OPINION/EDITORIAL

The Monetary Policy Dilemma: Price Stability vs Economic Growth?

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March 1, 2024/FSDH Research

THE CONSIDERATION
In February 2024, the newly constituted Monetary Policy Committee (MPC) held its first meeting for the year. This is also the first MPC meeting since July 2023. The meeting was held at a time when the inflation rate reached an 18-year high of 29.9%, the exchange rate remains volatile and annual GDP growth of 2.74% was slower than anticipated, although growth improved in the fourth quarter of 2023. The MPC expressed concerns about the persisting inflationary and exchange rate pressure and acknowledged the role of non-monetary factors such as insecurity, rising energy costs and disruption of global trade in triggering inflation. While the Committee noted the policy dilemma between ensuring growth and taming inflation, it expressed the view that sustainable economic growth can only occur in an environment with stable and low inflation.
THE DECISION
Given these considerations, the MPC voted as follows:
  • Raise the Monetary Policy Rate (MPR) by 400 basis points to 22.75% from 18.75%.
  • Adjust the asymmetric corridor around the MPR to +100/-700 from the previous +100/-300 basis points.
  • Increase the Cash Reserve Ratio (CRR) to 45% from 32.5%.
  • Retain the Liquidity Ratio at 30%.
Figure 1: Monetary Policy Rate (%)
Source: CBN
OUR REFLECTION
The MPC’s decision to raise the MPR and CRR reflects the intense focus on price stability in this new inflation-targeting regime. While this may come at a cost to economic growth, the Committee was well aware of the policy dilemma of either supporting economic growth or pursuing price stability. The rate hike was unsurprising, given the pace of price increases in the past few months. Since the last MPC meeting in July 2023, the inflation rate has increased by 5.8 percentage points to 29.9% in January 2024. Therefore, the magnitude of the rate increase suggests that the MPC was making up for lost ground. There is also the potential benefit of attracting portfolio investments into the country, which, if realised in large volumes, could positively impact the country’s exchange rate. However, it is important to make clear that investors are not only concerned about returns. Security/repatriation of investments, exchange rate stability and the Central Bank’s policies on FX repatriation have become important. Investors will, therefore, have to consider the associated risks before making huge commitments.
Figure 2: MPR vs. Treasury Bill vs. Inflation (%)
Source: CBN
Recently, we observed a correlation between the Monetary Policy Committee (MPC) rate increases and substantial growth in money and credit, indicating a counteractive measure. Despite four occasions of policy rate hikes in 2023, money supply (M2) and credit to the government expanded by 76% and 36%, respectively, between January 2023 and January 2024. Therefore, we could argue that the impact of interest rate hikes on inflation is limited or, perhaps, offset by the rapid increase in money supply growth.
 
More so, the discrepancy between the MPR, which supposedly is the benchmark rate, and other interest rates (on government securities) is of concern. Interest rates on government securities, particularly treasury bills, have behaved independently of the MPR over the years, although there have been some recent improvements in closing the gap. Following the hike in rate, the average yield in the FGN bond market inched up to 17.2% on Thursday (Feb 29th) from 16.8% on Monday (Feb 26th), while the average treasury bill yield rose from 16.6% to 16.9%. We believe further correction of this gap between the rates and the MPR is required to reposition the MPR as the true anchor rate, as it used to be. Furthermore, a much higher CRR affects commercial banks’ ability to offer credit facilities to businesses. Prior to this increase, Nigeria’s CRR was one of the highest globally. We are keen to observe the impact of this increase on the growth of credit to the private sector in the coming quarters.
Figure 3: Credit to the Private Sector (CPS) and Money Supply (M2)
Source: CBN
The CBN’s policy focus on taming inflation has been made clear to stakeholders in recent months. We note, however, that beyond monetary factors, the drivers of inflation are well-known in Nigeria. The lingering insecurity challenge, Nigeria’s infrastructure deficit, multiple taxes, high cost of energy and weak productivity are crucial issues that need to be addressed by the non-monetary authorities. Failure to do so will mean that the CBN and MPC will continue to play catch-up with inflation by raising interest rates. This may weaken growth prospects and further hurt the economy.
POLICY IMPLICATIONS
Constricting money supply growth through high interest rates is an important tool for the apex bank to tame inflation. However, this must be implemented cautiously and complimented with the fiscal authorities’ actions. We note the following:
  • The CBN should temporarily halt Ways and Means – lending to the government. Raising rates and increasing lending to the government is counterintuitive, and the cost will be borne by businesses in the form of higher borrowing costs and inflation. Fiscal authorities need to be forced to raise finance from non-CBN sources. Some options are aggressively reducing oil theft, exploring solid mineral exports and curbing illegal mining.
  • Fiscal authorities need to address the challenges businesses face and play their role in addressing inflation. The government must intensify efforts to address the inflation-inducing structural bottlenecks such as insecurity, weak productivity in agriculture, logistics and storage bottlenecks, and port inefficiency, among others. Anything short of addressing these challenges would imply that inflation will continue to trend upward, and the MPC will keep raising rates to catch up with inflation. We believe that having a positive real interest rate – where interest rates are higher than the inflation rate – is ideal, and fiscal and monetary authorities must collaborate to address inflation, one of Nigeria’s biggest economic problems.
  • Need for policy appraisals by the MPC. Nigerian businesses, particularly those operating in the real sectors such as agriculture, trade and manufacturing, are already dealing with multiple problems of FX depreciation, poor power supply and infrastructure challenges, which elevate their cost. A higher MPR and CRR increase the possibility of a higher cost of borrowing, especially given the magnitude of the recent rate hike. This will intensify pressure on businesses in the real sector that were already struggling to stay afloat. The MPC, therefore, must exercise care in making monetary policy decisions and appraise the potential impact of such a sharp increase on different economic agents before these decisions are made.
OUR EXPECTATION
Going forward, the decision at the next MPC meeting will largely depend on the performance of inflation. The next meeting is scheduled for March 2024, implying a one-month gap, as opposed to the initial two-month gap between MPC meetings. With this short window, coupled with the significant rate hike in the February meeting, we expect the MPC to maintain the existing policy stance at the forthcoming meeting. This allows for a thorough assessment of the impact of current measures on the economy.
Exchange rate depreciation amplified despite several policy changes
After the MPC meeting, the Central Bank governor provided insights on several reforms relating to exchange rate management. In this note, we review some of the actions of the Central Bank in the last few months.
 
