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The research was mainly carried out in the US mainly focusing on the one month Treasury bill to determine the effect of short term interest rates on inflation. Irving Fisher pointed out that with perfect foresight and a well functioning capital market; the one-period nominal rate of interest is the equilibrium real re-turn plus the fully anticipated rate of inflation. In a world of uncertainty where foresight is imperfect, the nominal rate of interest can be thought of as the equilibrium expected real return plus the market's assessment of the expected rate of inflation. The relationships between interest rates and inflation have been tested extensively. In line with Fisher's initial work, the almost universal finding is that there are no relationships between interest rates observed at a point in time and rates of inflation subsequently observed. Although the market does not do well in predicting inflation, the general finding is that there are relationships between current interest rates and past rates of inflation. This is interpreted as evidence in favor of the Fisherian view. Thus Fisher concludes: We have found evidence, general and specific, that price changes do, generally and perceptibly, affect the interest rate in the direction indicated by a priori theory. Fisher's empirical evidence, and that of most other researchers, is in fact inconsistent with a well-functioning or "efficient" market. This paper is concerned with efficiency in the market for one- to six-month U.S. Treasury Bills. Unlike Fisher and most of the rest of the literature, the results presented here indicate that, at least during the 1953-71 periods, there are definite relationships between nominal interest rates and rates of inflation subsequently ob-served. Moreover, during this period the bill market seemed to be efficient in the sense that nominal interest rates summarize all the information about future inflation rates that is in time-series of past inflation rates.


The main objective of Fishers study was to find the effect of short term interest rates on inflation. The study was mainly done in an efficient market. An efficient market correctly uses all relevant information in setting prices. If the inflation rate is to some extent predictable, and if the oneperiod equilibrium expected real return does not change in such a way as to exactly offset changes in the expected rate of inflation, then in an efficient market there will be a relationship between the one-period nominal interest rate observed at a point in time and the one-period rate

of inflation subsequently observed. If the inflation rate is to some extent predictable and no such relationship exists, the market is inefficient: in setting the nominal interest rate, it overlooks relevant information about future inflation.

Fisher in his research studied the following. Inflation and Efficiency in the Bill Market: Theory A. Returns and the Inflation Rate The nominal return from the end of month t- 1 to the end of month t on a Treasury Bill with one month to maturity at t-1 is 1. Rt=vt-vt-1/vt-1 =$1000-vt-1 /vt-1 where vt=$1,000 is the price of the bill at t, and vt-1is its price at t- 1. Since the bill has one month to maturity at t- 1, once vt-i is set, Rt is known and can be interpreted as the one-month nominal rate of interest set in the market at t- 1 and realized at t. Let pt be the price level at t, that is, pt is the price of consumption goods in terms of money, so that the purchasing power of a unit of money, the price of money in terms of goods, is z= 1/pt. The real return from t- 1 to t on a one-month bill is then 2. lt=(vt*zt-vt-1*zt-1)/vt-1zt-1 3. =Rt+t+Rtt 4 t = (z zt-1)zt-1 is the rate of change in purchasing power from t- 1 to t. In monthly data, Rt and t are close to zero, so that although the equality only holds as an approximation. Thus the real return from the end of month t- 1 to the end of month t on a Treasury Bill with one month to maturity at t- 1 is the nominal return plus the rate of change in purchasing power from t- 1 to t. The fact that lt, is a random variable at t- 1 only because at is a random variable explains why bills are attractive for studying how well the market uses information about future inflation in setting security prices. It seems reasonable to assume that investors are concerned with real returns on securities. Since all uncertainty in the real return on a one-month bill is uncertainty

