Why is the CBN struggling to manage inflation?

Election season is typically a time for presidential aspirants to prove their suitability for office to the electorate.

This time is no different. Just last week, one of the aspiring candidates communicated one of his proposed policies for Nigeria if elected—through a Twitter thread.

In one of the tweets, he remarked, "we will not use wage and price controls to fight inflation. Rather, we will pursue a contractionary monetary policy. We will mop up excess liquidity by reducing the money supply within an economy."

We will come back to this proposed contractionary policy but first, a look at why economists might have been puzzled by this announcement.

First, it's important to note that except this candidate plans to run for the office of the governor of the Central Bank of Nigeria (CBN), the president has no business meddling in monetary policy. Sure, he can advise the CBN governor or—more appropriately—suggest what policies he'd like to see the bank implement. But that's where his jurisdiction stops; he cannot implement policies on behalf of the central bank.

Back in 2015, it was reported that President Buhari promised to get $1=₦1. Whether he said those exact words or not, the idea was: that a strong naira would lead to a strong economy. Unfortunately, this is where political agendas and economic policy clash. Since Buhari came into power, CBN's monetary policy has been aligned with this alleged campaign promise, even to the detriment of the Nigerian economy. This alignment has thrown up questions over CBN’s independence, which is not a good sign. A good central bank is an independent central bank that implements its policies independent of the federal government.

Again, we won't go into whether or not this aspirant’s policies are valuable to the Nigerian economy today because, for CBN's policies to yield any desired result, the CBN must first regain the trust of Nigerians. And the way to do that is by rebuilding the credibility of the CBN.

We've spoken about why the CBN must be more credible in the past, but it's worth mentioning again because it is the foundation of any monetary policy.
 

How monetary policy typically works 

The central bank's role is quite broad. It encompasses everything from price stability to securing the value of the naira and coordinating the cost and supply of credit (through interest rates and banks’ loan-deposit ratios) in the country.

However, many central banks focus more on price stability because research shows that it is the most important route to achieving other goals like growth and high employment. It also enables monetary authorities to pursue secondary goals such as reducing economic fluctuations and managing financial crises.

But monetary policy is only as firm as the mechanism that follows it. For example, one common contractionary monetary policy is when the central bank or monetary policy committee raises interest rates to reduce the amount of money in circulation, hoping to reduce inflation in the economy.

Raising interest rates increases the cost of capital, leading to a drop in investment spending. With less investment, companies start to cut costs, and layoffs happen—or at least fewer people are employed—leading to lower income and causing aggregate demand to decline, reducing inflation. The lower the demand for goods and services in the country, the lower the prices for them, leading to the eventual drop in inflation.

This is the case in the US and many developed countries today. Given the two-decade high inflation rate in the US, the US Fed—its monetary policy authority—has increased interest rates higher than usual, causing an increase in investments in the US.

In March, when the rate hike began, the US Fed warned about the impact on the US economy. The Fed reported that the sharp rise in interest would hurt the US economy. In particular, it would reduce financial organisations’ “ability to raise capital and retain the confidence of their investors".

The implication of this has been a decline in the prices of significant US stocks. Between March (when the interest rate hikes began) and July, there was a 10% decline in the S&P 500—an index that measures the performance of the stock prices of the 500 largest public companies listed on the New York Stock Exchange. Also, as we highlighted previously, funding into the US tech ecosystem in Q1 2022 declined by 14% YoY and 25% QoQ.

The impact of this has even spilt over to emerging economies like Nigeria, where less investment is flowing into the golden tech sector, which witnessed a slowdown in funding in the first half of the year.

The US labour market has also reacted to the hikes with higher unemployment rates—caused by people returning to the labour market. As more people return to the labour market, employers have higher bargaining power because they have a larger pool of job seekers to choose from, which means they can offer lower wages. Lower wages mean less income which contributes to less inflation. Also, there have been announcements of hiring freezes and layoffs across the tech ecosystem.

Going by the monetary policy mechanism explained earlier, all these reactions are expected. History shows that while investors and the economy react this way, the impact is usually short-lived (typically for about a year) until the inflation is corrected.

