Selected Issues


Selected Issues

Understanding Monetary Policy in Nigeria1

Monetary policy in Nigeria is confronted with multiple objectives. Empirical results in this chapter suggest that interest rates have mainly reacted to exchange rate pressures as an indirect way of controlling inflation; the stated primary objective of the CBN. This, in addition to conflicting market signals from sometimes different de facto and de jure approaches to monetary policy conduct, complicates policymaking. Experience from other countries targeting inflation suggests successful conduct of monetary policy hinges critically on the extent to which the central bank is equipped with a clear mandate that assigns primacy to price stability, with a main short-term instrument to manage inflation and sufficient exchange rate flexibility and operational independence.

A. Introduction

1. In Nigeria, monetary policy is confronted with multiple objectives. Article 2 of the CBN act of 2007 entrusts the CBN with the formulation and implementation of monetary policy, with price stability being a principal objective, among other objectives such as safeguarding the financial system and value of the currency as well as other developmental functions.

2. In part due to the weakness of transmission mechanisms, the CBN’s de facto monetary policy mandate could potentially be different from its de jure one, and may give rise to conflicting market signals. Specifically, de jure, the monetary policy rate (MPR) is the main policy instrument to manage inflation in the short run (see Modeling the Monetary Sector of the Nigerian Economy, CBN, 2012). However, de facto, the CBN has recently depended on OMOs to mop up excess liquidity in the banking system to tighten monetary policy without changing the MPR. Although not formally an Inflation Targeting (IT) regime, the CBN communicates an explicit medium-term inflation target of 6–9 percent. To achieve this, the MPR in principle acts as an instrument for guiding money market rates towards operating targets while monetary growth is an intermediate target. The pursuit of multiple objectives and the seemingly conflicting use of monetary policy instruments complicate policy design and is often a source of policy slippages.

3. A comprehensive study to investigate the importance of the CBN objectives and the implications for the monetary policy conduct is thus warranted. The research question addressed in this chapter is which of the CBN objectives explain recent interest rate movements and what are the implications for the monetary policy framework. Using a Taylor rule, we examine whether movements in inflation, exchange rate or output gap determine changes in CBN interest rates.

4. Empirical results suggest that monetary policy mainly reacts to pressure on the exchange rate despite persistently high inflation. Using a simple Taylor rule, results show that the CBN implements its strategy in a flexible manner where the main goal over the sample period was exchange rate stability; an indirect way of controlling inflation (through imported inflation). As inflation is persistently high, a natural question to ask whether the implemented approach is indeed achieving the stated primary objective of monetary policy and if not, how the overall framework could be improved. The combination of a monetary targeting regime with a tightly managed exchange rate and an open capital account gives rise to a complex monetary policy environment. Successful cross-country experience suggests the importance of clearly signaling in the CBN’s communication strategy that inflation reduction is its primary objective, strengthen the use of the MPR as the nominal anchor for monetary policy and consider greater exchange rate flexibility among other elements required to move toward a full-fledged inflation targeting regime.

5. The rest of the chapter is structured as follows. The next section discusses the empirical methodology and results of the Taylor rule. Section C discusses the implications for monetary policy while section D suggests ways in which the operation of the monetary policy framework can be improved.

B. A Simple Taylor Rule Application to Nigeria

6. Taylor rules explain how central banks set their interest rates in response to inflation and macroeconomic developments. A review of the characteristics of Taylor rules as compared to alternative monetary policy guides can be found in Orphanides (2007). The basic structure of the Taylor rule is as follows:


where it is the central bank’s key monetary policy instrument, expressed as a function of rn the natural rate of interest, πt* the inflation target, π the inflation rate, and y˜t the output gap2. Taylor (1993) showed that the above parameters hold for the case of the USA. Numerous studies have ever since tested the simple model described above under different specifications, samples and countries, and econometric techniques.

7. Recent studies augment the Taylor rule to include interest rate smoothing and exchange rates. We augment the basic Taylor rule using equations (2) and (3) to include additional factors affecting interest rates (see Hammond, Kanbur and Prasad 2009 and Mohanty and Klau 2004), as follows:


where it* is the target interest rate, it-i is lagged interest rate to capture smoothing effects, and Δxt is the change in the real exchange rate. We use the interbank rate as the CBN’s key rate and year-on-year (y-o-y) changes in the CPI to calculate the inflation rate. The ρ coefficient in the above equation reflects the interest rate smoothing parameter (see Moura and Carvalho (2010)). Putting equation (3) into (2), we adopt the following specification for the augmented Taylor rule.3


8. Simple OLS is used to examine the determinants of interest rate changes. The equation above is expressed in regression form in Table 1 below. We use data for the period 2000Q1–2017Q1, and seasonally adjust all variables which are checked for stationarity.

Table 1.

