You've been measuring inflation all wrong, IMF tells central bank

The International Monetary Fund (IMF) has sharply criticised the Central Bank of Kenya (CBK), accusing it of relying on a “flawed” economic forecasting model that has for years systematically misdiagnosed the drivers of inflation or cost of living undermining President William Ruto’s efforts to curb surging living costs. 

In a confidential technical assistance report reviewed by Standard, IMF experts concluded that the CBK’s core forecasting model, the primary mathematical tool used to set interest rates, was “inadequate for capturing important policy channels and external shocks.”  

The shocking findings by the global lender come as the country grapples with inflation that hit 6.7 per cent in May and as the Ruto administration faces fierce public backlash over the run-away cost of living crisis.  

The IMF said it conducted a comprehensive review of the CBK’s Quarterly Projection Model (QPM). What they found was a system riddled with fundamental analytical flaws, their report published recently says.  

Perhaps the most damning criticism centered on the bank’s continued use of a Monetary Conditions Index (MCI), a composite gauge of interest rates and exchange rates, to guide policy decisions.  

The IMF team cited research by prominent economist Lars Svensson, who found that similar MCI usage in New Zealand before 1999 had “contributed to unnecessary interest rate variability and potentially unnecessary output variability.”  

The report concluded that Kenya’s reliance on the MCI represented a substantial deviation from best practice inflation targeting.

The IMF also tore into the CBK’s approach to fiscal policy, noting that the bank had been using the budget deficit as a proxy for government spending’s impact on demand, a method the report said had “important limitations.”  

“The deficit may reflect changes in expenditure, revenues or debt-service costs, each with different implications for aggregate demand,” said the report.  

The report noted that a higher deficit driven by lower revenues or increased debt payments does not stimulate demand, meaning, the CBK’s old model risked misreading fiscal contractions as expansions. 

The IMF report also unearthed a severe technical flaw in the policy transmission mechanism, noting that the CBK’s non-agricultural output was too sensitive to both the exchange rate and the interest rate.  

The report warned that following an increase in the interest rate, the currency would appreciate considerably and amplify the decline in output.  

This overreaction meant the old model exaggerated the negative impact of rate hikes, potentially scaring policymakers away from necessary tightening during inflationary episodes. 

The IMF also found that the CBK had been placing severe climate events in the wrong analytical category. 

Weather-related disruptions were previously proxied by agricultural output shocks but placed in the demand block, a decision the report said produced potentially misleading monetary policy implications.

In other words, supply shocks that drive up food prices were being treated as demand shocks, leading to inappropriate policy responses that could either exacerbate inflation or unnecessarily stifle growth. 

Beyond the models themselves, the IMF sharply criticised the CBK’s institutional infrastructure. The forecasting team, the report said, relies on maintaining data in multiple Excel files, a system the IMF described as prone to errors and one that consumes a significant amount of time from forecasters who should be focused on analysis. 

The IMF also raised alarm over the bank’s institutional fragility, noting that “many key macroeconomic indicators such as quarterly GDP by expenditure components... are largely unavailable, severely limiting the depth of analysis.  

The forecasting team remains small and faces the risk of staff turnover, with the bank attempting to mitigate this by rotating staff across roles, though at the expense of specialisation. The IMF highlighted that the compressed schedule of six MPC meetings per year places significant pressure on the forecasting team.  

The IMF has now laid out an urgent reform agenda that will bring radical systematic changes at CBK.