Interest rate setting in Egypt: a NARDL approach for estimating backward-looking monetary policy reaction function

ABSTRACT

The role of inflation versus output and exchange rate in designing monetary policy in Egypt has been subject to considerable debate in literature, even after the proclamation of price stability as the monetary policy objective in 2004 and the adoption of flexible exchange rate system in 2016. This study aims to investigate the main drivers of interest rate setting in Egypt throughout the period from 2005 to 2019. In this context, both an ARDL and NARDL econometric techniques are employed to estimate the backward-looking augmented Taylor monetary policy reaction function. The estimated equation estimates policy rate as a function in lagged inflation, lagged output gap, lagged policy rate, change in real effective exchange rate, in addition to other variables. The importance of this study arises from the lack of recent studies assessing interest rate setting in Egypt. The study concludes that monetary policy in Egypt has been accommodative to inflation and that Central Bank of Egypt responds asymmetrically to shocks in inflation, output and exchange rate.

KEYWORDS:

• Monetary policy reaction function
• Central Bank of Egypt
• ARDL
• inflation targeting
• NARDL

Disclosure statement

No potential conflict of interest was reported by the author(s).

The above figure depicts that policy rate has been responsive to changes in inflation and somehow output changes in the first subperiod, in the second subperiod, it is more inclined towards output movements. In the third subperiod, it is the changes in inflation (especially after the devaluation of exchange rate in November 2016) that triggered policy changes.

Figure A1 Development of Selected Macro Variables During the Three Subperiod

Source: Done by the authors based on data from CBE, Bruegel Data base and Bloomberg Database.

Notes

¹ These reforms incorporated the settling of non-performing loans, privatization of state-owned banks, restructuring large public banks, the liberalization of the foreign exchange and money markets, as well as the on-going efforts to promote banking supervision.

² The core inflation rate is derived from the headline inflation rate after excluding the price movements in items that exhibit undue volatility like fruits and vegetables and regulated items.

³ At the beginning of this subperiod, the CBE aimed at easing monetary conditions and providing liquidity to the market, through unconventional monetary policy tools like reducing the reserve requirements and the launch of the seven days and 28 days repo facilities. Consequently, liquidity deficit turned to a surplus in 2013 which prompted the CBE to initiate the seven days deposit auctions to absorb excess liquidity.

⁴ The ARDL model for co-integration is used when the variables have different order of integration. It means that the dependent variable is expressed as a function in its own lagged values and current and lagged values of the independent variables, for further details, refer to Hashem et al. (2001), Narayan (2004) and Nkoro et al. (2016).

⁵ All variables are seasonally adjusted.:

⁶ Hodrick Prescott (HP) filter technique is one of the most commonly used statistical technique to estimate potential output due to its flexibility in tracking the fluctuations of trend output and decomposing the aggregate output into both trend and cyclical components. For further information, refer to Shahin (2011) and El-Baz (2016).