Central Bank’s Monetary Policy Fails to Curb Inflation; Now What?

Inflation hit an 18-year high last June in Nigeria. The 22.8% all-items inflation rate hadn’t been seen since August 2005’s 28.2%. Despite its year-on-year figure, the twelve-month average for that month was 15.5%. June 2023’s? 21.54. Looking at food inflation, a similar trend follows for both years. In 2005, a high year-on-year inflation rate (38.5%) dwarfs the twelve-month average (20.5%). Contrastingly, year-on-year inflation is close to the twelve-month average in 2023, at 25.25% and 24.03% respectively. 

These indicate that 2005’s inflation was a spike, a momentary economic shock. The data clearly shows this: inflation went from 18.6% in July to 26.1% the next month. After hitting 24.3% in September, it will return to 18.6% in October and 11.6 by the year’s end. June 2023’s figures show a sustained inflationary environment. So, what did the country’s Central Bank do in both years?  

In January 2005, the Central Bank reduced its interest rate - then called the Minimum Rediscount Rate (MRR) before its December 2006 change to the Monetary Policy Rate (MPR) - by two percentage points to 13 per cent. During the high inflation months mid-year, it maintained the interest rate to ensure credit remained available to a growing economy. It attempted to tackle excess liquidity and reduce money supply by raising the cash reserve requirement (CRR) by 50 basis points to 10 per cent, persuading banks to hold on to a bit more of their cash.  

Fast-forward to July 2023, and the Central Bank’s response to sustained inflation has been to raise the MPR for the sixth time in twelve months – from July 2022’s 14 per cent to 18.5 per cent. The Central Bank also decided in September 2022 to raise the CRR by 500 basis points from 27.5 per cent to 32.5 per cent. In twelve months, the Central Bank has forced banks to hold on to more cash and reduced available credit to said banks, forcing them to make less money available to private borrowers and at higher rates of interest. All of this is to have the effect of reduced money supply – the sum total of cash in circulation in the country’s economy. However, none of these has had the desired effect; inflation continues to rise.  

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Tackling inflation involves understanding the cause, the driver of the present inflation. The consensus approach to inflation amongst most modern economists is monetarist, a belief that money supply is the primary factor affecting demand. This school of thought, developed by Milton Friedman in the 1960s, believes that inflation can be controlled by increasing or reducing money supply.  

In monetarism, reducing money supply might lead to short-term recession, as economic activity is restricted and growth slows. After all, money supply has outpaced economic growth; a slowdown is necessary. When money supply is excessive, its value falls and prices rise because the demand for goods and services outpaces production capacity.  

The issue with monetarism is based on its assumption that inflation is almost exclusively a demand-pull event. Hence, it uses money supply to attack demand. The issue with this is that the government choosing to control money supply will have the adverse effect of curbing economic growth. If there is too much money chasing too few goods, should the government aim to reduce the money or increase the goods? What if the amount of goods cannot rise? 

Increasing interest rates often mean employers will find it difficult to make bottom lines. Credit is less available and more expensive, and the increased rate of credit leads to an increased cost of production. The increased cost of production can come from other factors, which we will now examine concerning the Nigerian economy. 

An increased credit rate will raise production expenses, but how about the price of labour? Increased labour costs such as mandatory wage hikes will lead to higher production costs. However, wage increases are infrequent in the typical Nigerian workplace. Most workers go years without pay rises and unionization is low, leading to few wage negotiations and the onus being on the employer to raise wages as they see fit. Most don’t.  

Supply shocks could also lead to higher production costs as raw materials become scarce and inevitably more expensive – an example is the 2020/2021 shortage in semiconductors driving up the prices of computers. This increase in the cost of production inadvertently leading to an increase in prices is termed cost-push inflation, and it may have one primary driver: energy prices.   

The average factory will demand a base level of power and electricity to run, with this often being the highest operation expense alongside wages. In an increasingly automated production space, it stands alone, and the cost of energy becomes the main driver of prices. How much does it cost a wheat farmer to power his tractor, a trawler to operate a cold room, or a furniture maker in Benin to transport his goods to Abuja? Energy prices in Nigeria, from electricity to petrol and diesel, have gone up a sharp incline since January 2022.  

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Raising interest rates will often have a contractionary effect on production, not just demand. Companies are often forced into labour cuts. Producers are also working at a reduced or slower capacity, so they produce less, and scarcity remains. Importation spikes as production wilts. The increased importation tends to undo what should be the positive effect of higher interest rates on exchange rates.  

Higher interest rates should attract foreign capital as it becomes more profitable to be a leader in the economy, but a negative balance of trade offsets that as there is little demand for the country’s currency. In a twisted fate, the Nigerian central bank’s attempts to fight demand-pull inflation with money supply regulation have induced cost-push inflation. 

In this environment, scarcity in goods and services may outpace the reduction in money supply. Unemployment and low wage compensation become rampant, but demand remains, unable to fall below a certain base level. When supply cannot meet this base level, then money supply ceases to be effective. One might argue that Nigeria has hit this level and its citizens are being forced into acute economic austerity.  

The Friedmanite policies of the Central Bank of Nigeria look at inflation from one lens: that of the buyer. Control the buyers’ behaviour and you will control inflation. But there is a limit to this, and we might have hit that limit. There are alternative measures to fighting inflation.  

The German economist, Isabelle Weber, has pushed the “sellers’ inflation” theory into mainstream economic discourse. Sellers’ inflation occurs when producers pass on a shock to the cost of production to customers, but further increase prices to protect or enhance profit margins. Corporations drive inflation by seeking greater profits. She postulates that this is tackled by government intervention by way of price controls. This mechanism might force producers to allow profit margins to decline and abandon the “price over volume” strategy – less production but higher prices.  

She writes thus: “We should recognize the recourse to higher interest rates for what it is: a strategy to dump the costs of inflation onto labour (by suppressing wages), on to social programs (through austerity), and on to future generations (by discouraging investment).” This writer agrees: labour is being punished for inflation. The issue with price controls is that it assumes a seller’s inflation, and it is hard to argue that this is Nigeria’s case.  

Mustard Insights has published work on the industrial decline in Nigeria, exploring how government policies adversely affected the production sector. A burgeoning population means reduced production will immediately produce scarcity and inflation. The country’s government has pursued a fiscal policy of raising taxes and reducing government spending with the removal of the fuel subsidy. One might argue that Nigeria needs to go in the opposite direction.  

The Keynesian approach – so-named after its founder, John Maynard Keynes – argues that in periods like this, the government needs to employ an expansionary fiscal policy: increase public spending and lower personal and corporate taxes to enable economic activity, higher wages, reduction in unemployment, and increased consumer spending. The issues with this (increased money supply leading to excessive spending and inflation) can be tackled with a conversely contractionary policy. 

Keynesian or Friedmanite; theory is only useful when it can be applied in practice. Presently, Nigeria does not produce nearly enough of anything from food to domestic items to meet the needs of its population. This results in a scarcity that induced austerity cannot solve. People will still need food and housing. Nigeria’s path out of economic ruin lies in increased production, regardless of the method used to achieve it.