Monetary policy at the turn of financial markets: A forerunner or follower?

This paper seeks to establish whether the monetary policy stance of Central bank of Kenya (CBK) at the turn of financial markets is pre-emptive or a cleanup. The feedback loop between monetary policy reaction and the markets' response presupposes a sequencing that runs from the former to the latter. That hardly rule out the possibility of monetary policy responding to financial markets' actions, not necessarily preempting them. Deploying a structural vector autoregressive (SVAR) model on Kenyan data for the period December 2013 to June 2024, we establish that there is a dynamic interaction among key financial market prices that is not necessarily at the prompting of monetary policy. This points to how financial markets are pre-emptive, and the monetary authority playing catchup. Such sequencing comes with the possibility of monetary policy reacting to market movements more than markets responding to monetary policy signal, underlying the tension between monetary policy and fiscal policy. The direct connection between the CBK's policy signal and the inter-bank rate justifies the CBK's interest rate corridor around the former. We however consider that as a necessary but not sufficient framework for efficient policy signalling and transmission unless it is accompanied by measures to address inter-bank market segmentation as well as those that can injects vibrancy in the horizontal repo market. We further contend that the positioning of the foreign exchange policy in support of monetary policy objectives is encumbered by the small-open-economy attributes that limits the assumption that full flexibility is sufficient for full effectiveness.