I have found some useful resources online for your own research.

If you want more info on banks arbitraging the yield curve or the discount rate or a repo transaction go to
http://www.youtube.com/w...&p=CECDA315A8848B99
http://www.youtube.com/w...&p=CECDA315A8848B99
http://www.youtube.com/w...&p=CECDA315A8848B99

which are tutorials by some guy called Salman Khan (really smart dude in the US) that talks about Fraction Reserve Banking (our modern banking system).

If you want more info on the money creation process (in banks), exponential growth and inflation go to
http://www.youtube.com/w...LEA&feature=channel
http://www.youtube.com/w...3fk&feature=channel
http://www.youtube.com/watch?v=afWqKcqntfs.

@VVS. To address your misunderstanding/disagreement with the interpretation of the omo process. So if you look at the banking system we operate in now, for every Kshs1 in deposits the bank must keep 4.5% minimum or 4.5 cents in reserve. And this method of banking is called Fractional Reserve banking as only a fraction of deposits are reserved. So if you take it from the other angle for every 4.5 cents in mandatory reserve, 95.5 cents are excess reserves which can be lent out. All commercial bank mandatory reserves (4.5%) are held at the central bank. What the CBK lends through omo, are reserves, on which the money multiplier (MM) can be applied. All reserves they lend are completely new and they have been authorised to do so by CBK Act CAP 491 section 22 (1) - concerning the issue of notes and coins.

So taking the example of CBK and Bank A. Through omo purchases the CBK lends cash reserves to Bank A which increases the reserves of Bank A (asset) and also increases the deposits (liability) of Bank A. For CBK, the injection increases the balance of the reserve account of Bank A at the Central Bank (liability) and the CBK gets collateral-e.g., treasury bond (asset). This is how the process works as well for the Federal Reserve Bank in the US. In concluson the CBK's purchase of an asset (T-bond) has a multiple leverage effect on the money supply, so if the reserve ratio was 20% for every Kshs1 in reserves injected Kshs4 could theoretically be lent out. The formula is New Money Lent = Injected * (money multiplier - 1); e.g., a ratio of 20% is 4 = 1 * (5-1). Our reserve ratio is only 4.5%, but that doesn't mean that bank will lend out all that is theoritically possible, but gives them the flexibility/opportunity to do so.

On the question of funding a budget deficit. Look at all the CBK bulletins between May 2009 and Oct 2009 to see a good correlation of omo injections to treasury auctions where the govt realized new borrowings. 29 June - CBK injected 15 bn & govt borrowed 11.8 bn in T-bonds and 1.4 bn in T-Bills. 27 Jul - CBK injected 11 bn & govt borrowed 9.9 bn in T-bonds and 1.6 bn in T-bills. August 24-26 - CBK injected 10+5=15 bn & govt borrowed 1.7 bn from T-bills and 7.3 bn in T-bond. 23 sep - CBK injected 5.2 bn & govt borrowed 7.3 bn in T-bonds. 28 Oct - CBK injected 3.5 bn & govt borrowed 3.1 bn in bonds. Since the end of October the KenGen PIBO created a lot of excess reserves in the banking system. Where actual bank reserves averaged Kshs158 bn between May-Oct they are now averaging Kshs168 bn in Nov, so the CBK doesn't need to use the reserve repo as the deficiency in reserve money is smaller in Nov.

Including the recent infrastructure bond, it can be estimated that Kenyan public debt will have grown about 14.4% as of last week compared to the figures the beginning of 2009. Alternatively public debt will have grown 25.3% y-o-y (since Nov 2008) to bring it to about Kshs1,111.70 bn, which is highest growth in the past 15 years (but not higher than the 1992-3 years). So I share your concern over inflation in the next few years. Nway VVS I appreciate the debate and I am sure it will give others a reason to do more research. Hava great week.

@scubidu:

1) You are looking at NOMINAL growth in GDP. Sure that will 'grow' the economy but stokes inflation. See Monetarism. Or even better see Zimbabwe with 'exponential' GDP growth in NOMINAL but not REAL terms. So where will we be in REAL terms if we have continued high rates (caused in large part by unproductive government spending)?

