Choosing Between Hiking Rates or Doing Nothing

Since the Monetary Policy Committee (MPC) of the Central Bank of Nigeria (CBN) started increasing the key policy rate, there has been different opinions on the effectiveness of the rate hikes, with some school of thoughts saying the rate hikes will kill businesses. While these concerns are relatively genuine, it is important that we understand the concept of trade off and that the CBN’s hawkish rendition is basically choosing between ‘two evils’ such that the effect of one is lesser than the other. My focus here is entirely the CBN and not looking at the fiscal authorities since the CBN is the topic of discussion.

Before the rate hikes started, businesses have been dying due to significant FX pressures and uncertainties around the path of monetary and exchange rate policies. At some point, prices were increasing every day and we were all complaining about it. There is a limit to the amount of price increases that businesses can effect amid the limited income growth in the country. So those that cannot withstand the pressures end up leaving the country or dying. Bear in mind that since the CBN started this year’s tightening cycle, complementing its other reforms, the exchange rate has appreciated significantly – from a high of NGN1665/USD (official) or NGN1900/USD (parallel market) to about NGN1300/USD today. Without further shocks and if we remain like this, expect m/m inflation to drop consecutively from March. Unfortunately, the y/y inflation will still increase through May, due to the relatively low base from the prior year.

It is true that high food prices are the major contributor of higher inflation. Food prices currently account for about 60% of the increases in Nigeria’s headline inflation since the beginning of the year. It is also true that the deteriorating state of internal security and high logistics costs are big drivers of food prices increases. Still, supply side issues being a dominant factor behind inflation is not today. If you want to think back to a more recent timeline, think the Border closure of August 2019 and trace it down till today. In between that timeline, you tend to see abrupt price increases during periods of noticeable fuel price increases and currency pressures. Hence, what has been left out of the ‘supply-side factors’ analysis is that exchange rate pressures affect agricultural input costs and also logistics. If that is the case, then something needs to be done to address that concern. Besides, core inflation (all items less volatile energy and farm produce prices) is also on the rise, settling at 25.1% y/y in February. This suggests the impact of monetary factors on headline inflation.

Elsewhere, if inflation continues to rise and interest rates remain low, we will not find naira assets attractive. Rather, we will keep buying dollars and foreign currency assets to hedge against high inflation. This will continue to put pressure on the local currency. So businesses will still die of exchange rate pressures and we will still abuse the CBN of doing nothing while currency pressures and inflation are choking businesses. And if the locals are not incentivized to hold the naira, why should the foreign investors be keen to hold same currency?

Overall, it is necessary to understand that the CBN is at crossroads and must choose the best option between two choices such that the optimal decision produces a less painful outcome. So maybe the question in mind here will be that: Between the ‘evil’ of a daily local currency depreciation and a 600bps increase in the MPR, which has a lesser negative impact on businesses?