Response to Recession: Tactically Barking At The Wrong Tree


Wednesday, 19 October 2016 8.10AM / Temitope Babalola, Coffee Post

Certainly the present macro environment has been a challenging one so far, it has been characterised by twin shocks. On one hand cyclical shock which have relatively kept oil price subdued. While on the other end it finds itself up against socio political shocks which have cut oil production to new minimum levels.

At the initial point of the cycle, low oil prices coupled with earlier periods of relatively low macro prudential’s pushed the economy to a point of stag inflation; Thereby forcing us  to relive the 1970 oil shock therapy, once again.  When real gross domestic product grows at a slower pace and inflation was on an uptick path: the structural fall out, is an emerging divergent path between growth and inflation. The combination of prolonged restrictive monetary policy and delayed counter cyclical spending eventually emboldened an already budding systemic risk. Creating a scenario, where policy lags over a relatively short period allowed the downward current to continuously build an internal impetus of its own; thereby evolving from a hatching cycle of stag inflation to a recession.

The added casualty effect is that, domestic prices now ticks faster at a run way pace and growth seems to be more elusive. Thereby the existing divergent path between growth and inflation that began as a stag inflation has widened. Interestingly it has blown open to a negative divergent, where growth is the one in a negative territory. The outward sign can be captured by both the financial deepening ratio and aggregate credit intervention ratio respectively. Apart from the fact that many investment and macro analysts do share the opinion that both ratios create a mathematical relationship between monetary supply and the present value of gross domestic product.

Financial deepening ratio and aggregate credit intervention ratio also serves as a measure of robust financial intermediation in the economy (Fig1).         

Fig 1: Table representation of financial intermediation ratios from 2015 to 2016


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The financial deepening ratio rose to 0.4 compared to 0.21 in the previous quarter and 0.198 in the corresponding quarter of 2015. While the aggregate credit intervention ratio rose to 0.45 compared to 0.238 in the previous quarter and 0.23 in the corresponding quarter. The rise in both ratios was as a result of both monetary illusion (inflationary) and a shave (reduction) in the real gross domestic product. While mathematical it reflects a rise in intermediation ratio, at the same time it fails to reflect reeling adverse exogenous effects on the macro end: Once again reflecting the limitation of ratios.

A recession which is characterized by a divergent relationship between inflation and growth and at the same time domestic prices is been stirred exogenously. Present a conflict among goals situation before the monetary authorities. Price stability in many circumstances is the utmost priority of monetary policy, given the fact that inflation sap strength from real variables. Thereby many economists are of the opinion that monetary policy should create a relationship between its nominal anchor and real variables: Which is done in most circumstances by immunizing savings against inflation through a positive real interest rate as it end game. Positive real interest rates spans out as one of monetary policy’s major intermediate target on the short term.

Sadly an obsession for positive real rate or targeted inflation here could also lead to a break down among monetary variables, which could provide a host for contagion (rising non performing loan) and dampen an already thin macro confidence on the medium term. At the same time there is always a possibility of triggering a rigid strain on the dynamic adjustment path as a result of excess deleveraging that comes with picking inflation ahead of growth in this particular scenario. The reality is that price movement so far, is driven by exogenous factors and it is not within the ambit of the monetary authorities to control. Moreover money has neither been a major factor nor one of the factors driving this inflation. Certainly domestic prices have been driven structurally all along. Therefore monetary policy must widen its tolerance for inflation or turn a blind eye to inflation and accept the inevitable reality. That real variable for some time will be its blind spot.

Therefore growth seems to be the only option within the ambit of the monetary authority and going after growth is the only pragmatic monetary objective around.  In fact Alfred Minskin argued that in such circumstances, the very fact inflation is not within the control of the monetary authority. The ability to predict inflation by monetary authorities is almost impossible. Thereby picking inflation in this scenario will only spur further macro fragmentation and monetary policy will only end “up barking at the wrong tree.    

Fig 2: A graphical illustration of real interest and GDP from 2012 till date  

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While the monetary authorities were of the opinion that inflation do not lie within their ambit of control but they concluded that an “interest rate cut alone is not enough to stir growth”. They therefore avoided cutting interest rate so as to have a go at currency stability. Thereby employing the policy of preferred habitation to enhance Dollar liquidity and eventually strengthen the Naira. The intent is to plough high interest rate on government debt instrument as a carrot to attract foreign portfolio investors. By providing the right premium, government security would end up as the preferred habitat and a channel for foreign inflow. This policy seems to be more concerned about providing premium for existing real shock, rather than solving it. While the later gradually provide the needed slow biasness the Naira is in desperate need of, the former leaves the Naira more volatile at the mercy of hot money.

