. The Central bank of Kenya has continued instituting interventions in order to bring down retail interest rates in Kenya. Several theories have been advanced to describe the transmission of monetary policy rates to commercial bank retail interest rates. Key among these theories include the Keynesian, New Keynesian, Monti-Klein Model, and Monetary Policy Transmission Mechanism. It is upon these theories that this study was based. The empirical literature on the response rate of retail interest rates to monetary policy rate changes has exhibited different results based on financial institution, product, and country. The broad objective of this study was, therefore, to determine the effect of monetary policy on retail interest rates in Kenya. The specific objectives of the study were to investigate the effect of monetary policy rate changes on retail interest rates in Kenya, to determine the speed of adjustment of retail interest rates to monetary policy changes in Kenya and to determine the effect of bank size on retail interest stickiness in Kenya. The variables of the study included lending rates, deposit rates, interbank rates, and treasury bill rates. The study disaggregated data based on various categories of banks as large and small. The study used secondary monthly data for the period 2003 to June 2016. Engle-Granger 2-step Error Correction modelling method using time series data was employed in the study. The regression results found that the effect of the interbank rate on deposit rates of small banks was positive and statistically significant at five per cent level. The effect of the treasury bill rate and interbank rates on lending rates of large banks were statistically significant at ten per cent level. To estimate the speed of adjustment, regression results obtained the coefficients of error correction terms of –0.126 and -0.224 for lending rates of small banks and large banks, respectively. The coefficients of error correction terms for deposit rates of small banks and large banks were -0.137 and -0.171, respectively. All the coefficients of error correction terms were statistically significant at one per cent level. To determine retail interest rates stickiness, mean lag estimates of 8 and 4.55 were obtained for lending rates of small and large banks, respectively. The mean lag showed that lending rates of large banks took a shorter period to reach the long run equilibrium value compared to lending rates of small banks. Overall the effect of monetary policy on retail interest rates in Kenya is low and needs to be improved. The study, therefore, recommends that policies be put in place to enhance monetary policy transmission in Kenya.