about the change in the purchasing power of money during the month, one-month bills are the clear choice for studying how well the market absorbs information about inflation one month ahead. For the same reason, n-month bills are best for studying a month predictions of inflation B. The General Description of an Efficient Market Efficiency requires that in setting the price of a one-month bill at t- 1, the market correctly uses all available information to assess the distribution of t. When the market sets the equilibrium price of a one-month bill at t- 1, Rt is also set. In short, if the market is efficient, then in setting the nominal price of a one-month bill at t-1, it correctly uses all available information to assess the distribution of t. Since an equilibrium value of vt-i implies an equilibrium value of Rt, the one-month nominal rate of interest set in the market at t- 1 likewise fully reflects all available information about at. Finally, when an efficient market sets Rt, the distribution of the real return Ft that it perceives is the true distribution. C. A Simple Model of Market Equilibrium The preceding specification of market efficiency is so general that it is not testable. What the model lacks is a more detailed specification of the link between effeciency and vt-1,; that is, we must specify in more detail how the equilibrium price of a bill at t- 1 is related to the marketassessed distribution. This is a common feature of tests of market efficiency. A test of efficiency must be based on a model of equilibrium, and any test is simultaneously a test of efficiency and of the assumed model of equilibrium. The first assumption of the model of bill market equilibrium is that in their decisions with respect to one-month bills, the primary concern of investors is the distribution of the real return on a bill. A market equilibrium depends visibly on a market-clearing value of the nominal price vt-1, but it is assumed that what causes investors to demand the outstanding supply of bills is the implied "equilibrium distribution" of the real return. Testable propositions about market efficiency then require propositions about the characteristics of the market assessed distribution that results from an equilibrium price vt-1 at t1.

Since an efficient mar-ket correctly uses all available information, E(f) is also the true expected real return on the bill. The general testable implication of this combination of market efficiency with a model of market equilibrium is that there is no way to use ot-1, the set of information available at t- 1, or any subset of qt-1, as the basis of a correct assessment of the expected real return on a one-month bill D. The Nominal Interest Rate as a Predictor of Inflation There are tests that distinguish better between the hypothesis that the market is efficient and the hypothesis that the expected real return is constant through time. A constant expected real return implies that all variation through time in the nominal rate R, is a direct reflection of variation in the market's assessment of the expected value of t. If the market is also efficient, then all variation in Rt mirrors variation in the best possible assessment of the expected value of t. Moreover, once Rt is set at time t- 1, the details of Ot-1, the information that an efficient market uses to assess the expected value of At, become irrelevant. The information in 0,- is summarized completely in the value of Rt. In this sense, the nominal rate Rt ob-served at t- 1 is the best possible predictor of the rate of inflation from t- 1 to t. To test these propositions, it is convenient to introduce a new class of models of market equilibrium that includes as a special case There is, however, no need to apologize for the fact that the tests of market efficiency concentrate on the reaction of the market to information in the time-series of past rates of change in the purchasing power of money. Beginning with the pioneering work of Fisher, researchers in this area have long contended, and the results below substantiate the claim, that past rates of inflation are important information for assessing future rates. More-over, previous work almost uniformly suggests that the market is inefficient; in assessing expected future rates of inflation, much of the information in past rates is apparently ignored. This conclusion, if true, indicates a serious failing of a free market. The value of a market is in pro-viding accurate signals for resource allocation, which means setting prices that more or less fully reflect available information. If the market ignores the information from so obvious a source as past inflation rates, its effectiveness is seriously questioned. The issue deserves further study.

DATA SOURCES & DATA ANALYSIS The one-month nominal rate of interest Rt used in the tests is the return from the end of month t1 to the end of month t on the Treasury Bill that matures closest to the end of month t. The data are from the quote sheets of Salomon Brothers In computing Rt from (1), the average of the bid and asked prices at the end of month t-1 is used for the nominal price vti-. The Bureau of Labor Statistics Consumer Price Index (CPI) is used to estimate At, the rate of change in the purchasing power of money from the end of month t- 1 to the end of month t. DATA ANALYSIS The use of any index to measure the level of prices of consumption goods can be questioned. There is, however, no need to speculate about the effects of shortcomings of the data on the tests. If the results of the tests seem meaningful, the data are probably adequate. The tests cover the period from January 1953 through July 1971. Tests for periods prior to 1953 would be meaningless. First, during World War II and up to the Treasury-Federal Reserve Accord of 1951, interest rates on Treasury Bills were pegged by the government. In effect, a rich and obstinate investor saw to it that Treasury Bill rates did not adjust to predictable changes in inflation rates. Second, at the beginning of 1953 there was a substantial upgrading of the CPI. The number of items in the Index increased substantially, and monthly sampling of major items became the general rule. For tests of market efficiency based on monthly data, monthly sampling of major items in the CPI is critical. Sampling items less frequently than monthly, the general rule prior to 1953, means that some of the price changes for month t show up in the Index in months subsequent to t. Since nominal prices of goods tend to move together, spreading price changes for month t into following months creates spurious positive autocorrelation in monthly changes in the Index. This gives the appearance that there is more information about future inflation rates in past inflation rates than is really the case The values of the CPI from August 1971 to the present (mid-1974) are also suspect. During this period the Nixon Administration made a series of attempts to fix prices. The controls were effective in creating "shortages" of some important goods (eg the gas queues of the winter of

