MPC Commentary - When Time Consistency Becomes a Different Kind of Problem


Tuesday, March 21, 2017 7.02 PM / Proshare Research

The monetary policy committee at the end of its second meeting in the year 2017, concluded to play the familiar do nothing card. Thereby leaving the monetary policy rate and cash reserve ratio static at 14% and 22.5% respectively. Also keeping the liquidity ratio at 30% and it is asymmetric corridor un-tweaked at +200 to -500 around the MPR.

The monetary policy committee was concerned about the effect of shale production on the price of oil, ongoing monetary tightening in the United States, rising anti-free trade and the wave of populist’s movement in Europe. While on the domestic front inflation and rising non-performing loans in deposit money banks were the concerns.

What has really changed?
Inflation for the first time in fifteen months began to cave inwards as it dipped from 18.72% to 17.78%.  While month-on-month inflation also dipped slightly from 1.08% to 1.01%. Core inflation took a big dive towards the floor by shrinking from 17.85% to 16%.

Although food inflation still maintained its upward trajectory but erosion in headline inflation was inevitable as weaning base year set in. The Naira has strengthened at the parallel market: As it appreciated from 498/$ to 435/$, reflective of a 12% appreciation.

While the gross domestic product ‘’fared’’ better in Q4 2016 with 1.305 contraction compared to the previous quarter when it contracted by 2.24%. Certainly the trio of inflation, growth and the Naira are moving towards a positive direction.

This new found momentum is a product of aggregate output and consumer price index reacting to an improvement in both price and production of oil. While strains on nominal variables are easing off but it is not enough, given the substantial weakness already experienced in the net value of the legal tender and a depressed labour. 

Fig 1:  CBN and parallel market rate from January till date

Curled from abokifx, proshare 

How possible is a rate convergence?
External reserve has maintained an upward trajectory from 26 billion dollars in January 2017 to 30. 3 billion Dollars till date: this is reflective of a 17.61% increase in external reserve. It has maintained an upward trajectory as the central bank intervenes in the foreign exchange market.

More importantly, the stock of flow approach reflect a new dynamic where heavy injection has begun to sap strength from the growth of external reserves. Reserves are beginning to grow at a slower pace as it is gradually being strained by heavy intervention.

History has shown that market convergence is possible even with a light armory of reserves e.g. peso crisis in 1994. The crux of the economic issue is, can we sustain a market convergence given our present armory and a fragile net foreign inflow?

A persistent heavy involvement without a substantial increase in foreign inflow or aggregate foreign exchange through the economy makes convergence unsustainable. 

The inability to sustain a convergence is what reassures the dog to wiggle its tail, not achieving it. The very fact that pediment of opaque still resides in the foreign exchange market, do call for its restructuring.   

Fig 2: Growth in reserves in the month of March


           Curled from CBN

Does money deserve a bad name? 

We strongly opine that money has neither been a major factor nor is it one of the factors driving this particular inflation. Moreover the nature of this inflation is a cost push inflation which is triggered by an increase in the price of intermediate goods.

Therefore, they are cost shocks, where initial rise in inflation is period bound in nature and its self re-corrective. Thereby, a high interest rate becomes a burden under a cost-push inflation scenario, because inflation will re-correct itself as base year effect ring in. 

It’s no surprise that high interest rates ends up been a Trojan horse rather than a lever when cost-push inflation is experienced.  Instead it provides the right nursery for asset rotation, which ends up favoring fixed instrument.

Month-on-month inflation rose by 1.01%, reflective of a dip by 6.4% compared to the previous month. The very fact month-on-month inflation fell, besides month-on-month inflation is vulnerable to a one time-off effect. This does not provide enough premises to maintain a high interest rate.

The fall in monetary aggregate across board suggests that the possibility of having money drive a positive shock is still a distance off. Why put money in the dock for an inflationary trial? 

The other form of Consistency problem
Many economists are right for holding strongly to the opinion that nominal anchors are needed to ensure price stability and to tie down inflation.

More importantly it is a tool used to limit the time consistency problem. A scenario where monetary policy is conducted on discretionary day to day basis which eventually ends up into deep poor long run policies.

Apex banks avoid time consistency problem of discretional policy so as to avoid long run polices been driven by short term expectations. Therefore, the Central bank has been time consistent by doing nothing.

With the hope of tying down inflation, as it makes positive real interest rate its intermediate goal objective and avoid boosting output. While it is right that the apex bank must avoid trading long run for short term objectives; At the same time consistency is irrelevant, when it fail to manage a conflict among goals scenario and how?

The dynamic path on the long run has been heavily depressed and the only option is growth, inflation has never being within monetary policy sphere control. Therefore trying to tie down inflation is a mismanagement of a conflict of goal scenario.  

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