Nigeria: Taylor Rule OLS Results

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Robust standard errors in parentheses* significant at 10%; ** significant at 5%; *** significant at 1%

9. The results suggest that monetary policy mainly responds to changes in the exchange rate, with a significant interest rate smoothing effect (Table 1). Column (1) estimates the basic Taylor rule specification, and finds weak evidence of a backward-looking monetary policy as shown by a positive and statistically significant coefficient on the lagged inflation variable. Using the augmented Taylor rule specification in column 2) results in a significant improvement in model fit, as shown by the higher r-squared compared to the basic Taylor specification. Importantly, results suggest that the CBN interbank rate does not respond to changes in lagged inflation or output gap, while depreciation is associated with tighter interest rates. There is also a significant interest rate smoothing effect as evident from the statistically significant coefficient on the lagged interest rate variable. This implies that the CBN tightens monetary policy only when there are depreciation pressures on the naira, while inflation and output are not associated with movements in the interest rate.

10. Robustness checks confirm monetary policy tightening mainly in response to exchange rate pressures (Tables 2 and 3). Specifically, we use (i) the nominal exchange rate, the BDC rate, and the BDC spread (instead of real exchange rate); (ii) industrial production index (instead of GDP);4 and (iii) the monetary policy rate (instead of the interbank rate). Results hold regardless of the measure of the exchange rate used, even when using the spread with the parallel market as an independent variable (Tables 2 and 3). This confirms that “fear of naira depreciation” is what drove a tightening in monetary policy. Using the index of industrial production in some instances as a measure of the output gap instead of GDP suggests that the CBN tightens monetary policy when the economy is overheating while relaxing it when the economy is operating below potential (Table 2). Using the MPR as the dependent variable results in a slightly stronger interest rate smoothing effect, as expected, since the MPR has been relatively stable as the CBN uses other instruments to tighten monetary policy when needed (Table 3).

Table 2.

Nigeria: Robustness Check – Exchange Rate and Production Index

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Robust standard errors in parentheses* significant at 10%; ** significant at 5%; *** significant at 1%
Table 3.

Nigeria: Robustness Check – MPR

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Robust standard errors in parentheses* significant at 10%; ** significant at 5%; *** significant at 1%

C. Implications for Monetary Policy

11. The CBN’s monetary policy framework consists of a monetary targeting regime supported by a range of standard policy instruments. The principal instruments available to the authorities for policy implementation are the monetary policy rate (MPR), open market operations (OMOs) and the cash reserves ratio (CRR). In principle, the MPR is the nominal anchor for monetary policy: its role is to signal the CBN’s monetary policy stance and transmit changes in policy to the other lending rates forming the banking system. However, the transmission mechanism is weak and the MPR has not been deployed as a policy instrument since July 2016 with the result that the interest rate corridor has featured money market rates at wide variance with the policy rate (chart). At the same time, the CBN has a stated target range of 6–9 percent for inflation and publishes an annual benchmark for broad money growth (10 percent in 2017).

Figure 1.
Figure 1.

MPR and Other Interest Rates

Citation: IMF Staff Country Reports 2018, 064; 10.5089/9781484345481.002.A006

Source: Central Bank of Nigeria.1/ The wide lending-deposit rates spread is mainly explained by high non-interest cost (please see AIV and SIP 2016 for details).

12. Nigeria’s monetary policy operations are compromised by the desire to meet conflicting objectives. These objectives include contributing to economic growth and managing the exchange rate. The bank has also been involved in recent times in financing the government deficit and in quasi-fiscal activities. In 2016 for example, the CBN contributed 2 trillion naira in converted bonds and overdraft financing of the federal budget (chart) alongside additional direct financing of activities in the agricultural and other priority sectors.

Figure 2.
Figure 2.

CBN Lending to FGN, Dec. 2015-Dec. 2017

Citation: IMF Staff Country Reports 2018, 064; 10.5089/9781484345481.002.A006

D. Improving the Operation of the Monetary Policy Framework

13. The following two principles can be considered as being of critical importance for the current monetary policy framework.

  • Primacy of the price stability objective. With persistently high inflation, the CBN faces a difficult challenge in building credibility and anchoring expectations. An important issue is that high inflation extends the time horizon over which the central bank can reasonably expect to achieve its inflation target as the lack of policy credibility typically increases inflation inertia. For this reason, the CBN could consider setting out a clear disinflation path in its communications, to provide better signaling of its policy intentions.

  • Central Bank independence in conducting monetary policy. This applies particularly to the issue of fiscal dominance where the operation of monetary policy is compromised by the central bank’s role in financing the government deficit. Operational independence should moreover take place within a context of clear accountability to the government and the public. CBN communications could explain the rationale for MPC decisions by reference to the inflation outlook and its implications for macroeconomic trends. As inflation has been deviating persistently from the 6–9 percent target range, the MPC communique is the appropriate forum for setting out what adjustments to policy will be undertaken to bring the inflation rate back towards the target and over which time horizon.

The Problem of Multiple Objectives

14. Having multiple objectives inevitably gives rise to multiple instruments pulling in different directions at the same time with the result that it becomes very difficult to determine the policy stance and to explain it clearly to the public. Cross-country experience (IMF, 2015) suggests that credibly establishing the primacy of the price stability objective and thereby anchoring inflation expectations creates more room for the central bank to manage the policy trade-offs arising from conflicting objectives in determining the magnitude and the pace of monetary policy adjustments. For example, in such circumstances, it may be easier for the central bank to ignore sharp increases in inflation which it considers temporary whereas a less credible regime may be required to respond more aggressively to inflationary shocks than would seem appropriate.