1973-74), so that for this period there are nontrivial differences between the observed values of the CPI and the true costs of goods to consumers. For this reason, the tests concentrate on the "clean" precon-trols period January 1953 to July 1971. IV. Results for One-Month Bills Market Efficiency Given that the equilibrium expected real return is constant through time, the market efficiency hypothesis says that the autocorrelations of the real return Ft are zero for all lags. The sample autocorrelations of rt in Table 2 are close to zero. Recall from (5) that the real return rt is approximately the rate of change in purchasing power t plus the nominal interest rate Rt. The evidence from the sample autocorrelations of t and rt in Tables 1 and 2 is that adding Rt to At brings the substantial autocorrelations of At down to values close to zero. This is consistent with the hypothesis that Rt, the nominal rate set at t-1, summarizes completely the information about the expected value of At which is in the time-series of past values, t-1, t-2. . . . Tables 3 and 4 give further support to the market efficiency hypothesis. When ap-plied to (21), the hypothesis says that a22, the coefficient of ,-,, is zero, and the auto-correlations of the disturbance it are like-wise zero for all lags. The residual auto-correlations in Table 4 are close to zero. The values of a2, the sample estimates of a., in (21), are also small and always less than two standard errors from zero. When applied to (19), the market efficiency hypothesis is again that the autocorrelations of the disturbance it should be zero. The residual autocorrelations in Table 3 are close to zero. The success of the tests reported here is probably to a no negligible extent a consequence of the availability of good data beginning in 1953. Poor commodity price data also probably explain why the empirical literature is replete with evidence in support of the so-called Gibson Paradoxthe proposition that there is a positive relationship between the nominal interest rate and the level of commodity prices, rather than the relationship between the interest rate and the rate of change in prices posited by Fisher.4 With a poor price index, the Fisherian relationship between the nominal interest rate and the true inflation rate can be obscured by noise and by spurious autocorrelation in measured inflation rates. But over long periods of time-and the Gibson Paradox is usually posited as a long-run phenomenon even a poor index picks up general movements in prices. Thus if inflations and deflations tend to persist (an implication of the evidence presented here that E(at| It-1) is close to a random walk), there may well appear to be a

relationship between the level of interest rates and the measured level of prices, which merely reflects the more fundamental Fisherian relationship between the interest rate and the rate of change of prices that is obscured by poor data. In this study, which is based on the relatively clean data of the 1953-71 periods, the Fisherian relationship shows up clearly. CONCLUSIONS The two major conclusions of the paper are as follows. First, during the 1953-71 periods, the bond market seems to be efficient in the sense that in setting one-to six-month nominal rates of interest, the market correctly uses all the information about future inflation rates that is in time-series of past inflation rates. Second, one cannot reject the hypothesis that equilibrium expected real returns on one-to sixmonth bills are constant during the period. When combined with the conclusion that the market is efficient, this means that one also cannot reject the hypothesis that all variation through time in one- to six-month nominal rates of interest mirrors variation in correctly assessed one- to sixmonth expected rates of change in purchasing power.

IMPLICATIONS OF SHORT TERM INTEREST RATES BEING PREDICTORS OF INFLATION IN KENYA As we have seen, short term interest rates are used to predict inflation. Introduction Recent movements in interest rates, inflation and exchange rates present real dangers to economic stability. The economy has endured steep inflationary pressures and exchange depreciation for about 9 months in 2011. This started with the buildup in inflationary pressures early in the year, then the onset of exchange rate depreciation around April 2011, and the recent rise in interest rates. Notably, inflation rose from 4.51 in January to 19.7 percent by November 2011. Kenyas shilling depreciated from about Ksh. 81 to Ksh. 101 to the US dollar in October 2011. To address these problems the Central Bank of Kenya (CBK) belatedly increased the

