February 28, 2019 12:10PM / CBN
The study estimates a dynamic model using quarterly data spanning 1995 to 2016. Four dynamic models: level lagged variables, differenced lagged variables, log-transformed lagged variables and differenced log-transformed lagged variables were considered. The best predictive model was selected based on the Schwarz Information Criterion (SIC) value. From the empirical results, the level form models performed better than the differenced form models. On the basis of model parsimony, the level lagged model was the preferred model among the set of selected models. Predictions obtained from the model indicate that the model is stable as actual interest rate (IR) values, fall well within the computed 95% prediction interval. The study concludes that previous values of IR and money supply (MS) are significant in predicting future inflation rates in Nigeria.
Inflation is defined as a sustained increase in the overall price level over time. During periods of high inflation, the value of the domestic currency diminishes which negatively affects the economy (Folorunso and Abiola, 2000). Nigeria is witnessing high inflation with economic and social implications. As real income falls, due to the eroded purchasing power of the currency, there is a reduction in the amount of goods and services each unit of the currency can buy. Confronted with an already diminished disposable income, consumers are now faced with higher prices owing to higher production costs. The high inflation trend in the country has also led to increased demand by workers, especially those in the public sector, for higher wages. Furthermore, the desire to save and invest has been on the decline, adversely affecting economic growth.
Similar to the mandate of most central banks, price stability has remained one of the core mandates of the Central Bank of Nigeria (CBN). The interest in price stability emanates not only from the need to maintain overall macroeconomic balance, but also from the fact that price stability promotes investment, output and employment. However, despite several government policies and programmes in Nigeria, the economy has consistently experienced high inflation with attendant consequences on the most vulnerable. Since the work by Phillips (1958), most studies on inflation in developed economies have linked inflation with unemployment. Recent studies in these economies have tended to augment the classical Philips approach of inflation modelling with lagged and lead inflation terms (as surrogates for inflation inertia and expectation respectively); measure supply shocks such as relative food price, energy cost and import price and the real unit cost of labour and output gap. This resulted in the expectation-augmented Phillips curve, the New-Keynesian Phillips curve and the expectation mark-up models of inflation modelling (Richards and Stevens, 1987; Franz and Gordon, 1993; Brouwer and Ericsson, 1995).
Extensive studies on inflation using the Philips Curve approach and its variants have been carried out in Nigeria (Adebowale, 2015; and Orji et al., 2015). However, the Philips inflation modelling methodology has been criticized as inadequate in accounting for the dynamic structure of the inflationary process. Particularly, this approach fails to incorporate as many predictor variables as possible, and most times yields a single model from which judgement is based. Perhaps in an attempt to obtain a more robust view of the dynamics of inflation in Nigeria, some authors have used the univariate time series and the error correction and cointegration approaches, employing money growth, income and exchange rate movements as the focal variables. Examples of the use of the univariate time series models include works by Doguwa and Alade (2013), Otu et al. (2014) and Etuk (2017). The error correction and cointegration modelling approach include studies by Folorunso and Abiola (2000); Odusanya and Atanda (2010); Maku and Adelewokan (2013).
This paper adds to the literature on inflation in Nigeria by varying the period covered, methodology used, variables used and frequency of data among other factors to study the dynamics of inflation in Nigeria. Specifically, this study estimates a dynamic regression using quarterly data of inflation rate (IR), broad money supply (MS), real effective exchange rate (ER) and real gross domestic product (RP) from 1995 to 2016. The advantage of this modelling approach is its ability to deliver results based on underlying economic theory, data characteristics, and practical situations. The main objective of this study is to fit alternative dynamic regression models, select the best-fit model based on some model selection criteria and predict future inflation rates from the selected model. The rest of the paper is organized as follows. Section two presents the inflationary trend in Nigeria. Theoretical inflation modelling frameworks and selected empirical studies on inflation in Nigeria are discussed in section three. Section four describes the methodology of the study. Preliminary analyses and estimation results are presented in section five, and section six concludes the paper.
Some Stylized Facts on Inflation Movement in Nigeria
The inflationary trend in Nigeria can broadly be categorized into four periods of our national life. The first of these periods is the oil boom era of the 1970s which was characterized by fiscal dominance and considerable macroeconomic imbalances occasioned by the sudden rise in government revenue obtained from crude oil exports. These earnings were invested in gigantic capital projects embarked upon by the government under the Third National Development Plan (1975-1980), see Suleiman (1998) and Masha (2001).
Consequently, the period witnessed a sharp increase in money supply with the economy having to contend with serious liquidity challenges. With increased money in circulation and a fragile productive base, the classic case of too much money chasing too few goods ensued. This inevitably led to increase in prices of goods and services. The doubling of the minimum wage in 1975 as recommended by the Udoji Committee further fuelled the rise in the overall level of prices in the economy as the increased income and consequent increased aggregate demand was not matched by increased output.
In an attempt to curb the high inflationary trend in the economy which averaged 33.7% in 1975, the government liberalized imports which resulted to the huge inflow of goods and in termediate inputs into the country. In addition, banks were encouraged to extend more credit to the productive sectors of the economy in a bid to increase output and create jobs. These government policies helped to push down the inflation rate to 11.8% in 1979. The second period was in the 1980s which was dominated by continued overvaluation of the naira even in the face of dwindling oil revenue leading to significant distortion in the macroeconomic environment in an economy that was import dependent and with balance of payment challenges. Thus, by 1984, the inflation rate had risen to 41.2% due to devaluation of the naira and expansion in money supply. Responding to the high inflation rate, the government embarked on price control measures, which saw inflation rates falling to 5.5% in 1985 and 5.4% in 1986.
Again, signs of rising inflation were observed in 1988 and 1989 due to fiscal expansion which was financed by credit from the CBN (Adenekan and Nwanna, 2004). Increased agricultural output helped to reduce the rate of inflation to 8.2% in 1990. Due to high monetary growth and fiscal expansion in the 1990s, Nigeria was confronted with severe inflationary pressures. The inflation rate reached its peak of about 79.9% in 1995 (Bawa and Abdullahi, 2012). In an effort to reduce the surging inflation rate, the government implemented measures to ensure effective monetary policy, fiscal prudence and stabilization of the exchange rate.
These measures resulted in a reduction in the inflation rate from its peak in 1995 to 6.6% in 1999. Nigeria witnessed a sharp increase in inflation from 6.9% in 2000 to about 17.8% in 2005. This was attributed to government budget deficit over the years. The inflation rate declined to 5.4% in 2007 due to the implementation of sound monetary and fiscal policies. Inflation rate moderated substantially from 11.6% in 2008 to 9.7% in 2015 due to increased agricultural output and sound macroeconomic policies (Figure 1 shows the current trend in inflation and some selected macroeconomic indicators in Nigeria between 1995 to 2016). From the forgoing analysis, it is obvious that inflation remains a serious macroeconomic challenge in Nigeria, hence the need for continuous empirical analysis of the inflation trend in Nigeria, in order to support sound macroeconomic policy formulation and management.