Central Bank acts to prevent further fall in shilling rate

• Governor says move to increase interest rate will shore up weakening currency and cushion poor and middle class

The Monetary Policy Committee of the Central Bank voted to increase interest rates slightly in a move designed to stop the recent dramatic weakening of the shilling.

If it works, this could help save the majority poor and the middle class the pain they are feeling from rising electricity, transport and food prices since January.

The move is expected to result in an increase in Treasury bill and bond yields in a bid to attract money from foreign investors with higher rates.

This will help boost the value of the shilling and forestall the dangers of further increases in the price of local goods and services from expensive imported oil, consumer electronics, industrial machinery and raw materials.

The decision to raise the Central Bank Rate by 0.25 per cent to six per cent, came as a surprise to the financial markets which had taken a cue from CBK’s governor Njuguna Ndung’u’s position that he would not defend the shilling because he believed it was a temporary issue.

“The move by the Central Bank of Kenya to increase the bank rate by 0.25 per cent to 6 per cent came as a surprise,” said Ms Razia Khan, the head of research in Africa at Standard Chartered Bank “not because there was any doubt that it was needed, but because the move followed an unexpected 0.25 per cent cut at the MPC meeting just prior to this one, at the end of January 2011.”

Consumers buying power

However, in MPC’s deliberation, it emerged that the members feared the negative impact of rising food and fuel prices was likely to halve consumers’ buying power, which could see the middle class and the poorest members of the society cutting their spending.

It is a major policy decision aimed to signal the fact that the MPC is worried of the pain the masses could be feeling from rising prices and the expected political consequences.

It is also a delicate trade off aimed at demonstrating that the CBK is willing to apply some little pressure on the breaks and risk slowing economic growth—and ultimately job growth in the formal private sector—for the sake of taming inflation.

The majority poor population in Kenya usually bear the pain of inflation immediately, compared to the benefits of a fast economic growth, which takes a long time to trickle to the bottom after benefiting the rich and the privileged who can take up high-skill jobs.

Fuel prices are expected to rise further in the coming days reflecting weakness of the shilling to the dollar. Food prices could also increase if the region does not receive adequate rainfall as it has already been projected by the weatherman. Inflation is also rising in Tanzania and Uganda because of food shortages in some parts of these countries.

“Rising inflation risks and perhaps the pressure on the foreign exchange rate have obviously been factors in the MPC’s assessment. The impact of the long rains on food prices is only expected to be seen with some lag – while higher transport costs, because of the higher price of imported fuel – will be felt in food prices almost immediately,” said Ms Khan.

A weak shilling makes it expensive to import goods, of which oil constitutes a major share of what the country buys abroad.

A weak shilling also favours exports who earn more. In a fast growing economy like Kenya’s, economist argue there a fine balance must be struck to maintain an optimum and stable exchange rate that neither hurts exporters or imports in order to keep local prices low.

The MPC is an independent advisory board appointed by the president to advise the CBK on how to guide the growth of the economy to create jobs and keeping prices stable. The MPC uses the central bank rate to signals to financial markets where thinks interest rates charged by commercial banks should be heading either to moderate economic growth or inflation rates.

Ms Khan said that in the short term, this should be positive for the shilling, although the bond market will need to digest how much further tightening will be needed. 

For Kenya, larger risks still loom large, and the domestic response to international pressures will need to be considered.