On the Sources of Inflation in Kenya: A Model‐Based Approach

• DOI: http://doi.org/10.1111/saje.12072
• Author: Michal Andrle,Rafael Portillo,Andrew Berg,Jan Vlcek,R. Armando Morales
• Published date: 01 December 2015
• Date: 01 December 2015

ON THE SOURCES OF INFLATION IN KENYA:

A MODEL-BASED APPROACH

MICHAL ANDRLE

†,

ANDREW BERG

†,

R. ARMANDO MORALES

‡,

RAFAEL PORTILLO

*

AND JAN VLCEK

¶

Abstracts

We develop a semi-structural new-Keynesian open-economy model – with separate food and

non-food inflation dynamics to study the sources of inflation in Kenya in recent years. To do so,

we filter international and Kenyan data (on output, inflation and its components, exchange rates

and interest rates) through the model to recover a model-based decomposition of most variables

into trends (or potential values) and temporary movements (or gaps) – including for the

international and domestic relative price of food. We use the filtration exercise to recover the

sequence of domestic and foreign macroeconomic shocks that account for business cycle dynamics

in Kenya over the last few years, with a special emphasis on the various factors (international food

prices, monetary policy) driving inflation. We find that while imported food price shocks have

been an important source of inflation, both in 2008 and more recently, accommodating monetary

policy has also played a role, most notably through its effect on the nominal exchange rate. We also

discuss the implications of this exercise for the use of model-based monetary policy analysis in

sub-Saharan African countries.

JEL Classification: E52, E58, F47, O23

Keywords: Monetary Policy, Forecasting, Food Prices, Kenya, Low-Income Countries

1. INTRODUCTION

Central banks in sub-Saharan Africa (SSA) have had a mixed inflation performance in

recent years. On the one hand, since the early 2000s, many countries in SSA have

succeeded in re-anchoring inflationary expectations, reducing median inflation in the

region from 15% in 2000 to 6% in 2006. This has taken place in the context of

fiscal-based stabilisation efforts, in which many countries adopted policy regimes centered

on targets for reserve and broad money.1While de facto flexibility was and has always

been the norm – money targets are frequently missed in either direction – the adoption

of such targets was meant to signal that the central bank was “holding the line,” i.e. that

stabilisation efforts were on track and that fiscal pressures on monetary policy were

contained.

* Corresponding author: Senior Economist, Research Department, International Monetary

Fund, 700 19th ST NW, Washington, DC 20431-0002, USA. Tel: 2026239329. E-mail:

rportillo@imf.org

†Research Department, International Monetary Fund, Washington, DC, USA.

‡International Monetary Fund, Washington, DC, USA.

¶OGResesarch, Prague, Czech Republic.

1See International Monetary Fund (2008).

South African Journal of Economics Vol. ••:•• •• 2014

© 2014 Economic Society of South Africa. doi: 10.1111/saje.12072

1

E-mail: rportillo@imf.org

V

C2014 Economic Society of South Africa. doi: 10.1111/saje.12072

475

South African Journal of Economics Vol. 83:4 December 2015

South African Journal

of Economics

On the other hand, more recently, SSA has experienced large swings in inflation.2To

a large extent, this reflects external factors. The region has been buffeted by large external

shocks, starting with the first food and fuel crisis of 2007-2008, spillovers from the global

financial crisis in 2008-2009 and the spike in commodity prices in 2010-2011. However,

an important question is the role that monetary policy may have played during these

episodes, relative to the external factors. This is of particular importance to policy makers,

as there is an acknowledgement that existing frameworks, with their emphasis on money

targets and money target misses, have not provided a useful framework for thinking about

external shocks and the role that policy may have played in amplifying them. In this

paper, we apply a model-based approach to answer this question, with an application to

Kenya.

Central banks in advanced and emerging markets make use of a variety of models to

study these types of questions. These models are typically new Keynesian, which embody

the fairly general view that aggregate demand and monetary policy matter for output

dynamics in the short run. Unlike their Keynesian predecessors, these models are built on

micro-foundations and rational expectations.3At their core, they consist of a forward-

looking IS equation, a hybrid Phillips curve, a monetary policy rule and an uncovered

interest parity (UIP) equation.4An important feature of these models is the emphasis on

gaps in output and the real exchange rate – deviations between observed values and trend

or potential components – as drivers of inflation. Considerable effort therefore goes

towards distinguishing gaps from trend.

Our emphasis in this paper is on disentangling the role of external factors vs. the

contribution of monetary policy decisions (and other domestic factors) in the dynamics

of food and non-food inflation. To that end, we extend the standard framework by

introducing two separate Phillips curves, one for food and one for non-food. The

disaggregation requires that special attention be paid to various relative food prices: both

the domestic and the international relative price as well as the deviation between the two.

It also calls for a careful treatment of trends in these relative prices, which we explicitly

undertake here, for two reasons. First, trends in relative prices have implications for the

consistency between sectoral inflation rates and the inflation target (towards which

headline inflation eventually converges). Second, deviations between relative prices and

their trend becomes an important source of inflationary pressures, both sectorally and in

the aggregate, as these gaps enter the Phillips curves directly.

The Kenyan case is representative of the challenges SSA countries have faced in recent

years. As Fig. 1 indicates, Kenya experienced large swings in inflation, first increasing to

16% in mid 2008, falling back to under 4% in mid 2010, only to increase again to almost

20% at the end of 2011. While movements in international food prices account for some

of these fluctuations, monetary policy may have also played a role, with short-term

interest rates falling from 6% in 2009 to about 1% by early 2011.

We filter selected macroeconomic data from Kenya through the model, in order to

recover a model-based decomposition of most series into gap and potential/trend

components. The filtration exercise also serves to recover the sequence of macroeconomic

2See World Economic Outlook Fall 2011, chapter 3.

3See Clarida et al. (1999) and Gali and Monacelli (2005), among many others.

4See Berg et al. (2006) for an overview of the standard forecasting and policy analysis system

model.

South African Journal of Economics Vol. ••:•• •• 20142

© 2014 Economic Society of South Africa.

476 South African Journal of Economics Vol. 83:4 December 2015

V

C2014 Economic Society of South Africa.