Impact Of Financial Innovation On Efficacy Of Monetary Policy Transmission In Kenya

By Leonard Kipyegon
January 2015
The aim of this study was to investigate the impact of financial innovation on efficacy of monetary policy transmission in Kenya. The study also established the relative importance of the monetary policy transmission channels on target economic variables, particularly inflation and real output. The study used structural vector autoregression on monthly data for the period October 1997 to June 2014 divided into before – and after – financial innovation in order to evaluate the impact of financial innovation.

The results indicate that financial innovation has effects on key channels of monetary policy transmission and the dynamic responses of the identified shocks are largely consistent with theoretical expectations. A notable improvement was established on the effectiveness of interest rate channel, exchange rate channel and credit channel of monetary policy transmission with the financial innovation. Although expected decline was established on the Nairobi stock exchange with financial innovation, it was weak implying that the asset price channel is still evolving. The results also indicates improvements on the effect of central bank rate innovation on inflation and yet relatively weak was more persistent. However, central bank rate innovation on real output was weak in both before- and-after analysis implying that monetary policy shocks are not major source of fluctuations in real output.

The study demonstrated increasing importance of the central bank rate in accounting for fluctuations in consumer price index (inflation rate) in the analysis after financial innovation, with an improvement in the first year to 18.1 percent from 16.5 percent. Moreover, the relative importance of lending rates, exchange rate and private sector credit in explaining fluctuations on consumer price index has improved with financial innovation.

Therefore, the central bank can still effectively rely on interest rate, exchange rate and credit channels of monetary policy transmission in pursuit of its primary objective of price stability as financial innovation augmented these channels. The minimal effects of monetary policy shocks on the NSE index imply evolving potentials of assets price channel and there is need for further deepening of capital markets developments. There is also need to invest on proper timing of monetary policy adjustments as its effects on consumer price index persist.