Friday, November 15, 2013 / By Kola Ogunleye
There is a lively debate going on in the world of central banking today. The focus of the debate has centered mainly on the following: “Should central banks have a single explicit mandate of price stability or a so called dual mandate of price stability and maximum employment?”
Given that the kind of growth and development we desire in this country have not been achieved under a single mandate regime, it will be right to go for the dual mandate. In that case, whoever will be the next governor of the Central Bank of Nigeria must be able to make a legacy statement beyond the usual.
In this article we will attempt to review the performance of the CBN in relation to the single mandate of Price Stability granted it under the existing legislation and make a case for a modification or amendment to the law to give the CBN a dual mandate: Full Employment and Price Stability.
Definition and Historical Background
Broadly speaking, central banks’ mandates fall into three categories. The hierarchical mandate is one with a primary goal (e.g., inflation targeting) followed by other goals. The Bundesbank and its successor, the European Central Bank (ECB), is the most famous example of this type. The dual mandate bank is one with two co-equal primary goals (e.g., price stability and maximum employment,) with the US Federal Reserve being the most notable example. The third kind is a central bank that pretty much has a vague mandate (currency and stability, flow of credit and the like). The central banks of Canada, India and China are examples of this third type of mandate. Time and legacy have played a role in the establishment of these mandates.
Mandate Setting in Developing Economies
The recent global financial crisis has inspired much debate regarding the role of central banks. In developing economies, one important issue concerns the appropriate outcomes and instruments of monetary policy.
Mandate Setting in Developing Economies
Proponents of inflation targeting have argued that central banks should embrace just one clear objective: maintaining price stability.
Others have argued that, rather than focus only on price stability, central banks should also actively use monetary policy to foster economic development and job creation.
Although most central banks do not specify full or high employment among their goals or objectives, in developing countries many do engage in actions that promote job creation and economic development.
Before the global financial crisis, the IMF supported the adoption of inflation targeting by non-industrial countries. In a 2006 paper the IMF argued that, subject to certain caveats, inflation targeting led to better macroeconomic outcomes than alternative monetary policy regimes Following the crisis, however, the IMF position appears to have changed (O. Blanchard: Monetary policy in the wake of the crisis [IMF, 2011]). At the Asian level, R. Rajan and E. Prasad have argued in “Why an inflation objective?” (in Business Standard, 2008) that the Reserve Bank of India should relinquish all objectives other than price stability, while the Asian Development Bank argued that the People’s Bank of China should change its monetary policy framework and adopt elements of inflation targeting (see Asian Development outlook 2011: South-South economic links [ADB, 2011, box 3.9.1, p. 123]).
2 J. Felipe, in “Does Pakistan need to adopt inflation Targeting? Some questions” (2009), asks whether price stability is the most important objective for the State Bank of Pakistan, and concludes that an exclusive focus on price stability (in the form of inflation targeting) is inappropriate at this time. G. Epstein outlines arguments in Beyond inflation targeting (2009) that central banks should have a broader mandate than price stability, and provides case studies for India, the Philippines, and Vietnam.
CBN: Single Mandate Example
Section 2 of The Central Bank of Nigeria Act provides as follows in respect of the CBN mandate:
The principal objects of the Bank shall be to –
(a.) ensure monetary and price stability;
(b.) issue legal tender currency in Nigeria;
(c.) maintain external reserves to safeguard the international value of the legal tender currency
(d.) promote a sound financial system in Nigeria; and
(e.) Act as banker and provide economic and financial advice to the Federal Government.
Thus, the sole mandate of the Central Bank of Nigeria is the promotion/maintenance of price stability.
The issue to be addressed is how well the CBN is prosecuting its single mandate agenda within the context of the macroeconomic goals set by the government.
Any central bank is a part of its nation’s government. In Nigeria, our constitution assigns the power ‘to coin money (and) regulate the value thereof’- in modern parlance, the authority to make monetary policy – to the National Assembly. For over fifty years now, the National Assembly has delegated that power, subject to instruction and to ongoing oversight, to the CBN.
