I Heard the Central Bank Has Increased Interest Rates. What Does This Mean?

Good morning and how are you doing?

Friday letters are usually dedicated to taking questions from our community. Do you have a question for us? Please feel free to?

• send an e-mail to [email protected]; or
• send a DM to any of our social media channels, or
• simply fill out this form. Don’t worry, your responses are kept anonymous.

***

Question

I heard the Central Bank of Nigeria has increased interest rates. For an average Nigerian like myself, does this affect me? Or what exactly are the implications?

Answer

What has the CBN done again?

The CBN took two major decisions on Tuesday as its highest decision making committee, the Monetary Policy Committee, had its bi-monthly meeting for September. The CBN raised its benchmark interest rate to 15.5% from 14.0%. This interest rate is important because it is one of the major factors considered in setting the rate at which people and institutions lend and borrow in Nigeria. This means that if you want to borrow money today, you will be charged a higher interest rate. And if you want to invest or save, you are likely to get better returns than before.?

Another important decision the CBN took was raising the Cash Reserve Ratio (CRR) for commercial banks from 27.5% to 32.5%. What this means is that out of every N100 deposit in the vault of commercial banks, they must put N32.5 with the CBN to meet liquidity needs (withdrawals from customers and other banking operations). This means banks can only do business with N67.5 for every N100 deposit, which is lower than the N72.5 they could use before the policy change. With less money to do business, banks will not be able to lend or invest as they used to. The increase in CRR, just like the increase in the benchmark interest rate, will lead to an increase in lending and borrowing rates.?

You can see that the CBN took both decisions to achieve the same goal—to raise interest rates!?

But why is the CBN raising the interest rate?

The CBN took this decision to fight inflation by encouraging less borrowing and more saving. In August 2022, inflation rose to 20.5% in Nigeria, the highest in 17 years. This is really bad and we will explain.

Remember the common but not necessarily complete saying that “inflation is too much money chasing few goods?” Yes? The CBN is effectively taking money away from the economy to slow down the rate at which the prices of consumer items increase.

At this point, you are probably thinking taking too much money away from the economy will be bad for the economy. You are right, so let us explain further.?

Why is it important to fight inflation?

The main job of most central banks in the world is to ensure price stability. In simple terms, this means that central banks must try to maintain low and stable inflation with all the tools they have. What would suffice as a low and stable rate of inflation? In Nigeria, the target inflation rate is 6–9%; it is typically within single-digit in most countries.?

Looking at this target, people living in Nigeria would know that meeting it has been challenging recently. They can attest to the significant rise in the prices of consumer items over the past six years and the pain it has inflicted. Many people find it hard to feed and buy other essentials necessary for living a decent life. When there is high inflation, everyone becomes poorer, as each unit of a currency you own buys less quantities of goods and services. It is for this reason that inflation must be reduced to a bearable minimum.?

Why is the CBN acting now when inflation has always been high?

Let us just say that the CBN has been distracted by other goals. Nigeria’s inflation has been stubbornly high since 2016 at an average of 14.6% despite a target of 6–9%. This is not the experience of the rest of the world, as inflation was much lower elsewhere (inflation averaged 10.3% in Sub-Saharan Africa and 4.1% globally since 2016).?

But, today, this inflation problem is now a global one and not limited to Nigeria. The global economy changed due to COVID-19 and the Russia-Ukraine War, in ways that led to significant increases in the prices of consumer goods and services.?

According to the IMF, an institution that monitors the global economy, global monthly average inflation is expected to be 7.4% in 2022, the highest since 1996. In Sub-Saharan Africa, the IMF expects inflation at a much higher rate of 11.6% in 2022, the highest since 2008.?

The CBN is acting now because other countries that are now experiencing high inflation have moved swiftly to reduce it by raising interest rates. If the CBN does not respond by raising interest rates, not only will inflation continue to rise, but the Naira will continue to lose value against other major currencies like the US dollar. In fact, Nigerians will not want to save and invest in Naira because of the poor returns.?

The CBN can choose to ignore local inflation, but global central banks, especially in countries like the US and UK, are committed to their mandate and cannot afford to ignore it. The longer you ignore high inflation, the harder it becomes to bring it down because everyone gets used to it.?

Will this policy work since inflation is driven by issues the CBN cannot control?

Many people believe that inflation in Nigeria is driven by the cost of production and not necessarily due to people spending a lot of money. The truth is that it is driven by both, and actions must be taken to fight inflation. On the CBN’s part, raising interest rates is the appropriate policy action in this fight against inflation. If not for anything else, to ensure that people save and invest in Naira to protect the value of the currency. Also, to let Nigerians know that it is not normal to get used to high inflation and that the CBN will do its best to bring it under control. The good news is that these things help in the fight against inflation!

***

Did you find this newsletter useful? Please feel free to share it. You can read previous newsletters here