Central Bank Rate (CBR) to 11 percent in October 2011. Banks in their characteristic style increased their lending to between 20 and 25 percent. While the primary goal of these shock measures was to address inflationary pressures and the weakening of the Kenya shilling, the results were mixed and uncertain .Officially driven interest developments are not unprecedented in Kenya, but the use of the CBR as a signal for monetary policy is fairly recent. Primarily, high interest rates are likely to curb business investments and innovation, rising interest rates could also increase loan defaults in the banking system and bank vulnerability, high interest could also drive the costpush inflation due to medium term increase in prices associated with higher costs of business financing. Historical Interest Rate Trends Kenyas interest rates were fairly stable before 1990s due to a combination of price controls and banking controls in the country. Interest rate volatility quickly set in after 1992 multiparty elections. Together with runaway inflation, sharp rise in interest rates were noted in most of 1993. Treasury bills interest rates at one time reached 84.67 % in July 1993 and the interbank rate exceeded 68 percent in March 1993 (See Graph 1). The lending rate also rose steadily, exceeding 30 percent for the period October 1993 to October 1994. Lending rates remained above or close to 30 percent through September 1998, but declined in 1999. The rates peaked again at 24 percent in November 1999 and that was the highest rate that preceded a decade of low and stable interest rates. Indeed the lending rates remained within 12 and 16 percent through September 2011 causing a huge expansion in credit to the private sector, rising government debt appetite, and growth in the economy. Some interesting finding can also be found in the trend of interest rate spreads in Kenya. Graph 2 shows that the spreads were narrower prior to 1992 due to a period of marked economic controls in the economy. The spreads that time were a mere 4-5 percent. But, macroeconomic problems associated with excessive growth of money supply and the Goldenberg scandal contributed to a subsequent wide interest rate spreads. For example, the spreads rose to 17 percent by December 1994, and reached 20 percent by November 1995. The spreads only declined after the 2002 elections. Monetary Expansion and Interest Rates Graph 3 shows the monthly growth in credit, growth in money supply and lending interest rates

for the period 1997 to 2011. The graph shows a dramatic collapse of the credit growth in the period 2000 to 2002 followed by a sustained rise in 2003. The sustained rise in monetary base (M3) and subsequent decline in the lending rates from early 2003 through 2005 partly explains the unprecedented growth in banking sector credit to the private sector. The lending rates largely stabilized at about 12-15 percent during this period. Even though lending rates variations remained within narrow margins, we can see marked volatility in the monetary base accompanied by sharp fluctuations in the growth of private sector credit towards the 2007 general elections. High Interest Rates and Spreads The analysis above shows clearly that the country went through a long and sustained period of low interest rates from 2003 to October 2011. The CBK unexpectedly raised the CBR to 16.5 Percent on November 1, 2011 from 11 percent, then again to 18 percent after exactly one month. This was a total reversal of interest rate regime in Kenya since 2003. According to the CBK, this rate increase was designed to reduce inflation through slowing down consumption spending .The rate increase is also expected to reduce the pressure on the Kenya shilling exchange rate. However, external factors such as the Euro debt crisis could still keep the shilling exchange rate under pressure. High rates could also attract unreliable short term capital or hot money. Under the present economic conditions, the current interest rate policy could cause sharp contractions in growth and worsen unemployment and poverty situation. High interest rates lead to fall in business profits, fall in investment, which inevitably leads to lower economic growth, worsening unemployment situation, and poverty. High interest rates could also prevent establishment of new businesses. For instance, if a startup raises capital at say 20 % interest rate, it would need to charge larger margins than this to service the loan and stay afloat. The current economic conditions, particularly unpredictable monetary policies, uncertainties in the economy, high cost of production, and other risks in the country (such as uncertainties associated with 2012 elections and the war in Somalia) could work to curtail stable investment flows. High interest rates may also lead to higher market prices associated with rising costs of production (also known as cost-push inflation). This happens when companies increase their

