IMF asks Kenya to adjust monetary policy to capture key climate risks

In its latest Technical Assistance Report, the IMF says Kenya's monetary policy framework should become more model-driven, scenario-based and anchored on a revamped Quarterly Projection Model (QPM).

 

This framework serves as the central bank's main tool for forecasting inflation, economic growth and guiding interest rate decisions. 

The recommendations come as Kenya continues to contend with volatile weather patterns, fiscal pressures and an increasingly uncertain global economic environment.

According to the report, although CBK has made significant progress in modernising its monetary policy framework, the existing model no longer adequately captures the complex transmission channels through which government spending, exchange rates, commodity prices and climate shocks influence inflation and economic activity.

The IMF says the revised framework should place greater emphasis on scenario analysis, allowing policymakers to assess how different risks could affect inflation and growth before determining the appropriate monetary policy response. 

Such an approach, it say, would improve policy decisions and enhance communication with financial markets and the public. (IMF)

Kenya currently targets medium-term inflation of five percent, with a tolerance band of plus or minus 2.5 percentage points.

Since transitioning to an inflation-targeting regime, the CBK has relied on the QPM alongside statistical models and expert judgement to support decisions by the Monetary Policy Committee. 

However, the IMF argues that the framework requires substantial upgrading to match the changing structure of Kenya's economy.

Among the key recommendations is the integration of fiscal policy more directly into the model. 

While CBK staff had previously introduced a fiscal block, the IMF says government expenditure should play a more prominent role in assessing inflationary pressures and overall economic activity. 

"This would provide policymakers with a clearer understanding of how fiscal decisions interact with monetary policy," the report says.

The IMF also wants climate-related risks incorporated into routine macroeconomic forecasting. 

Kenya's economy remains heavily dependent on agriculture, making it vulnerable to droughts, erratic rainfall and other extreme weather events that can trigger food price inflation and disrupt growth. 

Incorporating these shocks into monetary policy models would improve the central bank's ability to anticipate inflationary pressures and respond more effectively.

The revamped model also strengthens the treatment of external risks by improving the exchange rate framework and introducing a simple model of the United States economy, enabling the CBK to better capture the impact of global developments on Kenya's economy. 

The IMF further recommends refining the treatment of food and energy inflation by modelling them separately, recognising that these components often behave differently from core inflation and are strongly influenced by supply-side shocks.

Despite the recommendations, the IMF commended the CBK for the progress made over the past three years in strengthening its forecasting capacity. 

The report says updated now casting and near-term forecasting systems introduced through earlier technical assistance missions have significantly improved the accuracy of GDP and inflation forecasts, supporting better-informed monetary policy decisions.

The Fund also observed that historical testing shows the new projection model performs considerably better than the previous version in explaining past economic developments and forecasting future trends. 

According to the IMF, the enhanced model generates clearer policy transmission channels, improves analytical consistency and provides a stronger foundation for evidence-based policymaking. 

However, the report acknowledges that Kenya still faces structural challenges in implementing advanced macroeconomic models.

Limited availability of quarterly expenditure-based GDP data, short historical time series for inflation expectations and evolving financial markets constrain model development. 

The IMF also points to capacity limitations within the CBK's forecasting team, noting that maintaining and continuously updating the framework will require sustained investment in technical expertise.

The recommendations form part of the IMF's ongoing technical assistance programme aimed at strengthening Kenya's macroeconomic policy institutions.

If fully implemented, the upgraded framework is expected to improve the CBK's ability to anticipate inflation risks, respond to economic shocks and communicate monetary policy decisions more effectively in an increasingly complex domestic and global environment.