Monetary Policy Implementation and Volatility Transmission Along the Yield Curve: The Case of Kenya

• Published date: 01 September 2017
• Author: R. Armando Morales,Fan Yang,C. Emre Alper
• Date: 01 September 2017
• DOI: http://doi.org/10.1111/saje.12155

MONETARY POLICY IMPLEMENTATION AND VOLATILITY

TRANSMISSION ALONG THE YIELD CURVE: THE

CASE OF KENYA

C.EMRE ALPER*, R.ARMANDO MORALES

†

AND FAN YANG

†

Abstract

This paper analyses the degree to which volatility in interbank interest rates leads to volatility in

financial instruments with longer maturities (e.g. T-bills) in Kenya since 2012, year in which the

monetary policy framework switched to a forward-looking approach, relative to seven other infla-

tion targeting (IT) countries (Ghana, Hungary, Poland, South Africa, Sweden, Thailand and

Uganda). Kenya shows strong volatility transmission and high persistence similar to other coun-

tries in transition to a more forwardlooking monetary policy framework. These results emphasize

the importance of a strong commitment to an interbank rate as an operational target and suggest

that the central bank could reduce uncertainty in short-term yields significantly by smoothing

out the overnight interest rates around the policy rate.

JEL Classification: E58 - Central Banks and Their Policies, E43 - Determination of Interest

Rates; Term Structure of Interest Rates

1. INTRODUCTION

Modern central banks typically act to smooth overnight interbank rates at or close to the

policy rate. Through day-to-day liquidity operations, the central bank drives the over-

night interbank interest rate to its desired level consistent with its targets and contains its

volatility around that level, aiming at influencing and stabilising longer-term rates,

important for overall level of prices and real economic activity. Changes in the policy

rate may not have the intended effect on funding costs for longer-term maturities, if

accompanied by increased volatility of the overnight market interest rate, all else equal.

1

In fact, the consensus for an optimal central bank operational frameworks relied on

the following elements (based on Bindseil, Evaluating Monetary Policy Operational

Frameworks, Jackson Hole, Kansas Fed Symposium, Unpublished Manuscript, 2016).

* Corresponding author: Senior Economist, International Monetary Fund, African Depart-

ment, 700 19th Street, Washington District of Columbia 20431-0001, United States. E-mail:

EAlper@imf.org

†

International Monetary Fund, African Department, United States.

We thank Herve Joly, Vitaliy Kramarenko, and two anonymous referees, for helpful com-

ments. The views expressed are those of the authors and do not necessarily represent the views

of the IMF. Standard disclaimer applies.

The International Monetary Fund retains copyright and all other rights in the manuscript of

this article as submitted for publication.

1

The effects of volatility in overnight interbank market on longer-term maturities have been

studied for advanced economies. Among others, see Ayuso et al. (1997), Avouyi-Dovi and Jondeau

(1999), Cohen (1999), Nautz and Offermanns (2008) and Carpenter and Demiralp (2011).

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C2017 Economic Society of South Africa. doi: 10.1111/saje.12155

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of Economics

a. A single and well defined day-to-day operational target, ideally a short-term inter-

est rate. “The first and most important objective against which to evaluate an

operational framework is its effectiveness from the perspective of the degree of

control of the operational target of monetary policy. In normal times, this means

essentially the ability to control short-term interest rates and can be measured by

comparing an announced operational target interest rate with the actual market

interest rate.”

2

b. The operational framework should be simple, ideally relying on open market oper-

ations, a reasonable structure of reserve requirements, and a symmetric standing

facilities corridor around the target interest rate.

c. Sufficient arbitrage and stability of relations between the overnight rate and the

rest of the interest rate structure, with normal market access for solvent agents.

For many developing economies, reliance on policy interest rates to signal the mone-

tary policy stance is a relatively recent phenomenon. Until recently, most developing

economies used to center their monetary policies on periodic quantitative targets for

money aggregates. Similar to experiences of industrialized countries in the early 1980s,

the move away from conventional monetary targeting in developing countries emerged

as a result of weaker relationship between money and inflation, owing to decreases in

inflation rates to single digits, rapid financial innovation, greater integration with the

global economy and deregulation of financial markets contributing to unstable money

demands.

3

Coupled with higher exchange rate flexibility and lower fiscal financing

requirements, several countries have switched to modern monetary frameworks by using

interbank interest rates as the operational target to achieve the inflation objective. How-

ever, operational challenges in hitting the operational target consistently raise questions

about the readiness of frontier economies to move more decisively to a full-fledge infla-

tion targeting (IT) framework.

4

This paper analyses the transmission of changes in the policy rate to the interbank interest

rate and assesses the degree to which volatility in overnight interbank rates affects volatility

in other maturities in Kenya relative to a sample of seven IT countries, namely Ghana, Hun-

gary, Poland, South Africa, Sweden, Thailand and Uganda. Previous studies found that rea-

sonable stability of short-term interest rates are conducive to stabilising long-term rates.

They also found that reserve requirements, improved communication and increased trans-

parency of the interbank rate target help mitigate volatility along the yield curve.

5

In line with the literature, the paper first estimates exponential generalized autoregres-

sive conditional heteroskedasticity (E-GARCH) models to examine the daily volatility of

interbank rates for Kenya and the seven selected IT countries. Next, it assesses, for each

2

See Bindseil, Evaluating Monetary Policy Operational Frameworks, Jackson Hole, Kansas Fed

Symposium, Unpublished Manuscript, 2016.

3

See IMF (2015b) for an overview of issues in evolving monetary policy regimes in the low-

income countries and other developing countries.

4

These issues are discussed in Maehle, Monetary Policy Implementation: Operational Issues for

Countries with Evolving Monetary Policy Regimes, Unpublished manuscript (2015) and IMF

(2014).

5

See Ayuso et al. (1997), Cohen (1999), Nautz and Offermanns (2008), Nautz and Schmidt

(2009) and Carpenter and Demiralp (2011), Abbasi and Linzert (2012), among others.

456 South African Journal of Economics Vol. 85:3 September 2017

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C2017 Economic Society of South Africa.