Forecasting and Monetary Policy Analysis in Low-Income Countries: Food and non-Food Inflation in Kenya

IMF Working Papers, March 7, 2013

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Developed a semi-structural new-Keynesian open-economy model with separate food and non-food inflation dynamics for forecasting and monetary policy analysis in low-income countries, applied to Kenya.
Analytical exercises:
- Filter international and Kenyan data (output, inflation and its components, exchange rates and interest rates) to recover a model-based decomposition of variables into trends (potential values) and temporary movements (gaps), including the international and domestic relative price of food.
- Use the filtration to recover the sequence of domestic and foreign macroeconomic shocks explaining recent business cycle dynamics in Kenya, with special emphasis on factors driving inflation (international food prices, monetary policy).
- Perform an out-of-sample forecast to assess likely paths for the economy and policy given inflationary pressures at the end of the sample (2011Q2).

Imported food price shocks were an important source of inflation in 2008 and in more recent episodes examined.
Accommodating monetary policy also contributed to inflation dynamics, most notably via its effect on the nominal exchange rate.
The model signaled that a policy tightening was required; the actual interest rate increase implemented was larger than the model predicted.

Model-based policy analysis can be informative for low-income countries when inflation has distinct food and non-food components.
Monetary policy should account for the exchange rate transmission mechanism when responding to imported food price shocks.
Using filtration to decompose trends and gaps helps identify the relative contributions of domestic and foreign shocks to inflation, improving policy diagnosis.

Subject: Financial services, Food prices, Foreign exchange, Inflation, Output gap, Prices, Production, Real exchange rates, Real interest rates
Keywords: CPI inflation series, food inflation, food price, Food Prices, Forecasting, Global, Inflation, inflation development, inflation dynamics, inflation expectation, inflation outlook, inflation rate, inflation surge, Kenya, Low-Income Countries, monetary policy, monetary policy response, Output gap, Real exchange rates, Real interest rates, reverse repo, Sub-Saharan Africa, WP