Upon assuming office in September 2023, the governor of the Central Bank of Nigeria (CBN), Mr Olayemi Cardoso, faced a pressured exchange rate, declining external reserves and an FX backlog estimated at US$7 billion. Responding to these challenges, the governor assured stakeholders of the Bank’s commitment to achieving a single FX market and ensuring “market forces determine exchange rates on a Willing Buyer – Willing Seller principle”. Some measures announced by the governor included lifting the ban on the 43 items, the review of the guidelines for International Money Transfer Operators (IMTOs) and Bureau de Change (BDC) operations and clearing about US$2.3 billion of the over US$4 billion legitimate backlog it inherited from the previous administration.
 
In response to these measures, the exchange rate experienced increased volatility and depreciation. In the fourth quarter of 2023, the Naira depreciated from ₦747.1/US$ in early October to ₦899.4/US$ in late December. This trend of depreciation continued into 2024. The official exchange rate, which was ₦907.1/US$ at the start of 2024, depreciated by over 83.6% to ₦1,665.5/US$ as at February 23. In the parallel market, the Naira fell to as low as ₦1880/US$ before recovering to ₦1750/US$ on February 23.
Figure 4: Exchange Rates Movement (N/US$)
Source: FMDQ, Nairametrics
While the outcomes of the CBN’s measures are yet to materialise in the form of a stable rate, there is some progress. For instance, as a result of the CBN’s directive to commercial banks to harmonise the reporting guidelines on the net open position, turnover in the FX market increased by 136% to US$5.45 billion on February 23, from US$2.31 billion in January. In addition, the CBN’s posturing on Ways and Means and measures to sanitise the BDCs and IMTOs are worthy of note. Furthermore, the CBN governor announced the clearing of an additional US$400 million FX backlog in February 2024, a move that sends positive signals to the market about the CBN’s commitment to win back investors’ confidence.
 
But the road to exchange rate stability will be long. The apex bank will need to continue the clearing of backlogs, contain the excessive growth of money supply and ensure transparency and clear communication on foreign exchange policy. The bank needs to temporarily halt Ways and Means and transfer its developmental lending activities to fiscal authorities.
Table 1: Some major foreign exchange reforms implemented by the Central Bank of Nigeria
After the MPC meeting, the governor stated that “as far as the Central Bank is concerned, we are moving to a very aggressive regulatory environment” where tolerance to not comply with relevant regulations is zero. Also, on February 27th, the CBN issued a circular noting that “the sum of $20,000 is to be sold to each BDC at the rate of N1,301/$ – (representing the lower band rate of executed spot transactions at NAFEM for the previous trading day, as at today, 27th February 2024)”. Altogether, we note the need for the CBN to constantly engage stakeholders to review several issues, such as the capitalisation of BDCs, sales of $20,000 and price regulation.
OUR VIEW
The measures taken by the CBN must be complimented by the fiscal authorities to achieve the desired outcomes. Fiscal authorities need to implement prudent reforms to improve spending efficiency and ease of doing business to boost local production and exports. Given the recent exchange rate depreciation in the year, an urgent review of the 2024 budget to align assumptions with realities and reallocate expenditures to productive areas of the economy is required. Fiscal authorities must step up their roles to support businesses and enhance productivity across key sectors. Overall, the foreign exchange management strategy needs to be coordinated to provide clarity and improve confidence. We expect the foreign exchange market volatility to persist in the short term, but a lot will depend on the pace of fiscal reforms to stabilise the real sector of the economy.

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