Analysis of Interest Rate Pass-through in Kenya

Abstract

Low stable inflation is virtually the main policy objective for most of the Central Banks around the world pursued in the context deregulated interest rate regime, globalization and rapid adoption of modern information and communication technologies. As a result, the interest rate channel of monetary transmission mechanism has attracted much more attention than ever before. This study deals with the interest rate pass-through, which is defined as the degree and the speed of adjustment of retail bank rates to monetary policy interest rate, in all Kenyan banks (large, medium and small banks). The effectiveness of inter est rate channel in economy is quantified by analysing the pass-through of policy interest rate changes to retail banking rate and loan and deposit volumes. Short term money market rate has been used as a proxy for the policy rate and various deposit and loan rates of different maturities together with volumes have been used for analysis. Unit root, autoregressive distributed lag model and error correction modelling is applied on the monthly data set (2003-2014) to find the short-run and long-run relationship between the interest rates. Results indicate that small banks have the most effective interest rate transmission mechanism, followed by medium then large banks. The low level of interest rate pass-through for large banks can be attributed to the high banking sector competition and high switching costs. The mean adjustment lags indicate that, changes in policy interest rate are not fully and frictionlessly transmitted to retail bank interest rates. These results suggest the importance of adopting forward looking approaches by the Central Bank in order to appropriately integrate the estimated lag period required for policy actions to affect the objectives of the Bank.