Understanding Nigeria’s soaring inflation and how to tame it

The new dispensation combined with quick policy actions on fuel subsidies and foreign exchange, as well as the arrest of the suspended central bank governor, has brought the question of monetary policy to the front burner.

With President Bola Tinubu announcing during his inaugural speech the need to “clean” the Central Bank of Nigeria (CBN) as well as the need to reduce interest rates to promote MSME-led growth, the question, therefore, revolves around what the CBN has been doing wrong, and what is the way forward.

The backdrop to this question is the uncomfortably high and rising inflation which hit an 18-year high of 22.41% in May. Inflation at over 22% is a big challenge for any economy. It means that prices double in less than four years. It means that salary earners lose 22% of their purchasing power every year.

It means that the government would need to generate 22% more revenue just to provide the same public services. It means that the Naira will likely weaken by 22%, less whatever global inflation is, in the next year. Inflation at 22% means that the challenge of moving the Nigerian economy forward and improving the lives of ordinary people forward is significantly harder.

This high inflation is especially worrying for food which, at nearly 25%, means that the poorest who as of 2019 already spent roughly 60% of their incomes on food, are in a very difficult position. When combined with other recent policy efforts, such as the removal of fuel subsidies, the seriousness of the challenge should be apparent as inflation has been projected to surge even higher.

Given that keeping prices “stable” or keeping inflation low is the core monetary policy objective of the CBN, then it is easy to make the case that the central bank has been, and is, failing its core mandate. If you add popular annoyance against exchange rate issues, then the scorecard is likely to be very poor.

In this note, we will argue that the failure is due to the CBN’s misunderstanding of its powers in terms of what it can and cannot do. This misunderstanding has led it down the unconventional policy route which, as expected, has resulted in higher inflation and not much else.

That misunderstanding however is a good lesson for the CBN going forward, especially in the context of the new government’s zeal to set a more credible path for monetary policy.

The big trade-off in monetary policy: Taming inflation versus promoting growth
First, a simplification of the big trade-offs when thinking about monetary policy, which is really all about controlling and managing the money supply to ensure that there is just enough money in circulation to incentivize real economic growth in a sustainable way. Of course, money (today) is really just a piece of paper (or a digital record) that has no intrinsic value.

That piece of paper does not cause rain, fight terrorists, reduce bottlenecks at the ports, or teach young people physics. In economics, we like to say that in the long-run money is neutral. If you wanted more water for agriculture, you would need to build irrigation facilities; and if you wanted to fight terrorists disrupting your economy, you would need more policing and intelligence.

This neutrality of money has very important implications for monetary policy. The first is that higher levels of money supply for a given level of economic activity just means higher prices (also known as higher inflation). Imagine a hypothetical yam-eating society in which their central bank decided to double everyone’s income by a cash transfer but the number of yams available, the real yam economy, remained the same. The only outcome will be higher prices for yams or yam inflation.

In practice, economies are a lot more dynamic but the principle is the same. Controlling the amount of money supply is the key factor behind managing inflation. If your money supply grows too fast relative to your real economy then you have higher inflation, and vice versa.

Ergo, if we observed that inflation was getting too high then the expected policy response would be to reduce the growth of the money supply. There are many tools for reducing the growth of the money supply but the conventional primary tool is through an increase in interest rates. The logic is simple.

At the margin, higher interest rates make borrowing more costly which means credit, to the private sector or governments, should reduce, and which means the money supply reduces as well. On the flip side, higher interest rates also incentivize banks to park money at the central bank to collect more interest which also tends to reduce the money supply. There are various other channels but in general higher interest rates tend to reduce money supply.

But higher interest rates also have other effects. Higher interest rates tend to slow down the economy. If you think of the channel through slowing credit growth then it is pretty straightforward to see how. So, the question then becomes, when faced with higher-than-normal inflation, should policymakers choose to allow higher inflation or raise interest rates to reduce inflation, even if it limits economic growth or employment?

The answer is almost always to opt for lower inflation. The first rationale behind this is that inflation affects everything, even the interest rate itself.

Think for instance of our yam economy and imagine inflation was 25% a year. What this would mean is that even if interest rates were as high as 20%, the providers of credit would still be losing value. In that economy, if a person loaned out the equivalent of one yam, at the end of the tenor, the principal plus interest would not be able to buy that same yam. In essence, real interest rates would be negative.

So, you would need even higher interest rates just to incentivize people to stand still in real terms.

The same dynamic works with exchange rates in an economy with higher inflation. Imagine inflation in the Naira-denominated yam economy was 25% but inflation in our neighbours’ CFA-denominated economy was only 1%. It would mean the Naira would have to depreciate by about 24% relative to the CFA just to stand still. If it didn’t, then yams from our neighbours would be systematically cheaper and everyone would opt for them and our economy would suffer.

The impact of inflation is so ubiquitous, from wages to government spending to interest rates to exchange rates, that when faced with a choice, monetary policy almost always has to opt for lower inflation even if it comes with some costs.

But that is not all. Imagine our yam creditor who has to decide what “real” interest rate to charge to ensure that she doesn’t end up losing value at the end of the term. She has to guess what inflation in the future would be. If she thinks inflation will be high then she has to charge a high interest rate to make up for it. On the other hand, if she thinks inflation will be low, then she can charge lower interest.

In essence, her expectations about inflation in the future affect what she does today, and therefore affects what really happens in this yam economy today. What this means is that, even if nothing happens, if people start to expect that inflation will be high then there are consequences to that.

From the perspective of monetary policy, this means that it is not enough to choose lower inflation, people need to believe that you will choose lower inflation and do what needs to be done to tame inflation. If people start to believe that inflation will be higher, then people start to act as if inflation is high and that results in all the consequences of high inflation even if nothing significant happens.