Inflation in Nigeria – are the authorities doing enough to combat the existing problem?

Context and rational

The onset of the COVID-19 pandemic, the war in Ukraine, and their effects on global output and supply chains have led to inflationary pressures globally. The COVID-19 pandemic has continued to disrupt the global supply chain, especially in China, while the war between Russia and Ukraine has affected commodity and food prices, leading to inflation rising to levels not seen globally since the global financial crisis in 2008. Inflation has been a pressing issue for policymakers globally. In November 2022, US inflation climbed down to 7.1% from a peak of 9.1% in June, the highest in many decades. Even though this figure represents an 8.5% decrease from its October inflation report of 7.7%, we would have to go back to 1981 to find a period when inflation in the US was that high, averaging 10% that year.

The Fed was initially slow to react to rising inflation; however, because of the expansion of economic activities, brought about by the relaxation of lockdown restrictions, higher COVID-19 vaccination, and restoration of normal pre-COVID-19 activities, the Fed raised its fund rate (the benchmark interest rate) from 0%–0.25% at the beginning of the year to 4.25%–4.5% in its last meeting in 2022, pushing borrowing costs to the highest level since 2007 during the global financial crisis. In response to a rise in the Fed's funds rate, the Central Bank of Nigeria (henceforth known as the CBN in the article) raised its monetary policy rate (the equivalent of the Fed fund rate in the US) from 11.5% in January to 16.5% in November 2022. The raise, according to them, was to address the rising challenge of inflation in the country. In the words of the central bank governor, “the committee resolved that the most rational policy option will be to further strengthen its tightening stance in order to effectively curtail the unabated rising trend of inflation''. The CBN’s hawkish decision implies that businesses and individuals seeking loans from banks would have to pay a higher borrowing cost.

If prices remain elevated and interest rate hikes in the US continue (as expected), a developing country like Nigeria may face difficulties because investors may want to withdraw their investments in favour of more appealing US markets, resulting in massive capital outflows for Nigeria and inflows for the US. By implication, a higher cost of borrowing for Nigeria would tighten liquidity and investment. This would slow the rise of inflation and bring in more capital flows from abroad. Also, since the country's official exchange rate is always tied to the dollar, the scarcity of foreign currency has made the difference between the official exchange rate and the black market rate even bigger. In essence, Nigeria should not be maintaining its peg against the US dollar because the policy is not sustainable in the long run due to our economic fundamentals, while raising interest rates to tackle rising inflation is not the solution for Nigeria.

Interest rates rise is not the solution to cooling demand

In the current situation, raising interest rates to cool demand and hence inflation is not the best approach because the current inflationary pressures, especially in food and energy, have been driven mostly by supply chain shocks and the war in Ukraine. During the Covid-19 lockdowns, global manufacturers and suppliers were unable to properly create and distribute items to customers. More recently, sanctions imposed on Russia have also reduced the supply, mostly of goods, thereby disrupting prices. If these two points are established as the main reasons for the hike in prices, then taming demand (by raising the prices of goods and services) is not the right approach to resolving the inflationary pressures. Moreover, Nigeria’s headline and food inflation are well above the monetary policy rate as evident from the chart, while raising the policy rate implies that the maximum lending rates remain elevated, hampering the cost of borrowing for sub-prime borrowers.

How then do we resolve the existing challenges?

Supply-side inflation is very difficult to manage. Indeed, the Fed and other central bank officials have stated that monetary policy is ineffective in dealing with supply shocks. Even though most of these central banks have backtracked on their words, it is clear that they did so because they were put under pressure to do something about inflation. However, with supply shocks popping up from time to time, central banks would struggle to keep firm control of inflation. Nigeria doesn't need to look any further than its fiscal authorities to fight supply-side inflation and get out of this mess. This is because markets are now less efficient, nations are economically separated, and employees are less able to traverse borders and, in certain situations, are less easily accessible inside borders. Since supply performance has gotten so much worse, tightening monetary policy would almost certainly make the problem worse.

Because of this, fiscal policy must be deliberate about making inflation less of a problem, especially for the homes that can least afford it. Whether or not the government gives a net fiscal boost, fiscal policy can help reach other goals that monetary policy can't. By implication, the fiscal authorities can play three important roles in alleviating inflationary pressures. These roles include easing the pain caused by high inflation, rising interest rates, and the economic slowdown; lowering the chance that the short-term economic slowdown will have long-term negative effects; and making the country more productive. Nigeria can implement these by adopting some of the existing policies in the UK, whereby the government targets the most vulnerable homes and provides energy subsidies on their monthly bills due to higher energy rates, and they also cater to the bills of the poor and most vulnerable by providing shelter and unemployment allowances. By playing these roles, they are reducing the effects of rising inflation on the poorest and most vulnerable households in Nigeria.

A final note

Even though raising interest rates is still the most popular antidote to fix inflation, in the current situation, raising interest rates to fight inflation could cause a recession because the problems caused by inflation are more related to the supply side than the demand side. In conclusion, a rise in interest rates in a developed economy like the US will always have an effect on a developing country like Nigeria. This is because Nigeria relies heavily on imports, which result in a capital outflow from the country. This puts pressure on the country's foreign exchange and external reserves. Because of this, it's likely that the CBN will continue to raise interest rates to keep attracting capital flows into the economy. However, as earlier mentioned, this tends to inhibit domestic growth since interest rates are already very high in Nigeria. The best way to find short-term and long-term solutions to inflation problems is to work on things that will improve the country's ability to supply goods and to make structural changes that will help the Nigerian economy be more productive.?