In furtherance of the mandate to support or maintain price stability, the CBN has adopted the Inflation-Targeting framework to control inflation and thereby maintain price stability. It achieves this by targeting a certain level of inflation and ensuring this target was met by monitoring a wide range of monetary, financial, and real economic variables.
The CBN operates a hierarchical but explicit mandate in the sense that other objects of monetary policy are secondary to the price stability objective and there is an explicit numerical target.
Inflation Targeting Regime in Nigeria – The story thus far
The core idea of the monetary policy regime in Nigeria has been construed to mean price stability at the expense of other key macroeconomic indicators like job creation that measures growth performance of a nation. Although the Nigerian economy has a fragile private sector, financial resources to the private sector in Nigeria, such as through loans, purchases of non-equity securities, trade credits and other accounts receivable have been constrained over the years following insolvency in many banks and effects of the global financial crisis in Nigeria. This triggered a hike in interest rate to the domestic private sector in Nigeria since 2006. The upward adjustment of monetary policy rate by the Monetary Policy Committee to force inflation to single digit has created adverse effects on activities of the private sector and the economy.
The intended or unintended consequence of this monetary policy stance in the overall economy begins with the reduction or stagnation of credit to the private sector, particularly, small and medium enterprises by commercial banks. This tight monetary policy stance reduces the ability of these businesses to take out loans from commercial banks at reduced market rates and expand existing businesses or start new ones.
The stagnation of credit to businesses in the Nigerian economy resulting from tight monetary policy from 2006 was primarily intended to reduce inflation. Inflation has been under control in Nigeria in the past couple of years. By all measurements, the CBN has been successful in the use of monetary policy tools to fight inflation.
However, such success comes at the cost of an unsustainable high rate of unemployment in the country. It must be noted that the private sector creates the most jobs in a free market economic system. Therefore, the current monetary policy in Nigeria kills jobs by squeezing existing and prospective businesses out or by reducing their capacity to absorb excess labour.
The case for an explicit full employment mandate for the CBN
With high rate of unemployment and more than 71 million people in abject poverty, Nigeria is hardly on track to meet the MDGs, particularly the number goal of poverty reduction. As Khan, a respected political economist rightly pointed out “Employment-intensive growth is the most effective method of poverty reduction because labour is the most plentiful resource that most poor are endowed with.”
In the past few years, economic policies in Nigeria have been narrowly focused on growth in contrast to development (UNDP, 2010). AsAmartyaSen, a well-known Indian economist reminds us “Adequate conception of development must go much beyond the accumulation of wealth and the growth of gross national product and other income-related variables. Without ignoring the importance of economic growth, we must look well beyond it.” Economic growth in Nigeria has not trickled down with a strong multiplier effect in the overall economy.
The above challenges underscore the need to reconcile the fundamental goals of economic growth, productive employment and poverty alleviation in Nigeria. These issues cannot be addressed through the MDG-related spending and the implementation of social and economic development programmes alone. Rather, the socio-economic challenges of the country, especially employment generation and poverty alleviation require the reexamination of its monetary policy frameworks.
MERITS OF SINGLE MANDATE
It is sometimes argued, however, that price stability can be the only objective for monetary policy in the long run, again placing price stability on a higher plane than full employment. In the long run, theory holds that the economy gravitates to full employment by self-equilibrating forces, principally through the effects of price flexibility. That is, if the economy is operating at a level of output below full employment, the price level will tend to fall, and at least for a given value of the nominal money supply, this will tend to stimulate aggregate demand. Over time, this process will raise aggregate demand to a level consistent with full employment. Hence, policymakers do not have to be concerned with full employment in the long run, leaving price stability as their unique long-run concern.