mark ups to compensate for costly bank financing. This is a special case where rising interest rates could reduce the effectiveness of monetary measures to tame inflation. Thus, supply constraints such as food supply problems or cost-push related drivers of inflation such as high fuel prices could keep inflation high and potentially lead to a more worrisome scenario of high inflation and low growth. High interest rates may also have some income distribution aspects. For example, high interest rates could disproportionately affect the middle class who ordinarily are less affected by supply side inflation. If this effect comes through, then depressed middle class consumption demand could sharply undo employment gains and poverty reduction efforts since 2003. Since interest rates are likely to slow economic growth (including causing unemployment, rising poverty) it could only be hoped that inflation will decline. Alternatively, high interest will also have negative effect on the banking sector. For instance, already the interbank lending is about 30 percent and quite unstable. This implies that some banks are accessing operational funds at very high rates. In addition, the recent increase in the cash reserve ratio will further strain banks and probably affect their profitability. The high interest rates may also bring to the fore the unusually wide interest rate spreads in Kenyas banking system. Recent information shows that savings rates are about 2 percent while banks base lending rates have reached 20-25 percent in November 2011. Indeed, the interest rate spreads widen whenever base lending rates go up guaranteeing banks supernormal profits. Policy Options Recent actions of the CBK represent a major shift in interest rate policy, which could have dire effects on Kenyas economy. For about 8 months the CBK had a window of opportunity to redress the problem of rising inflation and weakening Kenya shilling. But, monetary policy intervention came belatedly with the increase in the CBR rate to 11 percent. Before full transmission of this measure, the CBK again raised the CBR to 16.5 percent in November 2011. Once again monetary authority has increased the CBR to 18 percent, which is expected to cause sky high lending rates. Some questions still linger about Kenyas dramatic 2011 economic problems and policy response by government. For example, was there adequate assessment of

the impact of each CBR raise before another one was considered? Why, for instance, was the rate increased by a massive 5.5 percent from 11 to 16.5 percent within a month given that supply driven inflation was expected to decline with improved harvests during the period December 2011 to February 2012. According to Vision 2030, economic growth, poverty reduction and employment creation remain the core pillars of Kenyas economic development. For these reasons any shock therapy through curbing credit expansion in a low income country like Kenya, where youth unemployment is rampant, where 50 percent of population lives below the poverty line, and where the government requires massive resources to fund an election year budget and cater for devolved governments, is highly misadvised. An important balance need to be made: contain inflationary pressures while ensuring affordable credit to the private sector and to the government. In any case, we still need to protect governments budget program and also ensure a banking sector that can lend profitably without the risk of loan defaults. At the same time, a balance should also be found to ensure that savers earn a reasonable return on their funds. All this is possible in an environment of stable interest rates, stable inflation and exchange rates. Stability of inflation and exchange rates cannot be achieved through disproportionate and destabilizing interest rates increase. At the moment, we cannot rule out further CBR increases above 18 percent. Is the country ready to pay the price of falling growth, high unemployment, rising labour union pressures, poverty, inability of government to borrow for its operations, high loan defaults and bank weaknesses? In light of all this, following are some plausible alternatives to redress the situation and stabilize Kenyas economy: 1. Allow fiscal policy to work. Interest rate increases could be avoided if some aspects of import demand (for example raising tariffs) and domestic demand (reducing government consumption) are handled by the Treasury. The ministry of finance could use tariffs to curb the so called unessential imports. This will reduce unrestrained use of monetary policy instruments. 2. Undertake only moderate interventions whenever interest rates reach historically high levels. Treasury bill interest rates close to 20 percent are historically quite high. Monetary contraction

instruments such as the CBR should be used sparingly under such circumstances regardless of the rate of inflation. In addition, our analysis shows that monetary interventions lag growth of credit by a few months. Thus, the second 16.5 percent CBR increase should have been allowed to take effect. 3. Protect domestic investments and job creation. To support local businesses and create employment, the interest rates should be at meaningful levels. A reduction in the CBR is therefore suggested. 4. Take measures to reduce the interest on government borrowing and ensure public debt is sustainable. High interest rates occasion high borrowing and debt rollover costs for the government. With treasury bills and bonds above 15 percent, the costs of government borrowing are quite high relative to expected returns. 5. Protect the welfare of depositors by reducing bank spreads. Since direct controls of interest rates are risky, this can be done by setting the deposit rate as a given proportion of a banks base lending rate. Such a measure would promote savings, encourage long term financing, and promote innovation and consolidation in the banking system associated with narrower spreads, among other benefits.

REFERENCES Abbas Ali S. M. and Christensen Jakob E, 2007, The Role of Domestic Debt Markets in Economic Growth: An Empirical Investigation for Low-income Countries and Emerging Markets. International Monetary Fund. Central Bank of Kenya, 1996, Banking Act, Revised Version for 1996. Greene, W. H. (1993). Econometric Analysis. London: Prentice-Hall International Hall, A. R. (2005). Generalised Method of Moments. Oxford: Oxford University Press