The Relationship between Inflation Pressure and Interest Rates: An Empirical Analysis of the Fisher Hypothesis in Kenya

Abstract

The Fisher effects theory holds that there exists a relationship between nominal interest rates and inflation rates: an increase in the inflation rate should lead to a proportionate increase in the nominal interest rate holding the real interest rate constant. A market in which this theory is valid is therefore more effective at pricing debt securities correctly. This paper investigated the bivariate relationship between monthly inflation rates and monthly yields on 3-Month Treasury bills over the January 2009 to August 2015 period. Both time series were found to be integrated of order one. Cointegration testing concluded that there was no long run relationship between interest rates and inflation, and therefore the Fisher effects theory was not valid in Kenya over the study period. A VAR model was fitted on the data to investigate the lead-lag interactions between the variables and their lags. Finally, granger causality tests, which concluded bi-directional causality between interest rates and inflation, were carried out.

Keywords: Fisher Effects, Inflation, Interest Rates, Cointegration, Vector Autoregression