One thing to note, however, is that the rate hikes have led to immediate impacts on the real economy. But, it is not exactly the move of the US Fed that has led to this. It is an expectation of the move’s impact.

Let me explain. Whenever the monetary authority implements a policy, there's a time lag between the announcement date,  when investors react, when companies are affected and so on. However, what causes the immediate impact is the public's expectation of the impact the regulation will make. Earlier this week, the Chair of the US Fed, Jay Powell noted their commitment to fixing inflation by saying, “I can assure you that my colleagues and I are strongly committed to this project, and we will keep at it until the job is done.”

So, even before the next monetary policy meeting in September, investors have started reacting in line with the assumption that the US Fed will raise interest rates in its next meeting. Powell's strong words are backed up by strong institutions, which investors and the rest of the population believe in.

One of the economy's main drivers, especially when it comes to inflation and the monetary policy mechanism, is investor and consumer expectation. With the Fed indicating its plan to drive interest rates down, investors and consumers expect this to affect how much credit they have access to, the possibility of layoffs etc., and begin to change their spending patterns. And like a self-fulfilling prophecy, inflation is reduced.

A classic example of how expectations cause changes in inflation was how Mario Draghi, the former Governor of the European Central Bank (ECB), announced that the bank was ready to do whatever it took to resolve the Euro Financial crisis of 2011. It took only about a week for the market to course-correct in anticipation of the change by the ECB.

This anticipation stems from years of trust in the ECB’s credibility and, in the US’s case, the Fed. People in the country act in anticipation of the central bank’s actions based on experience. They are confident that if the banks say they'll improve the economy, without a doubt, they would because they have in the past.

Let's bring it home to see how key stakeholders respond to the CBN's monetary policies. 
 

How monetary policy works in Nigeria

In line with the US Fed's policy—and that of many key central banks worldwide—the Nigerian Monetary Policy Committee increased interest rates to 14%, from 11.5% in 2020. Given that inflation increased to 19%—the highest in over a decade, it made sense that the CBN was implementing this policy. With interest rates being higher than ever in the US and other countries, including Nigeria, increasing the rates meant it was a move to reduce inflation in the country.

However, as we explained before, Nigeria's monetary mechanism is not as smooth as in other countries.

For one, the negative interest rate gap—the difference between the inflation rate and the nominal interest rate—means an increased interest rate remains unattractive for many investors, especially when safer government assets like US bonds have higher rates.

Remember, one of the ways the monetary authority reduces the money supply (to reduce inflation) is by attempting to increase investments by making their interest rates more attractive. When the inflation rate is higher than the interest rate, people could lose money when they invest. Although this also exists in many other countries today, investors are more likely to switch to less risky assets in developed countries because of the high inflation rates globally.

With the US interest rate hike, there was a resultant capital flight to developing countries, preventing the interest rate in Nigeria from translating to increased investment.

Finally, the time lag between when the policy is announced and when the inflation eventually reduces also contributes to the break in monetary policy transmission. Going by research in the CBN's economic journal, it takes about 24 months for the money supply to have its full impact on inflation; but using an exchange rate and money supply as explanatory variables, the effect of inflation actualises within one year. 

This is where the expectations are critical for growth, such that key economic stakeholders react to the policy, leading to the self-fulling prophecy described earlier.  Nigeria’s inflation at 19% was not sudden. Inflation has been rising rapidly since 2020, and no CBN’s interest rate policies have indicated that it is committed to lowering inflation. The last major hike in interest rate was in 2016 when Nigeria was going through a severe economic recession. So, despite the rise in inflation from 11% in 2018 to 19% in August 2022, the MPC only deemed it fit to increase the interest rate in 2022. Investors' reaction—and the monetary policy transmission—will not be similar to that of the US because the credibility of both central banks is different. This is because of how unpredictable the CBN is, compared to other central banks.

 

Credible exchange rate management

A common area where the CBN's actions are very unpredictable is in its exchange rate management. Today, every investor, business person or individual is bound to get foreign currency at different exchange rates, depending on their use for it. Investors and exporters get at one rate, while people hoping to import items "unapproved" by the CBN are forced to get dollars at the parallel market rate.

