Vaccines for Nigeria’s Inflation Rate Syndrome

Perhaps it is important to refresh memories with the simple definition of inflation – a persistent rise in the prices of goods and services over a period of time. Putting this definition in perspective, inflation erodes purchasing power, undercuts the intrinsic value of income, and reduces “buying power”, increases cost of living and thus demeaning standards of living.

Summarily, inflation is seen to be cancerous and unwanted like the COVID-19 pandemic. While everyone tends to think negative of inflation, it is interestingly not entirely bad. As much as no country seeks a high inflationary environment, a low-inflation environment is synonymous to low economic activities and in extreme cases may be early signals of economic recession.

To better drive home the point, the “simple” opposite of inflation is deflation, termed persistent decline in the prices of goods and services over a period of time. No country wants to be stuck with deflationary pressures. A case in point is the Japanese economy, which was stuck in a deflationary mode for almost two decades, defying all policy measures aimed at stimulating aggregate demand and price increase until 2013 when Prime Minister Shinzo Abe’s “Abenomics” stimulus policies helped revive parts of the economy out of the doldrums.

With every country dreading the Japanese experience, popularly known as the “lost decade”, which undermined the economic progress of the hitherto Asian Tigers, deflation is not a preferred choice for any country. Thus, the aspiration of every policy maker is a fine balance that ensures stable prices, with tolerable inflation rate levels that support economic growth without undercutting standards of living.

In principle and practice, the Central Bank of Nigeria (CBN) has over time reiterated its preference for a low-inflation rate environment, with target range of six per cent to nine per cent for headline inflation. While Nigeria is not a pure inflation targeting economy like South Africa and Ghana, which anchor their monetary policies on inflation expectations and target, the appetite of the Monetary Policy Committee (MPC) is reflected in the consistent policies and advocacies of the Committee towards addressing some of the notable fundamentals behind Nigeria’s obstinate inflationary pressures.

Over the past decade, headline inflation has averaged 11.7 per cent, with ebb and peak of 7.7 per cent and 18.7 per cent in February 2014 and January 2017, respectively. Like a pendulum, Nigeria’s headline inflation is quick to reverse any benign trend, which has been largely reflective of statistical and seasonal effects. While monetary policy authorities have repeatedly adopted “hawkish” monetary policies, aimed at stemming the wild pressures, the impact has been seemingly negligible.

If at all noticeable, the impact of a higher interest rate environment on headline inflation can only be traced to its probable impact on exchange rate stability, which has implications for stabilising the prices of imported goods and services. Notably, a higher interest rate environment often serve as a bait for attracting foreign and local portfolio investments in sovereign instruments, thereby increasing the autonomous supply of foreign currencies in the form of “capital importation – the hot money component” and reducing the speculative demand for foreign currency stockpiles respectively.

Notwithstanding the observable impact of a tight monetary policy on exchange rate stability and its domino effect on inflation rate, such probable impact is often transitory and unsustainable, as the core drivers of Nigeria’s headline inflation are barely monetary.

So why burn candles in the day?

Having the headlamps on during a fog helps to mitigate accidents but it can never be the solution to the fog. The primary responsibility of every central bank is “price stability”, which may be elaborately summarised to mean 1. Ensuring the stability of prices of goods and services; 2. Ensuring the stability of price of the local currency – otherwise called exchange rate stability; 3. the stability of prices of capital – simply put stable interest rate. Interestingly, this economic trinity is popularly seen to be impossible.

Perhaps the most challenging part of any CBN governor’s job is determining the equilibrium of this trinity that optimises societal progress.

Implicitly referencing the cause-effect relationship amongst the three variables, Governor Godwin Emefiele in reviewing the Nigerian macros at its inaugural presentation on assuming office in June 2014 noted, “owing to the tight monetary policy of the Bank coupled with improved food harvest, inflation moderated to a six-year low of 7.9 per cent at end-April 2014. Debt-to-GDP ratio fell to 11 per cent, while foreign exchange reserves stood at US$37.15 billion as at 27th May 2014”.

This assertion succinctly describes how monetary policy tightening, manifested through high interest rate can help rein-in inflationary pressures and attract foreign capital, which is requisite for shoring up external reserve and ultimately stabilising the local currency, naira. This primary role of the central bank is what puts the monetary authorities out as being responsible for taming inflationary pressures. It is truly so in many countries, particularly developed liberal markets, with strong monetary policy transmission mechanisms and limited structural constraints. Albeit, the peculiarities of Nigeria’s inflation defy this “logical consensus” and high expectations from the monetary authorities in stemming inflationary pressures.

To start with, headline inflation has two broad components: Food inflation and Core inflation. Splitting the beans, the August 2020 headline inflation of 13.2 per cent was driven mainly by the soaring food inflation, which printed at 16 per cent, thus obscuring the relatively benign core inflation of 10.5 per cent. It is instructive to note that monetary policies can only at best be reflected in core inflation, particularly in a country like Nigeria where agricultural activities are still largely informal.

Whilst one may be quick to recognise the secondary role of the CBN in promoting economic development, the CBN indeed has limited role to play in improving agricultural productivity and addressing the structural challenges associated with harvest, transportation and storage etc.

A case in point is the masked impact of the CBN Anchor Borrowers programme, which helps to democratise credit to the otherwise financially excluded farmers. Notwithstanding the funding programme, a host of structural challenges may continue to mute the impact of the developmental intervention. With flood washing away over 450,000 hectares of rice farm, the demand-supply equilibrium for this essential staple has been distorted, thus suggesting probable price hike in the months ahead. This reality of inflation rate dynamics reinforces the limitations of Nigeria’s central bank in taming inflationary pressures.

