Speech

Monetary Policy and the Future of Central Banking: Implications for Africa

September 13, 2016

Ladies and Gentlemen, Governor Njoroge, I am honored to join you today to commemorate the 50^th anniversary of the Central Bank of Kenya.

I have had the pleasure of working closely with Patrick—if I may call you Patrick, Governor—during his previous incarnation at the IMF, and it is truly a joy to share this moment with you.

This is an important milestone for Kenya, so I am very happy to have this opportunity to reflect upon your journey over the past half century—and to discuss with all of you the way forward.

In the time we have today, I would like to discuss the current state of central banking in Sub-Saharan Africa and to explore the challenges that this region’s central bankers face as they address the increasingly complex forces at work in the global economy.

Of particular concern is a global economy marked by subpar growth with downside risks related to the ongoing adjustment in the global economy.

In addressing these challenges monetary policy has a central role to play. Along with government fiscal policies, well-designed and well-implemented monetary policies are essential for a country to achieve strong, sustainable and inclusive growth.

Evolution of Central Banking

Let me begin by briefly taking stock of developments in central banking and monetary policy over the last 50 years, and then placing those developments in the African context.

Traditionally, the primary objectives of monetary policy have been to maintain price and financial stability and to help achieve full employment.

At times there may appear to be a conflict between the goals of low inflation and economic growth. But we have learned from hard experience that high inflation distorts the private sector’s savings and investment decisions—leading ultimately to slower growth.

That is why countries have increasingly placed greater emphasis on price stability, and many of them have made low and stable inflation the primary objective for monetary policy.

To achieve the price stability objective, we have seen monetary policy frameworks evolve over time. In the period after World War II, monetary policy operated in the context of fixed exchange rates under the Bretton Woods system.

Following the collapse of that system in 1972, central banks generally used monetary targets and soft exchange rate pegs to bring down the high inflation that the world experienced through the early 1980s.

However, as inflation fell, and financial innovation emerged, the link between money targets and inflation outcomes became increasingly tenuous. In addition, the increase in capital flows—and the market volatility that followed—created significant challenges for small, open economies operating soft exchange rate pegs to deal with external shocks while seeking to achieve price stability.

This is why central banks have gradually switched to forward-looking monetary policy frameworks to stabilize their economies. Starting with New Zealand in 1989, many central banks responded to these challenges by switching to formal inflation targeting as a framework for monetary policy.

This approach essentially combines an explicit inflation target with a commitment to use market-based instruments and a flexible exchange rate to achieve the inflation target over the medium term.

Not all central banks adopted formal inflation targeting frameworks. But in most cases the operational framework has been similar—that is to say, it was centered on adjusting short-term policy rates to maintain low and stable inflation over the medium term.

These forward-looking monetary policy frameworks have been supported by legislative mandates to give central banks operational independence. This has been coupled with procedures that ensure central bank transparency and public accountability.

African Central Banking in Perspective

These trends certainly have influenced the way central banking and monetary policy have evolved in Sub-Saharan Africa. In the immediate post-colonial era, the new central banks lacked independence from their governments: they were directed to finance large fiscal deficits. There were pervasive foreign exchange and interest rate controls.

Starting in the late 1980s and increasingly during the 1990s, the region largely adopted monetary policy frameworks based on either monetary targets or exchange rate pegs. These were supported by smaller fiscal deficits and reduced central bank financing of those deficits.

Now, however, the weaker relationship between money and inflation, and the changing financial landscape, are again calling on African central banks to adjust their strategies.

Ghana, South Africa, and Uganda have adopted formal inflation-targeting regimes. Other countries with flexible exchange rate regimes are de-emphasizing the role of monetary aggregates and incorporating elements of the monetary policy practices of industrial and emerging market countries.

These practices include greater reliance on interest rates for the transmission of the monetary policy stance, improved liquidity management, and greater focus on policy analysis, forecasting, and communications.

Kenya does not formally target inflation. But since 2011 it has adopted a more forward-looking monetary policy framework centered around the CBK’s policy rate, which is set by a monetary policy committee. As many of you know, this policy is aimed at maintaining inflation within the government’s target range of 2.5 percent on either side of the 5 percent medium-term target. Using this framework, Kenya has successfully managed to keep inflation within the target range most of the time over the past several years.

Sub-Saharan Africa’s shift toward more forward-looking monetary frameworks has been supported by reduced fiscal deficits, generally more flexible exchange rate regimes, and a more intensive use of market-based monetary instruments.

At the same time, financial systems in the region have experienced significant deepening over the past decade. This should translate into potentially stronger monetary transmission over time.

A key element of this deepening has been the region’s emergence as a world leader in innovative financial services based on mobile phone technology. This has led to a breakthrough in financial inclusion, especially here in East Africa.

And as you know, Kenya has led the way: over 75 percent of your population has now financial access, up from about 40 percent just five years ago. This reflects the fast spread of M-Pesa, M-Shwari, and M-Kesho, which has helped reduce transaction costs and facilitate personal transactions.