Most importantly monetary policy could be staging itself up for an interest rate trap and how?  Monetary manoeuvring would be limited as the monetary policy rate (MPR) becomes more and more reliant on the interest rate of another country. For instance will the MPR be forced to take another pill of rate hike in reaction to an eventual Federal Reserve rate hike in December? So has to provide a more competitive risk premium and retain the chain relationship that exists with foreign portfolio investors. Russia and India tried out this preferred habitat policy and in return were indirectly locking up their real economies up through rate hikes (Fig 3). Even though the CBN indirectly admitted that going after inflation could be referred to as a barking at the wrong tree circumstance, regardless they tactically did not restrain from it.  

Fig 3: A graphical trend of monetary policy rate (MPR) and that of BRIC economies for the last 2 years.

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To provide the required momentum for an escape velocity at this point of the cycle, an interest rate cut alone would not be enough to provide such momentum. A well fitted kit box which consists of both the appropriate fiscal and monetary tools is needed to achieve the required momentum. Fuse with a more pro active political attitude will definitely complete the tools in the kit box. The present fiscal sterilization (TSA) is producing jittery nerves in the monetary supply chain.

The total deposit with the CBN by the end of the second quarter stood at 10.52 trillion Naira compare to 9.17 trillion and 6.908 trillion in the previous and corresponding quarter respectively. This is reflective of a growth in total deposit with the CBN by 8.11% and 52% compare to the previous and corresponding quarter. The persistent upward trajectory in total deposit with the CBN is triggered by the ongoing policy of fiscal sterilization. The amount of total federal government deposit with the CBN amount’s to 5.02 trillion Naira, which presently account for 47% of total deposit with CBN (Fig 4).

When compared to both 4.15 trillion and 2.29 trillion Naira in the previous and corresponding quarter respectively: Which is reflective of a 20.7% and 118% growth in the total amount of federal government deposit with the CBN, when compare to the previous and corresponding quarter. While most of the components of this particular universe has maintained a downward trend except for that of federal government deposit, which has kept an upward trajectory (fig 4).  Although delayed capital spending by government did contribute to such huge amount of deposit but the ongoing fiscal sterilization by the government is largely responsible for it. The intent of such fiscal measure is to improve federal governments macro prudential’s and reduces its leakages. Simultaneously, it is also increasing the pool of idle funds. Which gradually impedes deposit creation and could form credit blind on the medium term. 

Fig 4; A graphical representation of some of the money and credit aggregates from 2010-2016

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The Achilles effect from this fiscal sterilization is widely felt in the liquidity adjustment corridor. Earlier episodes, where excess cash reserves were reinvested by the CBN into the standing deposit facility seem to be eroded. Rather the amount of standing deposit facility has plunge from around 10 trillion Naira to 19 trillion Naira in 2014 each quarter compare to 4 trillion 1n 2016. While on the other end there is a gradual seismic pressure brewing in the standing lending facility window. In response to the pressure, this has led to more involvement by the CBN in the liquidity adjustment window (Fig 5). The demand in the standing lending facility at the end of the second quarter stood at N4.06 trillion compared to N450 billion and N2.2 trillion in the previous and corresponding quarter respectively. Reflective of a rise of 820% and 92% compare to the previous and corresponding quarter; at the same time reaching it highest demand in the last four years.  Moreover the interbank space has not been spared from the spill over effect, given the relationship call rates share with the liquidity adjustment corridor: holistically underpinning a sector strained heavily by the combination of prolonged repression in oil prices and existing distorting effect in the adjustment corridor as a result of earlier fiscal withdrawals.

Certainly at this point an increase in the quantum of borrowed funds to the real sector through deposit money banks will reverse weakness in the channels of credit and help to smoothen out the flow of funds path. A financial reengineering that allows the TSA to achieve a proper balance between macro prudential’s and credit creation will strengthen the multiplier effect. The ability to come out of this recession as pro cyclical shock rage on will depends heavily on how monetary authorities can subdue the turbulence in the liquidity corridor. Certainly some relaxation in the TSA will help to subdue the turbulence in that corridor and provide stabilization on short term rate too: obviously we cannot afford to put a large chunk of this genie (government deposit) in the bottle (CBN) any longer, it has to be put to work more efficiently (credit creation in the real sector).

Lastly the present operating monetary triangle of the CBN, where both a high interest rate (nominal anchor) and a defensive Open market operation approach provide the policy arrow head (apex) and a relative high cash reserve ratio serve as the base foot. A combination of such mix of operating instruments at this point of the cycle can create a collapse among its monetary variables,  embolden   macro fragmentation and how ? In such operating clime like this particular one, a high interest rate would likely inflame forces of contractions as it depresses the trio of aggregate demand, investment spending and total demand for credit.  Somewhere along the line the CBN will have to blunt one end of its operating monetary triangle, in order to provide leverage for growth.                 

Fig 5; A graphical illustration of the liquidity corridor

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