Monetary Policy Holding the Fort – How Much Longer?

Monetary Policy Holding the Fort – How Much Longer?

The Monetary Policy Committee (“MPC” or “the Committee”) of the Central Bank of Nigeria (CBN) faced a stark choice at its third meeting of the year. The backdrop of soaring inflation and a highly volatile naira, which had depreciated by 21.3% since mid-April 2024, left the Committee with two realistic options: to hold or to hike the policy rate. In keeping with its commitment to return to monetary policy orthodoxy with a shift to a focus on price stability, the MPC opted for a third consecutive interest rate hike, of 150 basis points (bps), to a record high of 26.25% in response to the continued rise in inflation, which hit a 28-year high of 33.7% in April 2024. The MPC’s move was largely in line with our expectations as we believe that a bold policy move was required to bring real interest rates closer to positive territory and halt the naira’s recent decline.

 

Cost-Push Culprits

Fuelled by higher food and energy costs, as well as continued currency weakness, inflation has persisted on an upward trajectory. According to Governor Cardoso of the CBN, “the balance of risks suggests further tightening of policy to build on the benefits from previous hikes”. This statement clearly indicates that the CBN intends to keep interest rates elevated for as long as necessary to tame inflation. Echoing widespread concerns, during the post-meeting press briefing, the CBN Governor acknowledged that cost-push factors, particularly rising food prices are a key culprit behind the nation’s inflation woes. He outlined a series of factors fuelling this acceleration. These included the surge in logistics costs for agricultural products, ongoing security challenges in key food-producing regions, infrastructure bottlenecks, and the impact of a weaker naira on the price of imported food items.

The Debate on Monetary Policy Transmission – Has Tightening Worked?

The MPC has now raised the benchmark interest rate by 1,475 bps since its tightening cycle commenced in May 2022, and within the same period, headline inflation has almost doubled – 17.71% in May 2022 to 33.7% April 2024. On the surface, this seems to point to the tightening measures being ineffectual at combating inflation. However, we believe that under the CBN’s previous leadership, the monetary policy transmission mechanism was effectively broken, and did not allow for the MPR to fulfill its intended role as the anchor rate. The current leadership of the CBN, from the outset pledged to fix this transmission mechanism to ensure the MPC’s decisions become more impactful, fulfil their desired objectives and complement the efforts of the fiscal authorities. We believe that the rise in fixed-income yields in tandem with the rise in the MPR in since the 400bps rate hike in February is testament to this.

Signs of Progress – Cautious Optimism

The naira’s appreciation, from a record low of ₦1,625 on March 11th to ₦1,284 in April 2024, appears to have playing a key role in moderating inflation. This recovery, triggered by the CBN’s policy interventions to correct distortions in the FX market, has been crucial in the slowdown in headline inflation and a decline in month-on-month inflation figures for the second consecutive month. Headline inflation rose by only 1.99% between March and April 2024, slower than the 2.78% recorded between January and February 2024. Month-on-month data shows a moderation to 2.29% in April from 3.02% in March, with food inflation slowing to 2.50%, down from 3.62% in March and core inflation declining to 2.20% in April from 2.54% in March.

The MPC views the recent moderation in inflation as a potential vindication of its hawkish monetary policy stance implemented since the February 2024. In its analysis, these measures are starting to bear fruit, gradually stemming the tide of inflation. As a result, there is growing optimism, albeit cautious, that inflation may reach an inflection point in the latter half of 2024, signifying a potential shift towards a downward trajectory.

 

Inflationary Risks of a Wage Review

We believe that the Nigerian government’s proposed minimum wage of ₦54,000 serves as more or less a negotiation tactic, while labour unions’ demand of ₦497,000 is downright unrealistic. A compromise is likely to be reached in the coming weeks, settling somewhere below ₦100,000. However, this increase in minimum wage could pose inflationary risks. Higher disposable income could lead to increased aggregate consumption, potentially pushing prices up. In addition, businesses may raise prices to offset the higher labour costs, further straining consumer wallets. In a worst-case scenario, this situation could spiral into an undesirable vicious cycle of stagnant economic growth and high inflation.

 

FX Market Volatility: Seasonality, Speculation, and Restoring Confidence

The MPC also described the recent volatility in the foreign exchange (FX) market as seasonally-induced, which is not uncommon in a freely functioning market driven by the interplay between demand and supply. Nonetheless, we believe that speculative activity has also been a significant contributor to the naira’s recent woes, with many market participants believing that the CBN lacks the liquidity to support the naira on a sustained basis. Proving them wrong and restoring confidence will mean ensuring transparency. While recent measures like addressing FX backlogs demonstrate action, achieving long-term success requires attracting long-term and sustainable foreign investment as well as boosting export earnings. This falls outside the CBN’s direct mandate and necessitates a broader collaborative effort.

Our analysis suggests potential appreciation for the naira in the coming months. This optimism stems from a confluence of expected foreign exchange inflows. The first is a sizable $2.25 billion facility from the World Bank. This breakdown includes $1.50 billion in Development Policy Financing and an additional $750.0 million allocated through Program-for-Results financing. Furthermore, the remaining balance of the $1.05 billion loan from the African Export-Import Bank (AFREXIM Bank) is likely to contribute further to FX liquidity. To solidify these gains, the government’s plan to issue an FX-denominated domestic bond by Q2 2024 presents another promising avenue. However, with Q2 2024 more than halfway through, it is worth noting that progress on this initiative appears slower than initially anticipated. This has begun to generate some unease and anxiety amongst market participants, potentially undermining confidence and contributing to further naira weakness.

Kenya’s successful Eurobond issuance in February 2024, securing $1.5 billion at a 7-year tenor with a high yield of 10.375% despite its existing debt challenges, serves as a noteworthy development. This oversubscribed offering ($5 billion in orders) suggests a potential resurgence in investor appetite for riskier frontier market debt, likely fueled by expectations of a dovish pivot from the US Federal Reserve. Given this backdrop, and with the potential for global inflation to moderate and global financial conditions to loosen, a Eurobond issuance could be a viable option for Nigeria as it seeks to address its FX liquidity challenges.

 

Policy Outlook: Balancing Act Required

We expect lenders to respond by repricing their loans upwards (by 200-300 bps). Existing borrowers, many of whom are already grappling with elevated production costs, threatening their viability and competitiveness, are likely to see their loan repayments increase, putting additional strain on their finances and potentially leading to defaults. On the other hand, we expect the yields on fixed income securities to remain elevated or even possibly trend higher, which is positive for attracting Foreign Portfolio Investors (FPIs) and strengthening the naira.

The MPC is expected to maintain a vigilant eye on key economic indicators, with a particular focus on inflation and exchange rate dynamics. This close monitoring is crucial to assess their subsequent impact on economic growth and macro stability. In the seeming absence of robust and complementary fiscal measures aimed at bolstering productivity, the CBN’s hawkish stance is likely to persist. While this approach may eventually deliver some degree of macroeconomic stability, it is not without trade-offs. The critical question remains: for how long can monetary policy continue to shoulder the burden in the absence of sound fiscal measures? A timely and effective response to this question is crucial to ensure long-term economic health and a sustainable path towards growth.

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