2) Fractional banking is easy to misuse. It is not the 'private' banks but the CBK that I worry about. Well, one more step & the GoK who are the real culprits. The continued (mostly) recurrent expenditure is a bad, bad sign. Even within the 'development' budgets, I wonder how much pork is hidden.

3) Helmut Kohl ran roughshod over a recalcitrant Bundesbank prior to the mergers of the Germanys for purely political gains. Kenya is even worse where the CBK governor serves at the pleasure of the prez. Or so seems. I believe the appointment is a prezzie preserve as well. We had an idiot called kotut during the goldenberg era.

4) It seems to me that the increase in M3 greater than REAL economic growth is a recipe for disaster. Unlike the USA, Kenya can't 'print' money while leaving rates low.

This is tragic...the new CBK bulletin has a section on Gout and "How-to-avoid-the-obesity-epidemic" WTH...but gives us no details on omo activity or gross domestic debt. Has anyone looked at the KEPPS transactions, during the week..."daily average volume of 2,980 transactions and a corresponding daily average value of Kshs65 bn"...We are given details of the Lombard window (4.2bn worth alone) but not open market operations (OMO)...last week was a significant week because of the massive subscription (Sh43 bn) of the infrastructure bond...so OMO shud have recorded big volumes

@VVS To answer the other questions...I stand corrected...I was referring to nominal GDP...when govt stokes inflation they get more creative & adjust the GDP deflator (in this case the inflation calculation) to reflect better real growth...my initial concern was the relevance of the CBR rate in taming inflation...my question was when will we (investors) know when interest rates should reset upward (thus real growth be affected) if our perception of inflation has changed. Interestingly I tracked the Kenyan CPI (Base: Oct 1997=100) from Dec-00 to Dec-07 when it rose from 129.00 to 239.81 (up 110.81 points). Then in 2008 all hell broke loose (locally & abroad) so CPI rises further to 345.03 (up 105.22 points) in Sep-09. So the change over the last 1yr 9 months has been almost equivalent to the past 7 years prior (a global phenomenon?). So now we see why the market basket wasn't working anymore because M3 was growing faster than real growth...either nominal GDP must grow exponentially or inflation declines to zero to grow in real terms (based on our history I'd put my money on GDP having to rise).

There was another passage in the Muga article saying "When we're in a severe recession, good productive capacity goes to waste. Auto workers sit home unemployed because nobody has money to go out to dinner. The first thing for the government to try is to reduce interest rates, to encourage businesses to borrow money to hire more workers and buy equipment. But, if interest rates hit bottom, then the government has to shock the system back to life by spending money directly. Say Washington hires construction workers to build something, and those workers start buying cars and going to restaurants, then, after a while, the economy is running again."

Considering the path the govt has taken through the infrastructure bonds (& even the passat purchase), for all the unproductive spending govt normally does they also have the capacity to spend well enough to promote growth. If I took a huge loan from a bank to buy a fleet of cars and the government did the same what would be the difference on growth? It is what these private producers do with the money that makes the money productive and in our present case the govt is trying to play the role of the private individual...I think that's the rationale the treasury is using, but the ills of this deficit borrowing manifests itself in the future as you've mentioned b4. The govt thinks this strategy will work long term and is making plans to float a eurobond next year http://www.africa-investor.com/article.asp?id=6062

in addition

1. how did cbk come up with a rate of 7 pct which is 400 basis points higher than the overnite rate???

2. why does a signallin rate(cbr) double up as a window rate???

the cbr rate is totally baseless as its totally in disconnect with market rates..the ecb/boe and fed rates are very close to market and thus when ammended send signals to the market that lead to a change in the relevant interest rates...

as vvs says kenynesian economics is all well and gud...however we used in kenya where our budget is 100% recurrent,little comes out of the same...btw cbk are yet to prove that the ifdb funds they received actually went into infrustructure

@VVS - So how does one gauge if there is a disconnect; i.e., the CBR is not being used effectively? Will the changes in the overnight rate provide this crucial insight?

Could omo injections of liquidity influence the 'targeting' of the overnight rate?

Since banks don't lend willy-nilly (great term btw) which rate (apart from cbr) would most influence bank lending decisions then? I believe the base rate is still 15.5%.