Kenya’s MPC Cuts Rates to Spur ‘Below-Potential’ Economic Growth

NAIROBI (Capital Markets in Africa) – The Central Bank of Kenya unexpectedly cut its key policy rate by 50 basis points to 9% today, citing well-anchored expectations of inflation and growth below its potential. The decision was against our forecast and the median forecast of economists in a Bloomberg survey for no change.

• Well-anchored inflation expectations and below potential economic output gives room for accommodative monetary policy, according to MPC.
• Food and fuel costs are likely to push inflation higher in 2H, possibly forcing a policy reversal in 2019.
• Risk of a weaker shilling because of global dollar strength.
• An interest-rate cap on what banks can charge on loans is still inhibiting the transmission of monetary policy, making the rate move less effective

Inflation, Rates Near Inflection Point
The Central Bank of Kenya’s justified the decision by saying inflation expectations are well-anchored within its 2.5-7.5% target range while economic output is below potential. The cut came even as policy makers cited the risk of “perverse” outcomes, before inflation starts rising in 2H.

The MPC also highlighted the risk of higher domestic fuel prices, due both to the increase in the national oil price and the imposition of excise tax on some fuel, as exerting a moderate upward pressure on inflation in the near term. But it expected overall inflation to remain within its target range mainly because of expectations of lower food prices as a result of favourable weather.

Dollar Strength Could Hit Shilling Again
Inflation figures for July, scheduled for release tomorrow, will give an indication as to what extent lower food prices may offset increased fuel costs. We forecast an increase in the headline inflation rate to more than 5% as a result of higher excise costs at the start of fiscal 2018-19. Inflation may slow slightly in August before climbing again in September when a value-added tax of 16% on fuel products is due to take effect.

The rate cut is likely to have a limited impact on the value of the shilling in the near term because of the low foreign participation in Kenya’s bond market, but it may raise concerns about whether the central bank can isolate itself from a rising U.S. dollar. A sharp upturn in the dollar starting in late 2014 hit the shilling with a vengeance in 2Q15 and domestic and foreign investors will be worried that this sequence of events will be repeated in 2H.

Interbank Market Still Divided
As we noted previously, the rate cut is likely to only affect the funding costs of the weaker banks in the Kenya because of distortions in the interbank market (see chart above). Still it will reduce the rate that larger banks can charge their customers to 13% and may thus prompt them to reduce their lending to riskier customers, hence the central bank’s “perverse outcomes” phrase.

We expect private-sector credit growth to accelerate further in 2H but remain below its level of two years ago, therefore it is unlikely to have a significant impact on economic growth.

Mark Bohlund covers Africa for Bloomberg Economics in London. He has previously worked as an economist at IHS Global Insight, BMI Research (now part of Fitch Group) and the Swedish Foreign Office.

Source: Bloomberg Business News