Stability-Focused Central Bank and Job Creation
A stability-focused central bank has a clear social contract with the rest of society: its role is to maintain prices and financial stability. In a developing nation context where volatility in international commodity prices and bad harvests can lead to price shocks, a stability-focused central bank has a commitment to prevent isolated bursts of inflation confined to a few goods from becoming widespread and persisting over time. A commitment to financial stability means ensuring that neither domestic nor external forces result in a disruption in the supply of credit for productive purposes. With the central bank focusing exclusively on stability, the objectives of creating an inclusive financial system and supporting economic development are left to the government.
Over the past decade-and-a-half, global sentiment has shifted towards scrapping other objectives and making price stability the sole or primary objective of monetary policy. Between 2003 and 2008, according to the International Monetary Fund (IMF), the number of countries classified as having an inflation-targeting monetary policy regime - where price stability is the sole or primary objective of monetary policy, and there is a publicly announced numerical target for inflation - rose from 23 to 44. 8 These numbers understate the central bank shift towards scrapping objectives other than price and financial stability - many more central banks have become focused on stability in practice, but do not meet the strict criteria for inflation targeting, since they choose not to specify explicit numerical targets for inflation.
Stability-focused central banks contribute to job creation in an indirect but important manner. A commitment to price stability allows wage claims between workers and employers to take place with some certainty regarding future cost-of-living pressures and financial conditions.
Uncertainties related to financial instability or high and unstable inflation can lead to social problems and industrial disputes. Price and financial stability are also very important in attracting and maintaining domestic and foreign investment. The perceived capacity of a central bank to provide stable inflation and prudent financial standards is an important determinant of vulnerability to sudden stops in international capital inflows, which can lead to sharp contractions in investment, output, and employment.
Where central banks have total control over only one instrument, the intuitive impulse is to pursue only one objective as well. As some observers have put it, “trying to do too much with one instrument is a recipe for ineffectiveness, especially in difficult times. Moreover, the notion that monetary policy can itself raise long-term growth through activist policies is problematic – in fact, faith in that belief led to stagflationary episodes in the U.S. in the 1970s and 1980s.”
But the foregoing analysis is misleading in a couple of respects. First, monetary policymakers should be concerned about two long-run properties of the economy. One is price stability and the other is the variability of output around full employment. Policy has to be judged by its success in both dimensions. Second, policy is made in the short run, not the long run. The speed of return of output to its potential level is influenced by policy decisions and cannot be treated with indifference. It may just take too long and waste too many resources in the interim to rely on the self-equilibrating forces of the economy.
The appropriate goals for monetary policy depend on the structure of the economy and the preferences of the citizenry. Advocacy for a dual mandate for the CBN is informed by the structure of the Nigerian economy, the current state of our development, the limited scope of our financial infrastructure, the urgent need to provide jobs for our teeming population and through monetary policy the capacity of the CBN to influence real outcomes (in spite of the limitation of the transmission mechanism).
Tradeoff between inflation and output variability
Although it is possible in principle to achieve price stability and full employment simultaneously, an inevitable tradeoff between the variability of output and the variability of inflation exists. This tradeoff is most obvious in the case of a supply shock, for example an abrupt increase in the price of oil. An adverse supply shock typically raises inflation and lowers aggregate demand (by reducing the purchasing power of consumers), thereby moving inflation up and output down. This gives rise to a well-known dilemma for monetary policy: Should monetary policy ease to reduce the decline in output or tighten to counter the rise in inflation? The structure of the economy is such that the quicker monetary policy tries to return inflation to its target (to reduce the variability of inflation), the greater the variability in output.
The choice of a hierarchical versus a dual mandate may be the most important consideration determining where a country ends up along this tradeoff. That is, countries with hierarchical mandates are more likely to end up with lower inflation variability at the expense of higher output variability. A dual mandate, therefore, provides flexibility for the central bank to select the point along this tradeoff that matches the public's preference.
It is crystal clear that the National Assembly needs to urgently amend the CBN Act with a view to incorporating the full employment mandate in its provision as the current single mandate of price stability has not served the nation well. Nigeria would be following in the tradition of countries such as Canada, Australia, United States, Japan etc. whose central banks have been charged with the mandate to maximize employment and their people’s welfare.
