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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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Fighting high inflation rate at the expense of high unemployment and poverty rates is not approprate

On the one hand, recession hurts the ability of an economy to operate at its full potential. Firms are forced to operate below capacity as aggregate demand dwindles; pushing down the level of equilibrium aggregate production below full employment. A recessionary gap is thus created; a scenario in Keynesian Model, implying a contractionary business cycle. On the other hand, economies experience boom during expansionary business cycle. Expansionary cycle creates inflationary gap resulting from higher aggregate demand level above aggregate production and consequently overheating rapidly rising prices before leading to a ‘burst’. Due to these opposing circumstances, there is need for stabilization.  A counter-cyclical stabilization works to smoothen out business cycle fluctuations by expansionary public spending or tax cuts in recessions and/or contractionary policy in boom periods. These policies generally encompass both discretionary changes in monetary policy resulting from specific policy decisions and automatic stabilizers that occur when policy thrust automatically respond to changes in economic activity.

Some economists argue that the monetary policy should flexible enough so as to implement discretionary counter-cyclical policy when they are most needed.  A situation of  tight monetary regime where monetary easing is required will only lead to further growth contraction as high interest rate constrain local production capacity. The avoidable scarcity of these  domestic items will be created with serious consequences for inflation; in addition to defeating the domestic capacity development objectives of the government.

The Nigerian situation calls for a review of the tight monetary regime

Although the principal object of the Central Bank of Nigeria (CBN)  is to ensure monetary and price stability, it also has developmental functions in addition to providing economic and financial advice to the federal Government. In that case, the monetary authority has responsibility for economic growth as much as it has price stability  mandate. Declining growth rate, growing unemployment and poverty rate should be a concern as much as inflation is. The impact of the high interest is unfriendly to the situation of the economy.

Aggregate demand channel has been negatively impacted

Economic theory and research outcomes have identified a number of ways through which monetary actions are transmitted to the real economy by altering the amount of money in the economy; directly or indirectly. Directly through the sale and purchase of short term government securities in open market operations or indirectly through the use of the short term benchmark interest rate. The first channel of impact is through the aggregate demand on both the output and prices; a process called the demand channel. When monetary policy is contractionary or tight as is currently the case in Nigeria, borrowing costs increase, making it less likely for consumers to demand commodities they would normally finance such as houses or cars. And for businesses, they become less likely to invest in new equipment, projects, or buildings. Theoretically, the reduction in the level of economic activities will push inflation lower because lower demand usually leads to lower prices. 

The retail lending rate rose from an average of 18.36% in 2007 to 23.5% in 2012. During the same period, the monetary policy rate (MPR) rose from an average of 9.13% to 12%. However, the MPR declined to as low as 6.08% in 2010 before the commencement of the current spate of monetary tightening. The retail lending rate has however trended upward even at the low MPR in 2010; indicating a disconnect between the MPR and the retail lending rate at this point. This could be blamed partly on the curtailment of lending by banks during the global financial crisis as asset prices collapsed. The period was characterised by a sharp dry up of bank credit to both the corporate and retail consumers, as the regulator battled to sanitise the banking system. While the monetary policy approach to resolving these issues has worked to stabilise the industry, the punitive classification of risk assets may have raised the bar on credit evaluation thereby weeding out some classes of borrowers. An important parameter in that process is the dynamics of the retail lending rate in which the prime lending rate declined compared to an increase in the maximum lending rate between 2009 and 2012. The decline in prime lending rates indicates an increased preference to supply credit to select prime customers, usually corporates.

The balance sheets, bank lending and exchange rate channels were also not spared

An increase in interest rates also tends to reduce the net worth of businesses and individuals. This is called the balance sheet channel of impact; that makes it tougher for them to qualify for loans at any interest rate, thus reducing spending and increasing price pressures. This occurs by making many erstwhile feasible projects unprofitable at a higher hurdle rate as the weighted average cost of capital (WACC) increases with each interest rate hike. It therefore introduces the problem of adverse selection to the lending process - a situation where the level of interest rate weeds out likely quality credits leaving only the potentially bad ones; a scenario that may be playing out in Nigeria.

An interest rate hike also makes banks less profitable in general and thus less willing to lend. This is called the bank lending channel. This is because the fall in credit demand accompanying a monetary contraction robs the bank of the credit margin which cannot always be substituted for by trading/holding of liquid assets, including government securities. However, where monetary tightening results in higher real yields on secured and liquid assets and is followed by widespread deleveraging, the fall in deposit rates could allow for a substantial spread which would enable banks remain profitable.

High rates normally lead to an appreciation of the currency, as foreign investors seek higher returns and increase their demand for domestic assets. The recent surge in foreign portfolio investment alludes to this. At over 12% yields on government securities, Nigeria appears to be the only country with a sovereign risk rating of BB- that offers such a significant return on risk free assets. This is in addition to the sustained positive real return over the last 2 years as the monetary authority keeps it so at every level of inflation. In return, the surge in FPI has resulted in an increase in the value of the naira in recent times. 

However, through the exchange rate channel, exports become less competitive with their volumes reduced as they become more expensive, and the level of imports rise as they become cheaper. While it can be argued that our non-oil export industry is small, the naira value of oil export earnings, the major source of government revenue, becomes lower with implications for fiscal expenditure profile and outlook. For instance, the adoption of a N160/US$ exchange rate for the budget 2013 revenue assumption may weaken the government revenue profile in 2013 if the current monetary policy stance sustains the exchange rate at N155/US$, a very strong possibility.