15. Price stability should be maintained as the centerpiece of the monetary policy framework. While the central bank could consider other objectives in determining the shape of policy adjustment, there are compelling reasons why price stability should be maintained as the centerpiece of the monetary policy framework. The central bank can determine the inflation rate over the medium term, whereas the sustainable path of the real economy is largely determined by nonmonetary factors that cannot be directly observed and are in any event, outside of its control.

Upgrading the Operational Framework

16. The MPR is intended to stabilize and align short-term market rates to reduce liquidity risks and assist banks with their pricing policies. With stable short-term rates, changes in the policy rate are more likely to be quickly reflected in changes in banks’ own deposit and lending rates thereby aiding monetary transmission. By setting aside the MPR, as the CBN has done recently, a good opportunity to impact banks’ pricing behavior is being neglected. In addition, more stable and predictable short-term interest rates facilitate the development of markets for securities at longer maturities, reinforcing policy transmission further along the yield curve.

17. Allowing market rates to deviate from announced “policy” rates creates market distortions. Interbank rates in this case often better represent the true stance of monetary policy than the MPR as they are determined by reference to actual quantity adjustments. From a policy perspective, this creates problems of consistency, and as a result, communication of the policy stance and its links to targets and objectives becomes very challenging. With interbank rates outside the limits of the interest rate corridor for extended periods, there is a clear inconsistency between interest rates and the target for broad money which needs to be resolved through either a revision of the reserve money target and/or repositioning of the interest rate corridor.

Supporting Measures

18. Robust short-term liquidity forecasting capacity is critical to help the CBN decide on how much liquidity to provide or withdraw from the market to smooth large interest rate fluctuations. It needs to be well coordinated with liquidity needs for government cash management. Building the analytical capacity to support a forward-looking approach to monetary policy is an ongoing task requiring inter alia continuous investment in improving data quality and availability.

Moving Away from Broad Money and Exchange Rate Targeting

19. As monetary policy-making becomes more sophisticated, the role of money as an intermediate target may be reduced. Analysis of monetary aggregates cannot take the place of developing an analytical framework for the transmission channels through which various shocks affect the economy, and the appropriate policy mechanisms to contain their impact on inflation. In particular, the primacy of the medium-term inflation objective can help provide the right perspective (and flexibility) on intermediate targets on money which can then play more of an indicator role to guide policy.

20. The empirical analysis in this chapter suggests that the exchange rate is the de facto anchor for the monetary policy framework, with clear primacy over the price stability objective. This central role assigned to the exchange rate raises many issues. While some attention to the exchange rate is warranted given its impact on inflation dynamics and expectations formation, managing the exchange rate without a policy framework with a clear hierarchy of objectives, poses major challenges. These include the need for a transparent way to model the equilibrium exchange rate and identify situations in which the real exchange rate deviates substantially from equilibrium. In any event, it seems plausible that Nigeria can target to achieve its aims to limit the impact of pass-through inflation using the MPR as an anchor rather than the exchange rate. Countries which have transitioned to greater exchange rate flexibility have done so within the context of a clear communications strategy which emphasizes the primacy of the price stability objective and using a unified framework within which to analyze monetary and exchange rate policy. The policy framework moreover requires efforts by the authorities to develop deep and liquid FX markets to facilitate exchange rate flexibility as well as enhanced capacity to manage exchange rate risk.

Enhancing Communications

21. The central bank communications policy is a central element in the monetary policy framework. It should include (i) the inflation objective and its rationale; (ii) the monetary policy strategy—how CBN actions relate to inflation objectives; and (iii) the expected future trajectory of the key policy rate and its relationship to the inflation target. There are a number of ways in which the CBN can improve its communications. Of central importance in this regard is using the monthly MPC meeting communique to strengthen the forward-looking content of communications on monetary policy, in particular by signaling the trajectory of the MPR.

E. Conclusion

22. Successful conduct of monetary policy hinges critically on the extent to which the central bank is equipped with a clear mandate that assigns primacy to price stability, and sufficient operational independence. Experience from other countries suggests that fiscal dominance, frequent political interference, and murky objectives severely hamper the smooth implementation of monetary policy. Sequencing is important therefore and clearly establishing the primacy of price stability among CBN objectives as well as the principle of independence will moreover clear the way for progress on a broader range of macroeconomic objectives.


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Prepared by Amr Hosny and Liam O’Sullivan with inputs from Toyin Olusegun and Moses Onyema Oduh (Central Bank of Nigeria).


The output gap variable is calculated as the difference between actual nominal GDP and its long-run trend estimated using the Hodrick-Prescott filter.


Hosny (2014; 2016) performs a similar analysis for the case of the Central Bank of Egypt.


The correlation between quarterly production index and GDP is 0.79 over the 2011Q1–2014Q1 period.