Refresher

The Central Bank of Nigeria (CBN) announced its monetary policy stance in its recently concluded 295th Monetary Policy Committee (MPC) meeting, held on May 20 and 21, 2024. The MPC decided to raise the monetary policy rate (MPR) by 150 basis points, from 24.75% to 26.25%, with an asymmetric corridor of +100/-300.

Inflation has continued to be persistent even with the consistent increase in MPR, indicating the limited effectiveness of monetary policy. The cash reserve ratio (CRR) was retained at 45% and the liquidity ratio at 30%. The rise in the MPR marks the third increase this year, with the intention of curbing inflation. In this piece, we attempt to demystify these monetary policy instruments and explain how the policy announcement will influence various segments of the Nigerian economy. We also provide additional insights on monetary policy effectiveness, the non-normality of aggregate demand distribution, and some cost-push factors that feed into inflation.

Understanding the CBN Monetary Policy Instruments

The Monetary Policy Rate: The key instrument of monetary policy for the CBN is the MPR, which is the interest rate at which the CBN lends money to commercial banks. The MPR anchors all other interest rates in the money market and the economy. The 26.25% increase in MPR will result in an increase in interest on loans given to individuals and businesses by commercial banks. The idea is that with higher borrowing costs, consumer spending and business investment slow down, reducing aggregate demand and inflationary pressures.

Cash Reserve Ratio: The CRR is the percentage of a bank’s total deposit that must be held in reserve and not lent out or invested. A 45% CRR indicates that banks must hold 45% of their total deposits as reserves. The CRR is a core instrument of monetary policy and is used to control the money supply. A high CRR reduces the amount of funds available for banks to lend, which helps limit consumer spending and business investment, reducing the pressure on inflation.

Liquidity Ratio: The liquidity ratio is the percentage of a bank’s net demand and time liabilities that it must maintain in the form of liquid assets such as cash and saleable securities. A high liquidity ratio means fewer funds are available for lending, limiting economic activities and aggregate demand. 

Asymmetric Corridor +100/-300: The asymmetric corridor is the range set by the CBN where interest rates can fluctuate in the short term. It is divided into an upper bound and a lower bound. For an MPR of 26.25%, the upper bound is 27.25%, and the lower bound is 23.25%. To put it in better perspective, +100 denotes that banks can borrow from the CBN at a rate of (26.25%+1%), and banks can deposit money at a rate of (26.25%-3%). This implies that rates can fluctuate between 23.5% and 27.25%. The idea behind the asymmetric corridor is that it allows the CBN to have more flexibility in its monetary policy. By setting different rates for borrowing and depositing, the CBN influences the behaviour of banks more effectively.

Effect of Policy Announcement on Households

The increase in the MPR will disincentivise households from borrowing. This is largely attributable to higher interest rates in the banking system, which are slowing down economic activity.

Effect of Policy Announcement on Businesses

Higher interest rates in the banking system will also result in a decline in investment borrowing, which can increase the strain on productivity. It could also affect consumer demand, which can have consequences for employment.

Effect on Policy Announcement on Foreign Portfolio Investment

The increase in the MPR can further attract FPI into the Nigerian economy as investors seek higher returns on investment. It should spur carry trade, which can improve dollar liquidity and ease the pressure on the exchange rate.

Is Monetary Policy Enough?

Economic theory admits that money supply is a core determinant of inflation. Inflation is often described as the difference between nominal and real GDP. Reducing nominal GDP or improving real GDP can, therefore, tackle inflation. While the former means cutting down the money supply, the latter means increasing productivity.

Conventional wisdom in monetary policy implementation is that there is a tradeoff between inflation and unemployment, but this hardly holds in Nigeria. This is a clear indication that increasing production costs rather than the increase in aggregate demand spurs inflation. This also indicates that boosting productivity instead of constraining the money supply is a better way to tackle inflation. 

Nigeria’s inflationary problems are largely exogenous to monetary policy, away from the exchange rate channel. One core argument the proponents of increasing the MPR have made is that a high-interest rate in the banking system will lead to an increase in FPI. While this is true, rising MPR will also lead to increased borrowing costs, which could actually feed into inflation.

Instead, the government can explore other means of raising dollar liquidity within the Nigerian economy by reducing oil theft and exporting more crude oil. Data has shown that Nigeria loses millions of dollars in crude oil theft, which could have been a source of revenue.

Additionally, it should be highlighted that the CBN has consistently printed money for the government, which justifies the increase in MPR by arguing that there is so much money in circulation.

Aggregate Demand is not Normally Distributed.

The definition of inflation, where too much money chases too few goods, is based on the assumption that people have a lot of money to spend. However, a significant number of Nigerians are hand-to-mouth consumers. A multidimensional poverty report indicates that about 133 million Nigerians are poor. These are indications that aggregate demand is not bell-curved. This means that aggregate demand is not normally distributed and that a smaller number of Nigerians hold the bulk of the money in circulation. The idea of monetary policy is that there is a lot of demand in the economy, which should also be characterised by low employment numbers. However, this does not hold, as Nigeria suffers from stagflation (high inflation and unemployment).

Cost-Push Components of Nigeria’s Inflation  

Nigeria has faced security challenges that have reduced agricultural productivity. The country is yet to come out of the effect of the 2019 border closure due to nominal rigidity. The removal of fuel subsidies and the devaluation of the naira have significantly fed into inflation. These issues have greatly impacted food and non-food prices and have greatly constrained productivity. As a result, it would take only a substantial increase in aggregate productivity and supply to push down prices in the medium to long run.

Conclusion

The CBN’s monetary policy stance has had limited success in controlling inflation. Continuously increasing the MPR makes borrowing more expensive, potentially further slowing down the economy. While there are expectations that the exchange rate channel might help mitigate the exchange rate pass-through to inflation, boosting productivity and aggregate supply remains the most reliable strategy for reducing prices.