Inflation in Nigeria is structural and high interest rates appear to be compounding the problem

The debate on whether inflation is a structural or monetary phenomenon has been on-going for some time. The constrained business environment which continues to keep the economy well below its production possibility frontier is also worthy of note. Another factor is the structural disconnect that allows fiscal excesses to create systemic liquidity without any productive impact with strong implications for price stability. The resolution of these issues is at the heart of a balanced monetary policy framework.

The implications of this is that the proportion of and rise in costs caused by the myriads of supply side constraints, especially infrastructural challenges, in the prices of goods and services is very high. We believe that this effect is big enough to sustain inflation rate in the double digit region if the monetary contraction continue to add to the supply side problems. One argument that highlights this conclusion is the fact that inflation rate were at their lowest during the period of accommodating monetary policy in 2007-08. And in those periods, economic growth was also high.Since the monetary authority has recognised the structural nature of inflation and the improvement in fiscal policy, we believewhat the Nigerian economy requires at this crossroad of structural reforms, is a complementary interest rate environment that supports the reduction of retail lending rates to single digit levels.

Period of monetary easing has coincided with declining inflation suggesting productive use of liquidity

The 2007/08 period was preceded by strong institutional development and fiscal commitment to economic liberalisation. Investment in infrastructure was also modest with high expectations upon which long term productive investments could be made. And investment was growing alongside aggregate demand in an environment of both high liquidity and monetary accommodation. Monetary aggregates- broad money, net credit to the economy, and credit to the private sector grew at an average annual rate of 52.8%, 176.9% and 72.1% per month respectively between 2007 and 2008, while inflation, although rising remained in single digits for most of the period. The global recession which started in 2008 and the oil production shock caused by the Niger Delta insurgence arguably contributed to the volatile economic conditions afterward.

The periods of monetary easing through 2009-2010 coincided with a peak in inflation; perhaps a lag effect of earlier monetary expansion and primarily due to the sharp depreciation of the naira. It was also the period of major moderation in inflation from the peak of 15.6% to 11.8% as the exchange rate stabilised and the adjustment was priced into costs; it might as well be a result of the global economic recession. This suggests that barring structural constraints, given the typically high the marginal propensity to consume in an economy with vast idle resources and high absorptive capacity, high liquidity will not necessarily cause inflation. In the presence of heavy structural constraints, what monetary tightening does is to simply add to the constraints and force down aggregate demand and prices with limited impact.

The credit channel of monetary policy transmission mechanism may be more effective at inflation management

Since the 1980s, the hitherto established view that the cost of capital is the key link in the transmission mechanism of monetary policy has come under intense challenge by the modern view which saw the supply of credit to firms as the key factor.The traditional Keynesian ISLM view of the monetary transmission mechanism indicates that an expansionary monetary policy will lead to a fall in real interest rates, which in turn lowers the cost of capital, causing a rise in investment spending, thereby leading to an increase in aggregate demand and a rise in output.

The simplified assumption that a firm’s cost of capital is determined by a single interest rate is consistent with the Modigliani and Miller theorem that a firm’s cost of capital is not affected by its leverage based on the assumptions of a perfect market and no transaction costs. The asymmetry of information due to market imperfection and thus the presence of agency and bankruptcy costs have led theorists to the consideration of the credit channel as an alternative transmission mechanism of monetary policy. The liquidity preference theory shifted monetary economists’ focus from interest rate to the money supply as the key link in the transmission mechanism.

We recognise the problem of unproductive liquidity injections from fiscal excesses which could compound systemic liquidity and pose a threat to exchange rate stability and hence price levels. It is a product of the structural disconnect in our economy which allocates the highest financial flows to the smallest contributor to growth. However, we are of the opinion that targeted market rules and regulations as well as quantitative monetary interventions and incentives, as proven by the positive outcomes of some of the recent rules around interbank and foreign exchange market activities would suffice at managing such liquidity.

We believe that a supply of money approach otherwise known as quantity based anchor, which regulates aggregate demand, may be more effective. This is because a monetary policy system that monitors the flow of liquidity and uses the open market operation to mop up any excessive and unproductive injections directly will do better than a generalised benchmark interest rate that punishes all sectors of the economy regardless of whether they benefit from the liquidity flow. While they tend to have the same effect on short term market rates, a targeted approach will have a more positive impact on economic activities as businesses can access longer term finances (through the capital market) at relatively cheap rates.

Nigeria needs monetary policy easing to prevent the economy from an economic cliff

Monetary policy has a strong role to play in expanding financial inclusion and ensuring that proper financial intermediation other than securities trading remains the hallmark of the banking system. An important task in this regard is working with the fiscal authority on the roles of the monetary authority in the development strategy of the government. The current weakness of that handshake is constraining the monetary authority to a reactive stance at the expense of a supportive monetary policy direction particularly in relation to interest rates.

We must note that the Nigerian economy faces its own economic cliff to which a commencement of monetary tightening reversal and a comprehensive review of the financial intermediation process and policy transmission channels is important. Such a review will increase access to finance for small scale businesses who are major employment creators. Other sectors, especially light manufacturing in food and beverages, housing, and construction would increase their share of GDP while the increasing aggregate supply is likely to create competition that would have a positive inflationary effect.

In our opinion, monetary policy dynamics are not static and the market understands this. More importantly, the positive edge which monetary policy has over fiscal policy is the short term flexibility and usefulness at providing cyclical and countercyclical solutions. Therefore to forestall pushing the economy down the growth slope, and to help boost economic activities going forward, we recommend that the monetary authority should limit the use of OMO for to support the short term rate at the current level. In addition, at the shortest possible  time, the Central Bank of Nigeria should signal the commencement of monetary easing so as to boost economic activities, save the economic from free-fall and reduce unemployment.

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