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17August2018

Sustained monetary tightening may be hurting the economy

In macroeconomics, the modern view of credit channel rather than the cost of capital channel as the key link in the transmission mechanism has been gaining ground. A former Chairman of the US Federal Reserve Bank, Paul Volcker stated that the relationship between inflation and interest rate is rather obscured; but it is easy to explain the control of money supply to check inflation. He however warns that the structural imbalances in the system could make either mechanism not to work at any point in time since when you control one variable, people can work their ways round it.

Then the question is why is the Central Bank of Nigeria through its Monetary Policy Committee sustaining the monetary tightening stance despite the appealing case for  easing especially when it inflationary pressure is rather structural than monetary? In addition, why does the CBN use interest rate as its instrument of monetary policy despite its being less effective at managing inflation than the money supply mechanism?

Monetary policy objectives are generally inflation control and output stability

Monetary policy has been operated with a variety of objectives in mind over the years. However, it appears that the objectives generally boil down to adjusting the supply of money in the economy to achieve some combination of inflation control and  output stability. Economists generally agree that in the long run, when the resources of the economy are in full use, the level of output is fixed and any adjustment to money supply will only cause prices to change. However in the short run, a period during which excess capacity exists and companies have room to increase production as demand rises, changes in money supply do affect the actual production of goods and services. This is because prices and wages usually do not adjust immediately. For this reason, monetary policy is a meaningful tool for achieving both inflation and economic growth objectives.

This might be the reason why the policy objective of the Central Bank of Nigeria (CBN) and its monetary policy thrusts are essentially the attainment of price stability and sustainable economic growth. Associated objectives are those of full employment, stable long-term interest rates and real exchange rates. Although the focus of monetary policy has shifted largely in favour of price stability- especially with the adoption of inflation targeting in 2008, the monetary authority acknowledges the need to create a balance with the other macroeconomic objectives of the Government.

However, considering the recent slowdown in economic growth, the price stability objective of the CBN and the consequent high benchmark interest rate over the last 3 years may have started to hurt the Nigerian economy. While monetary policy may have been forced to become reactionary, frontloading the liquidity impact of fiscal policy excesses, economic growth is being compromised in the process. In addition, given the level of resource unemployment- human and material, monetary surpluses/excesses that are channelled to productive use are unlikely to cause inflation.  Therefore , the perceived structural disconnect in the economy can  be helped by balanced monetary policy actions among which a single digit lending rate is central.

Monetary tightening and high interest rates ultimately result in declining GDP growth and lower inflation

Sustained sharp and/or miscalculated monetary policy tightening could push the economy into a recession where consumers tend to cut down on spending to as low as subsistence; business production declines, leading firms to lay off workers and stop investing in new capacity; and foreign appetite for the country’s exports may fall. The recent slowdown in the GDP growth is indicative in this regard.

Although it has been argued in certain quarters that a combination of structural constraints which could not be addressed with monetary policy actions and supply side shocks- flooding for instance- are largely responsible for the slowdown, denying the huge small and medium scale subsector access to finance through high interest rates and loan policies robs the nation of substantial complementary growth that could cushion the effects of the structural constraints. All sectors currently depend largely on natural factors to survive, for instance climate and increased land use in agricultural sector. And many of them will perform better, grow faster and provide mass employment with sound financial inclusion premised on affordable credit.

Within the parlance of the quantity theory of money, monetary tightening pushes the economy towards the point where less money chases more goods. This happens when consumers are broke and firms cut back on hiring and spending; leading to a decline in the general price level as we have seen in recent times. Monetary policy also achieves this through expectations—the self-fulfilling component of inflation.

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