Nature and Dynamics of Adjustment of Commercial Banks’ Retail Rates to Monetary Policy Changes in Kenya

Abstract

Monetary authority’s legitimacy is based on the underlying assumption that policy actions are transmitted to market interest rates instantaneously, symmetrically and in a linear fashion. However, empirical evidence suggest that commercial banks’ pricing behavior, collusion and structure of financial system have an important bearing to transmission of policy-induced changes to the wider economy. Using monthly time series data from June 1993 to February 2012, this study investigated these assumptions by exploring nonlinear adjustment of commercial banks’ retail rates to monetary policy changes. Error correction model were re-parameterized to capture nonlinear aspects that may influence interest rate transmission via commercial banks in Kenya. The results revealed that adjustment towards long run equilibrium interest rates is sluggish, speed of adjustment of commercial bank retail rates to monetary policy changes ranges from 5 per cent per month to 15 per cent per month. Secondly, nonlinearity was established as speed of adjustments asymmetrical across monetary policy regimes and/or continuously time varying. The findings revealed that lending rates are rigid downwards as they adjusted faster during expansionary monetary policy regime compared to contractionary monetary policy regime. Third, there was evidence to suggest that nonlinearity adjustment simultaneously time varying and regime