Nigeria: Between Inflation and hard place

Godwin Emefiele. CBN Governor

In its final Monetary Policy Committee meeting for 2016, the Central Bank of Nigeria (CBN) held its main interest rate, the Monetary Policy Rate (MPR), at 14% in November. Price stability and the limitation of monetary policy in affecting output were the main reasons for sticking with its tighter monetary stance, which began with a two percentage point rate hike in July.

Most economists surveyed by Reuters expected this decision, a rare consensus in a year marked by inconsistent policies from the CBN that made their moves hard to predict.

The Inflation and Output Battle

MPR decisions prior to July suggested the apex bank was attempting to kickstart economic growth at the expense of inflation. In November 2015, it decreased interest rates despite inflation breaking above its unofficial 6-9% target.

A lot has changed since then. Firstly, inflation accelerated much faster than anticipated. When the CBN increased the money supply in November 2015, inflation was 9.3%. Exactly a year later and inflation had nearly doubled to 18.5%. Secondly, the CBN floated the Naira in June 2016, allowing itself greater flexibility over monetary policy. But for the CBN to maintain credibility and attract foreign investors, it needs to make sure that inflation expectations are anchored, and the Naira is not expected to depreciate by a substantial amount in the future. The final major development was on the fiscal front: The passage and partial implementation of the 2016 budget triggered fiscal spending that gives the CBN more breathing space to tackle inflation.

Nevertheless, there is a prevailing disharmony in current policy. Last year, the Finance Minister Kemi Adeosun echoed manufacturers by calling for an interest rate cut, primarily to reduce government borrowing costs. In response to the initial monetary tightening in July, an Economics Professor at the Olabisi Onabanjo University, Sherriffdeen Tella, said, “It is an unfortunate decision. When you have prices going up, what you should do is to find a way to reduce the interest rate, and not to increase it….”. This quote appears to contradict standard economic theory – the inverse relationship between domestic interest rates and price levels is Econ 101. However, this argument will be recognised by those familiar with academic monetary economics. Simply put, if an economy has markets dominated by monopolies or oligopolies then a higher interest rate which increases borrowing costs would be passed on to the consumer – leading to higher inflation.

Nobel laureate Christopher Pissarides used a similar argument to explain why prices in Greece are not competitive and remained elevated during the 2011 Euro crisis. This positive relationship between interest rates and inflation is surprisingly common in empirical monetary economics papers and is usually referred to as The Price Puzzle. There is some evidence to suggest it applies just as forcefully in Nigeria.

Still, one challenge with the CBN’s contractionary policy is the argument that the bank simply cannot control cost-push inflation, which is what Nigeria is currently experiencing. Higher rates mostly deal with demand-pull inflation, usually by increasing the cost of spending and investment to reduce economic output. If this limitation is true, then one might argue that the CBN has no direct route to control inflation with interest rates.

The Plan

The central bank understands the cost-push inflation problem and its primary plan is to use the new flexible exchange rate to suppress underlying inflationary pressures. By keeping rates high, the CBN is increasing the real rate of return in the economy, perhaps to attract foreign exchange supply.

With higher dollar supply in the economy, the Naira should start to appreciate. The supply of dollars will then allow sectors like manufacturing to import raw materials easier and at a lower price, allowing them to increase output. Therefore, at the end of the day the CBN, via higher interest rates, increases dollar supply, reduces inflation (as imports become cheaper) and raises output in the economy. This is, perhaps, Godwin Emefiele’s last-ditch attempt to rejig the economy. At the September MPC meeting, he stated that there had been $1bn in foreign inflows since July. Furthermore, a private equity firm’s purchase of a stake in Nigerian biscuit maker Beloxxi for $80m has prematurely been heralded as further evidence of the return of foreign investment.

However, there are drawbacks. Firstly, keeping interests rates high reduces borrowing and potentially, output. This means monetary policy could be counteracting the effect of the government’s expansionary fiscal plans. To combat this, the CBN is providing loans at lower rates to priority sectors such agriculture.

Another worry is that the CBN may feel compelled to maintain this contractionary stance in the medium term. As the CBN still needs to convince its investors that inflation and the Naira would be controlled, the inflow of dollars into the economy would be slow and it is likely that the Naira would remain weak in the short run and inflation will remain high. Moreover, the current rigidity and opacity in exchange rate determination potentially undermine all efforts to boost dollar supply, and could further erode central bank credibility.

The Nigerian Government’s Inevitable Role

Ultimately, monetary policy is too blunt a tool to steer Nigeria out of recession. The fiscal authorities have an important role to play. Whilst the CBN might achieve some short-run success, fiscal policy must address the more long-term structural issues. Furthermore, supply side policies must be adopted to make Nigeria more productive. Improving our infrastructure would increase growth and also lower inflation as energy and transport costs would be reduced. We also need to further diversify export earnings. These suggestions are not new – Nigeria experienced an almost identical economic crisis in the 1980’s but the present administration, spearheaded by the same leader from that period, can ill-afford not to make the same mistakes this time around.

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