On May 23, 2022, the Central Bank of Nigeria (CBN) increased the Monetary Policy Rate (MPR) to 13 percent from 11.5 percent—a rate which had been retained for 16 months prior to the increase. The Cash Research Ratio (CRR) and Liquidity Ratio (LR), on the other hand, remained at 27.4 percent and 30 percent, respectively. The CBN revealed that the MPR was increased to curb the growing rate of inflation. Inflation and food inflation in Nigeria increased month-on-month by 0.90 percentage points and 1.17 percentage points, respectively.
Across the policy circle, there have been debates on whether the increase in MPR can be an effective tool in curbing Nigeria’s inflationary problems. On one hand, the MPR has been retained for 16 months, yet the inflation rate within the period has fluctuated significantly. On the other hand, theoretical suggestions note that increasing the MPR would raise the cost of borrowing in the banking system and limit the supply of money, thereby curbing inflationary pressure. This was the gist in the classroom when we took courses on monetary policy. However, the Nigerian economy does not explicitly follow economic doctrines, and as such, it remains important to calibrate theories to suit the workings of the Nigerian economy. Two things are very important: having a solid background in economic theory and having a good knowledge of the Nigerian economy.
Nigeria’s Supply Driven Inflation
Generally, there are two kinds of inflation —demand-driven inflation and supply-driven inflation. Different policy mechanisms are required to control both kinds of inflation. Monetary policies are effective in situations where inflation is demand-driven; in conventional language, too much money chasing too few goods. In such cases, the CBN can easily increase MPR, increasing interest rates within the banking system, which in turn increases the cost of borrowing, thereby curbing excess demand. However, the Nigerian economy is not faced with the challenge of excess demand.
Nigeria's inflation is primarily caused by two key factors: a low level of aggregate supply and rising production costs. Insecurity and the federal government's border closure policy have contributed to the economy's low level of aggregate supply, while currency depreciation in the parallel market and rising energy prices are major contributors to rising production costs. These factors (except for currency depreciation) are exogenous and independent of monetary policy. According to the Manufacturing Association of Nigeria, energy costs account for 40% of production costs. These factors dampen the level of aggregate supply and are known to breed stagflationary tendencies —which is a situation where economic activity is low yet inflation and unemployment are high. This signals a dilemma in economic policy because policy actions that are aimed at lowering inflation may result in a further decline in economic growth and a further increase in the rate of unemployment.
Why increasing MPR may not reduce Inflation
The supply-side nature of Nigeria’s inflation means that demand-side measures of the CBN may prove ineffective. This is because the factors that are largely causing the rise in prices cannot be controlled by the CBN. While the CBN has some control over the exchange rate, the depreciation of the naira is largely attributed to the continuous demand for the dollar against the naira. Data has shown that import values have consistently been higher than exports. This signifies one of the reasons for the consistency in naira depreciation and the need for an effective diversification policy aimed at promoting import substitution and export promotion in areas where Nigeria enjoys a strategic advantage. In fact, increasing the MPR can be counter-productive. This is because increasing interest rates as earlier revealed will increase the cost of borrowing and further raise the cost of production, constraining new investment and economic activity. The increasing cost of production in turn limits aggregate supply which can further raise the price level.
A Case for Increasing MPR
Proponents in favor of raising the MPR argue that rising interest rates in the United States and other countries may cause a drop in portfolio investment or even cause investors to shift their investments to these countries. This causes a decrease in carry-trade, which can lead to a decrease in foreign exchange earnings and put more pressure on the naira. This, in turn, will lead to a further rise in inflation, which the CBN is trying to avoid. However, I argue that this channel of monetary policy transmission may not be substantial in mitigating the negative effect emanating from other channels, particularly the increased cost of borrowing.
Government policies should be focused on improving aggregate supply in the economy. Deliberate efforts have to be made to address the key issues that have led to the growing decline in aggregate supply. Firstly, the full opening of the borders will improve aggregate supply and minimize deadweight losses that have emerged as a result of market inefficiency—because of the increased disparity between demand and supply. Secondly, the need to reduce the cost of production cannot be overemphasized. The current trend in the parallel market shows the exchange rate to the United States dollar at above ₦600. This feeds into the cost of production and translates to an increase in prices. This highlights the importance of implementing policies that are aimed at reducing import levels while increasing exports. Export diversification policies remain critical in easing the pressure on the naira in the international market and call for the need to harness the numerous opportunities along the value chains of various sectors in the economy. Furthermore, while acknowledging the importance of improving the security situation in the country, external shocks as a result of the pandemic and the Russia-Ukraine war only underscore the need to improve local productivity, particularly wheat and petroleum products. This is a reflection that increasing MPR may not be the silver bullet to curb the rising inflation in the country. However, in the coming months, we will find out how effective the increase in MPR is.