On top of this, Kenya also has one of the most diversified and deep financial sectors in Sub-Saharan Africa. Your well-established government bond market is providing key support for effective transmission of monetary policy. Other African countries are making similar progress.

Challenges Facing Africa

Nonetheless, many central banks in Sub-Saharan Africa are facing serious obstacles as they design and implement effective monetary policies—not least because of the combination of external and domestic challenges. Allow me to elaborate.

The external factors are well known to this audience. Many African countries have been feeling the pain of the collapse in commodity prices. Growth has fallen sharply, and inflation is rising as a result of exchange rate depreciation.

Countries that are less dependent on commodities exports—including Kenya—are doing better. But the room for maneuver that their central banks have enjoyed for the past several years is becoming more confined.

A key reason for this is the region’s integration into global trade and financial networks. You are subject to forces well beyond your control.

For example, the uncertainty surrounding the timing of exit from unconventional monetary policies in advanced countries has increased the volatility of capital flows. The risk is that a sudden reversal of capital inflows could lead to a large and disorderly depreciation of the local currency, with adverse implications on both inflation and financial stability.

All of this greatly complicates the conduct of monetary policy. Still, the good news is that many of Sub-Saharan Africa’s central banks have built adequate international reserve cushions. This includes Kenya, giving the CBK greater room for maneuver, and reducing the risk of a sudden reversal of capital flows in the first place.

This confluence of international developments is heightening the domestic challenges that central banks are facing. Many still have limited operational capacity. This partly reflects persistent weakness in government cash flow management, which makes it difficult for central banks to adequately manage liquidity conditions.

Together with restrictions on access to central bank standing facilities for lending to banks and allowing them to place deposits with the central bank, at times this results in large variances between policy rates and the market rates relevant for commercial bank liquidity managing. This risks rendering policy rates irrelevant for commercial bank pricing and lending decisions, thus reducing the effectiveness of monetary policy.

Another challenge facing many African countries is the persistence of very high spreads between the interest rates offered on deposits and those charged on loans. This has led to understandable frustration among borrowers about the cost of credit, and has produced political pressure for interest rate controls.

However, the politicization of monetary policy bears well-known risks—for the soundness of the financial system and for credit access, notably higher-risk borrowers. International experience suggests that, in many cases, interest rate controls may actually end up reducing access to the banking system for small borrowers—such as farmers, SMEs and consumers—and may also revive informal lending at much higher cost for borrowers.

In addition, linking deposit and lending rates to the central bank’s policy rate may compromise the independence of the central bank, and hamper its ability to enact monetary policy towards achieving its main objectives—that is to maintain price and financial stability and to support the economy.

Finally, the limitations of high-frequency economic indicators in many countries, especially on external trade and the real economy, constrains monetary authorities’ ability to take corrective actions in a timely manner.

The Way Forward

So how can we best address these challenges? The answer will not be the same for countries.

Where countries have chosen to belong to a currency union, or maintain a hard peg, the exchange rate will continue to anchor monetary policy. In countries where institutional capacity remains very weak, building that capacity should be the first priority.

But for many others, notably the frontier economies in Africa that are rapidly integrating into global financial markets, more forward-looking monetary policy frameworks will be needed in the coming years.

Let me now turn to seven principles to increase the effectiveness of monetary policy for countries seeking to move towards forward-looking monetary policy frameworks, which are based on the experience around the world on such frameworks. Here I would like to emphasize that I am making points that apply across the region. Kenya already has embraced many of these principles.

First, the central bank should have a clear legal mandate of policy goals and operational independence to pursue these goals.

Second, the primary, medium-term objective of monetary policy should be price stability. Monetary policy ultimately has a limited capability to directly influence real variables such as output growth over the long-term.

Third, the central bank should make a medium-term numerical inflation objective the cornerstone for its monetary policy actions and communications. A transparent inflation objective provides a simple benchmark against which to measure performance.

Fourth, the central bank should carefully take into account the implications of monetary policy adjustments for financial stability. However, this should not come at the expense of undermining the central role of the medium-term inflation objective. Any significant erosion of central bank credibility can change inflationary expectations for the worse. This, in turn, could have an undesirable impact on real activity and financial stability.

Fifth, the central bank should have a clear and effective operational framework, by setting an operating target and clearly communicating the link between such an operating target and the medium-term inflation objective. This supports the functioning of money markets.

Sixth, the central bank should have a transparent, forward-looking monetary policy strategy that reflects timely and comprehensive assessments of the monetary transmission mechanism.

Seventh, central bank communications should be transparent and timely. This helps reduce uncertainty, improves monetary policy transmission, and facilitates accountability. The goal must be to build credibility.

Conclusion

Having listed these seven principles, I would like to stress each country faces unique conditions and challenges that will dictate the pace at which they proceed. What is essential is to have internally consistent policy goals, the institutional arrangements that give the central bank the operational independence to pursue these goals, and transparency.

Many countries in Sub-Saharan Africa, including Kenya, are well advanced along this road. It is an important achievement. The IMF is fully committed to provide any assistance that the Kenyan authorities and those across Africa may need to continue upgrading the monetary policy frameworks to address the challenges of the future.