NAIROBI, Dec 15 (Reuters) - The Kenyan shilling retreated against the dollar on Thursday after a 2 percent rally in the previous session, but traders said tight domestic liquidity and reduced demand for the dollar would keep the local currency supported. At 0709 GMT, commercial banks quoted the shilling at 87.25/45 against the dollar, weaker than Wednesday's close of 87.00/20. "There is a bit of buying after yesterday's rally. But we still expect the shilling to firm on tight liquidity as the new CRR (cash reserve ratio) comes into effect today," said Julius Kiriinya, a trader at African Banking Corporation. The Central Bank of Kenya said in its November policy decision it would raise the CRR for banks by 50 basis points to 5.25 percent from Dec. 15 - meaning lenders have to hold more shillings. Traders said they expected the shilling to trade in the 86.50-87.50 range during the session. They said demand for dollars had fallen due to the central bank's raising of its key lending rate by 11 percentage points to 18 percent since Oct. 5. The bank continues to mop up shillings through repurchase agreements, taking 6 billion shillings ($68.7 million) out of the market in operations in the last two sessions, both of which were heavily oversubscribed. "Dollar demand is fizzling out due to high interest rates that has made it expensive for clients to book forwards. The central bank could also be back mopping up shillings again, which will strengthen it," said Kennedy Butiko, deputy head of treasury at Bank of Africa. The shilling is off an all-time low of 107.00 hit in October, but is still 7 percent weaker than the dollar in the year to date.

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