What is worse is that sometimes, it's difficult to tell if or when you'll have access to the foreign exchange, even when you're eligible to access the official sources. The reports of airlines being unable to repatriate over $400 million out of Nigeria because of dollar scarcity are examples of the unpredictability of dealing with the CBN.

Indeed the dollars have been scarce due to capital flight and reduced foreign investment in the country. Total foreign investment declined from over $23 billion in 2019 to less than $7 billion in 2021. In Q1 this year, the entire investment was only about $1.5 billion. These funds typically come through banks, but with these investments dried up, the banks have to rely heavily on the CBN. In 2019, banks sold over $8 billion to the CBN (and bought just $5 billion) from the CBN, which came from foreign investment. Since 2020, the CBN has not brought up to $1 billion from the banks. Now banks cannot get enough dollars as they need to meet customers' obligations.

One of the ways the CBN could've made the exchange rate management more predictable was by devaluing the exchange rate close to the parallel market rate, making it reflective of the available foreign exchange.

However, this has not been the case for a long time. Instead, the CBN has repeatedly tried (and failed) to sustain the exchange rate to the dollar artificially. For example, shortly after the CBN assured Nigerians that it would store up foreign exchange buffers to protect the Naira in 2020, it was forced to devalue the Naira from ₦308 to $1 in March 2020 to ₦381 to $1 in August 2020. This impromptu devaluation has continued till now, with the official rate currently at ₦420 while the parallel market rate is about ₦693.

This differs from the move of the Fed announcing that it would increase rates and doing so; stakeholders expect it and plan as a result. For instance, although US inflation slowed in July, many investors believe the Fed will still raise interest rates until it reaches the initial target of 2% or less. In Nigeria, stakeholders attempt to plan ahead of the volatility and uncertainty but struggle to do so. This increases the risk of doing business which further deters investors away.

Devaluing the naira further will lead to a higher exchange rate, which will make imports more expensive, but that's what the CBN will have to do to reassure foreign investors and Nigerians of the bank's credibility. Suppose people can predict what the CBN will do next based on macroeconomic events; even though it's not favourable in the short term, predictability is critical to business success.

It is clear that the US economy is currently reeling from the impact of the increased interest rate, but the Fed is willing for the economy to go through short-term pain until it achieves its goal of a lower inflation rate. The CBN must tow the same lane by stating its goals clearly, and doing whatever it takes to achieve the goal.

It's not easy being superman

In some cases, even the CBN's policies have seemed counterintuitive to Nigeria's inflation problem. For instance, in March 2020, the CBN injected over ₦1 trillion into the Nigerian economy to help fight the impact of the Covid-19 pandemic, a move that the fiscal authorities should've made. This had an impact on inflation. Likewise, the CBN continues to fund the Federal Government through its ways and means of financing, increasing money supply and worsening inflation. So, it's no surprise that investors are sceptical when the CBN says it's fighting inflation in the country. 

However, it's worth noting that these actions by the CBN are aimed at improving growth in the economy because of the low credit available in the country—to individuals, organisations and the government. For instance, while the CBN has transferred over ₦35 trillion in credit to the private sector, commercial banks have only contributed about ₦25 trillion. Likewise, the CBN's ₦16 trillion debt to the federal government dwarfs the private sector's ₦2 trillion.

This mirrors our previous findings on Nigerian companies not taking advantage of the capital market because of how shallow it is—lacking enough liquidity to fund companies. However, in that same article, we highlighted that one way the CBN under Charles Soludo's tenure unlocked liquidity in the sector was through the consolidation of banks, not by pumping money into the economy. Granted, 2005 was much different from today because we were not suffering from record-high inflation rates and low growth. However, the moves by Soludo and the Central Bank at the time helped the Nigerian financial sector withstand the shocks of the 2008 financial crisis.

Taking a cue from the global economy today, it is evident that many economies worldwide suffer from the impact of record-high inflations and low growth. However, central banks focus on maintaining stability in the economy and leaving the economy's funding to the government through fiscal policies.

Moves like this strengthen the credibility of their central banks so that when they make decisions to steer the economy in the right direction, the economy reacts accordingly.

So, here's a note for the next CBN governor or the current governor (if he plans to change), for your policies to generate desired results, you need to show Nigerians that you're credible by setting tangible goals and sticking to them.