Pre-MPC Commentary – Inflation, FX Considerations Should Stay MPC Hand

Culled—Proshare

September 25, 2017/Vetiva Research

At the start of this week, the Monetary Policy Committee (MPC) of the Central Bank of Nigeria (CBN) will sit for its 115th meeting, confronted by the reality of sticky domestic inflation and weak economic recovery, as well as accelerating monetary tightening in the United States (U.S.). More generally, in determining the optimum short-term path for monetary policy levers, the MPC would have to weigh up contesting issues of inflation, foreign exchange stability, economic growth, and government financing. Perusing these issues, we eschew the view that economic growth arguments warrant monetary easing at this time. Rather, we believe that foreign exchange and price stability are more potent mechanisms for economic stabilisation.

Bearish inflation outlook urges tight policy stance
Primarily driven by base effects, recent currency stability, and lower energy costs, annual inflation has trended down – from 18.7% in January to 16.0% in August. However, inflationary pressures remain strong as excluding more volatile food and energy prices, average month-on-month inflation is relatively unchanged from 2016 (2017: 1.13% m/m vs. 2016: 1.15% m/m).

Moreover, food prices are expected to accelerate as a result of recent flooding in Benue State, the “Food Basket of the Nation”. Considering this, our medium-term outlook for inflation is bearish (2017 average inflation forecast: 16.6%), and we do not foresee annual inflation dipping below 12%, the threshold above which the CBN judges inflation to be harmful to economic growth, until August 2018. Amidst this, the urgency of the price stability agenda calls for tight monetary policy in the interim.

Verdict: Hold
“The current period is not appropriate because inflation is not only high, the ongoing deceleration is equally not strong enough and is vulnerable to a costly setback. This, invariably, reduces the policy choices to either of further tightening or maintaining the status quo ex-ante.” – Adebayo Adelabu (CBN Deputy Governor)

Preserving FX gains retains priority status
A notable positive in Nigeria’s 2017 economic picture is the marked improvement in the foreign exchange market. The introduction of the “Investors & Exporters” window has been a significant game-changer, with strong volumes in that segment buoying overall market liquidity. Rate convergence across flexible markets and a steady accretion in external reserves are notable positives.

Despite this, optimism must be tempered as capital imports remain tepid compared to previous levels (Q2’17: $1,792 million vs. Q2’14: $5,804 million), and FX liquidity remains strongly tied to oil prices. Meanwhile, as the U.S. accelerates its monetary normalisation process, a stronger dollar and “risk-off” sentiment in global markets would likely induce depreciation pressure on the naira. Given FX stability is essential for both inflation and economic growth, monetary easing at this time may prove damaging to Nigeria’s economic landscape.

Verdict: Hold
“The fundamental question, which in my view remains unanswered, is will the tentative drift in the direction of consolidating our multiple FX markets survive a downturn in oil prices?” – Adedoyin Salami (MPC member)

Weak credit growth offering a case to ease?
Economic recovery has been slower than expected, with Q2’17 GDP growth coming in at 0.5% y/y, lower than the consensus expectation of 1.3% y/y. With Services (-0.6% y/y) and manufacturing still weak (0.6% y/y), the high cost of capital may act as an abrasive for the wheels of economic expansion. Credit expansion to the private sector remains weak (declined 0.02% ytd), though this may not be addressed by lowering interest rates as commercial banks continue to shun higher employment-generating areas such as agriculture and SMEs given their inherent risk. With reasonable doubts over the efficacy of monetary transmission to private sector credit, the MPC may find more joy in stimulating growth by tackling inflation.

Verdict: Hold
“It seems that DMBs favour capital-intensive industries that have low employment generation area such as oil and gas, telecommunications and electricity sectors. Other employment generation areas which include agriculture, small-scale industry and transport services are not favoured.” – Dahiru Hassan Balami (MPC member)

CBN strains for fiscal policy handshake
Expansionary fiscal policy is the bedrock of the economic policy of the current administration, reflected in significant infrastructure spending, as well as steady support for state governments in their fiscal consolidation efforts. This has been a challenge amidst falling federal revenues – Q1’17 budget revenue 25% short of target, forcing greater government borrowing. In particular, the CBN has partly financed fiscal activities amidst a shortfall in FGN revenue and borrowing. As a form of monetary easing, this is at odds with the current tight policy stance of the CBN, a contradiction that the two dissenting MPC members highlighted at the July meeting.

Expanding their position, the efficacy of monetary policy is greatly reduced if policy levers are utilised inconsistently, underpinning their vote to lower the monetary policy rate to align all monetary policy conduct. Following this argument, there is a case for easing monetary policy and reducing government borrowing costs to achieve alignment. However, we note that using monetary policy in this way may be inappropriate for government financing in Nigeria as it can erode monetary policy independence, impair fiscal discipline and further stoke inflation.

Verdict: Hold
“Given that monetary policy management is presently about funding the Federal Government – in other words, the stance of policy is easing, policy consistency and credibility demand that the Monetary Policy Rate (MPR) be significantly reduced to reflect the underlying preferences of policy managers. I thus voted for a 2.0 per cent reduction in the MPR.” – Adedoyin Salami (MPC member)

Status quo to be preserved
The fragility of Nigeria’s FX market gains and economic recovery, as well as evident inflationary pressures, cautions against substantial changes to current monetary policy. Moreover, loosening monetary policy may not have the desired effect on economic growth amidst conservative loan growth in the banking sector. In light of these, we anticipate a HOLD decision at the conclusion of this week’s MPC meeting. That said, we expect the CBN to persist in efforts to reduce market interest rates – through its auctions and OMO interventions – in a bid to ease government borrowing costs.

Verdict: Hold

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