Why is the Monetary Policy Committee (MPC) of the Central Bank of Nigeria not making a cut in the base rate several months after it tightened monetary policy? Rising from its September 2017 meeting, the Committee decided by a vote of 6 to 1 to retain the MPR at 14 per cent alongside all other policy parameters fixed since July 2016.
The MPC seems not to be taking advantage of the many windows of opportunities in the global and domestic environment to reduce the rate at which the CBN lends to commercial banks. As rightly noted in the Committee’s communiqué no 115 issued at the end of its meeting, ‘global output is projected to improve further in 2017, as growth forecast by the IMF in its July World Economic Outlook was projected at 3.5 per cent, up from 3.2 per cent in 2016’. On the domestic front, the economy has witnessed an end to a 15-month recession while manufacturing activity continues to pick up as confirmed by the Bank’s Purchasing Managers Index which is in excess of the 50 index points threshold.
Similarly, data from the CBN show a remarkable spike in foreign exchange reserves from a low of US$24.53 in September 2016 to US$32.9 billion as at 25th September, 2017.In the same vein, the National Bureau of Statistics report for the second quarter of 2017 indicates that capital importation grew by 95 per cent over the previous quarter. Furthermore, the success of the Investor and Exporters’ window of the foreign exchange market which has improved liquidity with over US$7 billion inflow since it was introduced in April 2017can only point to a boost in foreign investor confidence.
These developments have enabled some degree of stability in exchange rates across all the segments of the foreign exchange market. They have equally rubbed off positively on the equities segment of the capital market where year-to-date returns have been a little shy of30 per cent reflecting growing investor confidence. What is more, recent price developments indicate that headline inflation has trended downwards from 18.72 per cent in January to 16.01 per cent in August2017, a pointer to some easing of underlying inflationary pressures.
Not a few Nigerians had expected that these positive developments in the economy in recent times powered by a rebound in crude oil price and output ought to have provided some scope for monetary policy easing. A rate cut, in the opinion of many, would improve credit delivery to the real sector, reduce cost of capital for firms leading to more job opportunities, spur the stock market and could help reduce the high non performing loans in banks. It is therefore expected to stimulate spending and buoy business confidence. An accommodative monetary policy stance at this time is also argued to have the benefit of reducing the cost of servicing government debts which has been crowding out public spending. So, just why is the MPC reluctant to effect a cut in the MPR in spite of the obvious merits of the policy choice? The answer can be found in what has been described as the ‘policy trilemma’ or ‘impossible trinity’ which expresses the limited options available to Central Banks in setting monetary policy.
According to this theory, credited to Robert Mundell and Marcus Fleming, a country cannot achieve the free flow of capital, a stable managed exchange rate and independent monetary policy simultaneously. By pursuing any two of these options, it necessarily sacrifices the third. Like every other Central Bank, the CBN faces this classic policy trilemma. In view of the primary mandate of the CBN which is to maintain price and exchange rate stability, it will be near impossible for the apex bank to pursue lower inflation and interest rates, maintain exchange rate stability and shore up foreign exchange reserves all at the same time.
Therefore, a rate cut at this time can only be at the expense of the progress already made in the area of exchange rate stability—which is itself a prerequisite for achieving lower inflation rate. Inflation has partly been driven upwards by the rising cost of imports on account of high exchange rate. A lower MPR would not only put pressure on the exchange rate and exacerbate inflationary pressures but also pull the real rate deeper into negative territory as the gap between the nominal interest rate and inflation widens. Headline inflation may be receding but the current level(at 16.01 per cent) is substantially in breach of the CBN’s upper reference band of 9 per cent. Besides, the food index component remains elevated at 22.25 per cent.
Furthermore, a lower MPR is capable of instigating global capital flow out of the country especially in view of the fact that the improvement recorded in capital importation in recent times was more from the highly volatile portfolio investment.Capital flows into developing economies face threat from the fog in Brexit negotiations and the likely impact on UK economy.Despite keeping rates on hold at their record low of 0.25 per cent (by a vote of 7 to 2), the Monetary Policy Committee of the Bank of England at the end of its September meeting, signalled it was gearing up for a rate increase, possibly later this year, in order to subdue inflation within itsofficial target of 2 per cent.
Perhaps a bigger threat emanates from the normalization of monetary policy by the United States’ Federal Reserve. To understand why, it will be recalled that at its December 2015 meeting, the Federal Open Market Committee (FOMC) decided to begin the normalization of monetary policy which is simply a plan for returning both short term rates and the Federal Reserve’s securities holdings to more normal levels after the federal fund rate wasreduced to nearly zero in the wake of the global financial crisis which began in 2007. The Federal Reserve has signalled to raise the fed fund rate from the current 1.25 per cent to 1.5 per cent later this year, 2 per cent in 2018 and 3 per cent in 2019.This hawkish policy stance in the United States is expected to strengthen the dollar and is capable of tightening external financing conditions.With consumer inflation at 12.3 per cent in August (significantly higher than the policy target of 8 per cent), the Monetary Policy Committee of the Bank of Ghana has also kept its policy rate of 21 percent unchanged after its September 2017 meeting citing among other reasons further strengthening of the US dollar following the monetary policy normalization in the United States of America.
For structurally weak economies, there is a large body of research which support the view that interest rates are sticky downwards. By implication, a lower policy rate does not necessarily transmit into lower retail lending rates. This position is also canvassed by Y. V. Reddy, former Governor of Reserve Bank of India who points out that ‘reduction in interest rates by itself does not increase credit flow owing to rigidities in the economy’. These ‘rigidities’, heightened by infrastructural deficits, are quite pronounced in sub-Saharan Africa.Asked why the reduction in the MPR of Bank of Ghana (BoG}by 150 basis points (from 22.5 per cent in May to 21 percent in July 2017), had not positively reflected in the lending rates of the commercial banks to the private sector, the Governor of BoG, Ernest Addison, observed that commercial banks had some other operating costs to grapple with. Given the current financial position of Deposit Money Banks in Nigeria, chances are that the risk-averse banks, now dealing with high non-performing loans (well above the regulatory threshold of 5 per cent) as well as a creeping rise in cost of operations (no thanks to epileptic power supply), would rather apply a lower MPR to cushion these coststhan pass any basis-point cut to borrowers.
The economy may have technically exited the recession but real GDP growth of 0.55 per cent in the second quarter of 2017,driven chiefly by the oil and gas sector, remains weak and vulnerable to exogenous shocks. A number of important job elastic sub-sectors are still in the negative territory. For example, while the transport and storage sector fell by -6.18 per cent, the Information and Communication sector slowed by -1.15 per cent in real terms year on year. Moreover, the horse may be out of the proverbial barn in the sense that a lower policy rate at this time may be counter-productive in the light of findings from studies conducted by the CBN which put inflation threshold for Nigeria at between 10 to 12 percent. The implication is that until inflation drops to around 12 per cent, lower interest rates may not necessarily stimulate growth.
Therefore, for the economy to regain traction, targeted fiscal action has a lot to recommend it given the monetary policy trilemma. Fiscal policy can indeed support aggregate demand and near-term growth without creating an incentive for capital to flow out of the country. Accordingly, the government should intensify efforts atimplementing the 2017 budget particularly directing capital spending at the growth-stimulating sectors of the economy in line with the Economic Recovery and Growth Plan.