More importantly, the outlook for inflation rate is concerning, as the 13 per cent year-to-date rise in petrol price begins to reflect on transportation cost and consumer goods’ prices. The higher electricity tariff for consumer segments A, B and C would also exacerbate the inflationary pressure, especially given its implication on production costs.

Whilst both transportation and electricity are components of core inflation basket, the rising costs are non-monetary, rather a reflection of the structural macro challenges which are outside of monetary policy sphere. In fact, a tight monetary policy may heighten the crisis, as higher financing cost for power, transportation, manufacturing and infrastructure development amongst others would increase operating cost and ultimately impact consumer goods’ prices.

…and what’s the vaccine for Nigeria’s rising inflation?

There are two pertinent questions that monetary economists are not asking to understand the position of the CBN and perhaps objectively assess the current regime’s unorthodox policies are: 1. Why is the CBN not increasing interest rate to stem the rising inflation? 2. Is the CBN not aware that a higher interest rate may help to stem the pressure on the Naira? Let’s attempt to answer these questions, perhaps situating the response in the contest of the CBN’s dilemma.

As the rising inflation rate coincides with declining interest rate, it is apparently tempting to play to the gallery by upholding the rationale of the monetary economists who increasingly posit the need to increase interest rate to stem inflationary pressures.

First, it is important to understand that headline inflation has very weak correlation with interest rate in Nigeria, given that the headline inflation basket is mainly composed of items such as food, which has little or no interactions with monetary policies in Nigeria. As observed in the case of flood washing away rice farms in Kebbi State, the rise in food inflation are mainly structural, beyond the CBN mandate and has less sensitivity to monetary policies, especially as the Nigerian agricultural value chain and logistics remain largely informal.

With core inflation at 10.1 per cent, the CBN may have less justifiable incentive for monetary tightening, particularly at a period when money supply aggregates are below the pre-set targets for the year. More so, the modest rise in core inflation has been devoid of money supply, rather it has been driven mainly by supply disruptions occasioned by closure of land borders, weak supply of credit, COVID-19 induced “lockdown” and other structural factors. This evidences the fact that the rising inflation has not been demand-pull, rather reflective of supply shocks.

Thus, pursuing a low interest rate to stimulate credit to all the three economic agents; households, businesses, and government, can help reflate both demand and supply sides of the economy with the prospect for stemming supply induced inflationary pressures.

Incidentally, increasing interest rate at this time may exacerbate the supply-induced inflation, as a higher cost of capital for infrastructure and production, would ultimately be priced in the form of higher prices for consumer goods and services. The uncommon logic of using low interest rate to stem Nigeria’s inflation

Whilst it may be an “unpopular logic”, pursuing a low interest rate regime and channeling system liquidity towards infrastructure development and productive finance may be the true vaccine for Nigeria’s obstinate inflationary pressures.

As the CBN continues to leverage complementary tools; policy measures, moral suasion and direct interventions, to redirect credit towards financing of infrastructure and productive activities across the real sector of the economy, it may be able to address some of the age-long structural challenges undermining adequate local supply of basic consumer goods and subsequently rein-in the rising inflation rate.

Thus, it is a chicken-and-egg dilemma, which comes first: should interest rate be lowered to stimulate supply and stem cost-push inflationary pressures or should the CBN wait for inflation to moderate before unlocking credit to the real sector?

The hard decision Nigerians must make

With savings rate lowered to barely 1.25 per cent and treasuries trading at low single digit, there are concerns on the ability of Nigeria to mobilise savings for the much-needed investment in Nigeria’s real sector. However, the hitherto unusually high-interest rate regime is rather a disincentive for channelling savings into investment. It is pertinent to note that savings in banks is a fraction of an economy’s savings pool, particularly in an economy like Nigeria, with low banking penetration.

More so, investment as loosely used in the macroeconomic parlance refers to fixed capital formation, which is purely investment in infrastructure and the real sector of the economy for sustainable expansion of output, unlike the perennial investment in sovereign instruments, with public sector borrowing crowding out private sector credit and investments in the rea sector.

Thus, the current low-interest rate environment may serve to discourage passive investments in sovereign instruments, which has very limited impact on economic growth, job creation and production while encouraging private-sector investments in the real sector. Interestingly, investments in sovereign instruments accentuates inflationary pressure, as it further exacerbates the demand/supply gaps for consumer goods, while private-sector investments through equity or debt financing that guarantee productive activities and capital formation help to strengthen local supply and moderate inflationary pressures.

More importantly, fixing Nigeria’s infrastructural deficit and industrialisation requires cheap, long-term capital that can encourage entrepreneurial activities, generate jobs for the teeming youths and ensure the profitability of businesses. As observed over the past decade, a high-interest rate regime can only at best widens the inequality gaps in Nigeria, undermine the competitiveness of locally manufactured products and threaten the survival of emerging SMEs.

Beyond the relatively higher cost of doing business in Nigeria, local firms have had to compete with foreign peers, whose operations are financed with low single digit debt, thus naturally undermining the competitiveness of Nigerian firms, which are financed at double digit interest rates.

It is a choice for Nigerians, either earn a high interest on savings to pay higher cost for goods and contend with the social cost of rising unemployment, as Nigeria increasingly become a dumping site for foreign goods, or take the pain of earning low interest rate on savings, finance productive activities to lower inflation rate and earn sustainably higher income through mutual prosperity.