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Justification for a Cut to the Monetary Policy Rate in a High Inflation Environment

Proshare

Thursday, November 09, 2017 / 9:40 AM /FDC

Nigeria’s Monetary Policy Rate (MPR), i.e. the cost of obtaining funds from the Central Bank of Nigeria (CBN), needs to be reduced significantly to expand the country’s economic output. The MPR correlates directly with lending rates of commercial banks and when it is high (it’s currently at 14%), it results in exorbitant borrowing costs for the banks, and their private business customers. 

While everyone desires reduced interest rates, the fear of the possible inflationary impact associated with an MPR cut keeps the rate high and thus, limits private borrowing. In the short term, a reduced MPR may be inflationary as access to cheaper money increases consumption and demand in an environment where the market does not have enough goods and services. 

However, rising prices will be short lived and soon corrected by lower prices through a medium to long term output expansion. Increased private borrowing will support growth resulting in the increased production of goods. Without a reduction in the MPR, Nigeria’s double digit inflation rate will continue in the medium term, with only marginal monthly declines. 

The need to cut the Monetary Policy Rate
In the short term, the concern is that lowering interest rates will make access to borrowing cheaper, and lead to an increase in consumption and aggregate demand. This higher demand will lead to an increase in prices as goods and services become scarce (inflation). This has, so far, made the prospect of a rate cut unwelcome since the economy already sustains a high inflation rate. 

However, sometimes more pain is required to see positive results. To use an analogy, one who is suffering from a fracture or dislocation might have to endure greater pain while his bones and joints are being fixed. In the end, however, he will be able to regain mobility that would not be possible if no intervention had been taken. By not addressing the MPR, the Monetary Policy Committee (MPC) is avoiding its role in resetting the broken bones of the economy. 

Evidence from African Peers
Apart from serving as an incentive for borrowing, a reduction in the key lending rate will also reduce the level of nonperforming loans in the banking system from the present 15%, as it becomes cheaper for money borrowers to refinance their loans. The ability of borrowers to repay will lead to a decline in banking firms’ costs and widen their expansion prospects. 

Potential impacts of a Monetary Policy Rate cut
In the short term, the economy may have to tradeoff between lower interest rates and a higher inflation rate when the MPR is lowered. Part of the cheaper borrowings will be channeled to household spending, which will lead to an increase in demand on aggregate. Competition for goods and services will increase prices, which will lead to a higher inflation rate. Consumers’ income will be able to buy fewer goods and services with the money they have. 

In the long run, however, private business expansion via borrowings will increase the volume of goods and services available in the economy. The increase in aggregate supply will reduce prices of domestic commodities. A larger volume of locally produced goods will also reduce the need for imports. Hence, there will be less imported inflation. The combination of higher domestic production and fewer imports will bring prices down. This will offset the earlier loss in real income when the MPR was first cut.

 

Nigeria’s peers on the African continent that have recently cut rates have seen a decline in their rates of inflation, while at least one that has maintained the status quo, like Nigeria, has seen its prices rising.

 

Ghana cut its MPR three times since January 2017. It was at 25.5% in the first month of the year, and subsequently through to August, the rate was lowered by 450 basis points (bps). The year on year Gross Domestic Product (GDP) growth rate, which stood at 4.5% in the fourth quarter of 2016, increased to 6.6% in Q1’2017, and thereafter to 9% in Q2’2017.

 

The inflation rate in January was at 13.3%, easing to 12.3% in August. This might have been a result of an expansion in economic output driven by access to cheaper borrowings. It is also worth mentioning that domestic prices in African countries are usually largely determined by the exchange rate as well.

 

Theoretically, prices generally increase when the currency has lost value due to higher import costs. However, despite the fact that the Ghanaian cedi lost 3.66% year to date,4 its inflation rate has been easing. Zambia equally cut rates three times in the past year. In September 2016, its MPR was at 15.5%.

 

As of August 2017, its MPR had also been cut by 450bps to 11%. Between these periods, the inflation rate significantly declined from 18.9% (double digit) to 6.3% (single digit).

Conversely, on the eastern part of the continent, Ethiopia has maintained the status quo like Nigeria, since January 2017. Its inflation rate has increased from single to double digits. It was at 6.1% in January, and as of August, it grew to10.4%.

 

These examples demonstrate that maintaining the status quo does not necessarily translate to an easing of inflation, while a policy of lowering interest rate does not always cause higher consumer prices. 

 

Conclusion

There is a lot to gain from reducing the MPR in Nigeria as the increase in prices that may accompany it will still be outweighed by a long run decline. The idea of enduring more pain to assuage an existing pain could be a strategic directive in Nigeria’s macroeconomic modeling. The country needs to take a different approach in order to avoid being stuck on a path of taking the same measures with the same results.

 

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