Real Interest Rates, Inflation Dynamics, and Financial Stability in Kenya

This study investigates how changes in real interest rates, shaped by the Central Bank of Kenya's monetary policy, directly affect inflation patterns and financial soundness in Kenya from 2005 to 2025. Employing time-series analysis, bank-level panel data, and an event study of CBK policy actions, the study focuses on real interest rates-defined as the difference between nominal policy rates and the buyer price inflation rate-as the central variable. Financial soundness is assessed through inflation volatility, bank profitability (ROA & ROE), NPL ratios, sovereign bond yields, and exchange rate volatility. The research demonstrates that real interest rate changes serve as a primary channel linking monetary policy to macro-financial outcomes in Kenya's frontier market. Crucially, real interest rates that rise with policy tightening help stabilise short-term inflation but create credit risk trade-offs in the banking sector. Conversely, when real rates turn negative, price instability and economic uncertainty are amplified. Shifts in real interest rates impact bank profitability, sovereign bond yields, and exchange rate volatility-highlighting their centrality to macro-financial resilience. The event study shows that CBK rate announcements immediately move equity prices and Treasury yields, underlining the potency of real interest rate signals. Overall, the findings position real interest rates as the anchor of price stability, banking sector strength, and financial soundness in Kenya.