Monetary policy stance going forward: In future, the CBN will further improve its macro adjustment mechanism and make Nigeria’s Monetary Policy more forward-looking, more anticipatory, better targeted and more flexible.
Above all, the CBN will appropriately strike a balance between maintaining rapid economic growth, restructuring the economy and managing inflation expectations, so as to achieve sound and rapid economic development with employment-intensive growth.
Meanwhile, the CBN will improve credit allocation, increase support to economic restructuring, and guide financial institutions and financial market in better serving the real economy.
Finally, the CBN will further promote reforms of the exchange rate regime in a gradual and coordinated manner, with a view to enhancing exchange rate flexibility, and to keeping the Naira exchange rate basically stable at an appropriate and balanced level.
The China Example: Economic Pragmatism at work.
Since 2007, the US subprime crisis, the global financial crisis and the European sovereign debt crisis have stoked volatility in global markets with varying degrees of impact on the world’s economies. To ensure the sustainable and steady development of the nation’s economy and maintain a stable price level, the People’s Bank of China (PBC) has adjusted its monetary policy stance three times to good effect.
The First Adjustment: Responding to the Crisis
Due to the global financial crisis, China’s GDP growth rate fell to 6.1% in the first quarter of 2009. Meanwhile, the consumer price index (CPI) dropped continuously, sagging to –1.8% in July 2009.
In response, the PBC adopted a moderately loose monetary policy stance and launched a series of measures to ensure economic growth and financial market stability. In the second half of 2008, the PBC strengthened its support for economic development, lowering the benchmark deposit and loan rates on five occasions and reducing the reserve requirement ratio (RRR) four times. In 2009, China reported GDP growth of 8.7% and was the first country to recover from the crisis.
The Second Adjustment: To Combat Inflation
As the world economy recovered, inflation in different countries began to rise from the second half of 2010. Due to soaring global commodity prices and a continuous rise in domestic labour costs and resource prices, China’s inflation pressure increased in the second half of 2011. In July 2011, China’s CPI growth reached 6.5%. In the face of upward inflationary pressure, the PBC took immediate action: it shifted its monetary policy stance from moderately loose to prudent at the end of 2010 and changed its monetary policy goal from fighting against the crisis to combating inflation. From 2010 to the third quarter of 2011, the PBC lifted its benchmark deposit and loan rates on five occasions and increased the reserve requirement ratio 12 times to 21.5%. By the end of December 2011, the rising trend of China’s price level had been contained with CPI inflation dropping to 4.1%. Meanwhile, China’s economy continued to grow rapidly and registered GDP growth of 9.2% in 2011.
The Third Adjustment: To Stabilize Economic Growth
As the European sovereign debt crisis continues to worsen, China’s economy has also changed. Economic growth has slowed and the inflation rate has dropped. In particular, the downside risks to economic growth have increased since early 2012, inflation has fallen rapidly in China. The CPI reading posted 3.4% and 3% in April and May, respectively. Faced with these new challenges, the Chinese government decided to stick to the principle of seeking progress amidst stability, appropriately balancing the relationship between maintaining steady and rapid economic development, restructuring the economy and managing inflation expectations. The priority was now to stabilise economic growth.
Accordingly, the PBC has gradually changed its monetary policy stance, lowering its reserve requirement ratio on three occasions in December 2011, February and May 2012. After these adjustments, the reserve requirement ratio had come down 1.5 percentage points to 20%. Meanwhile, the PBC reduced its benchmark deposit and loan rates in June 2012.
In addition, the PBC has also used a mix of monetary policy instruments to appropriately increase market liquidity. These monetary policy measures have been effective: in the first quarter of 2011, China’s GDP grew by 8.1% year on year while, in May 2012, China’s CPI inflation dropped to 3%.
We look forward to receiving nominations from well informed for the best man for the CBN’s helmsman job – someone who can effectively execute the dual mandate. Readers can send their contributions to the Project Team Leader:
Ray Echebiri, Editor-in-Chief