Rethinking Monetary Policy in Uncertain Times

With rising level of uncertainty across the globe, central banks are rethinking their approach to monetary policy, writes Obinna Chima

The level of uncertainty in the world economy that was aggravated by the outbreak of the COVID-19, was recently heightened by the outbreak Russia’s war in Ukraine. Clearly, these have remained a strain on the global economy, as it has led to upsurge in energy and food prices, which are currently driving galloping inflation rate and weighing on economic growth.

Owing to this, many countries that included The United Kingdom, United States of America, South Africa, Ghana, India, among several others have all raised interest rates in their bid to fight rising inflation.

Some are also rethinking their approaches to monetary policy as they continue to weigh the best tools to apply to calm the markets and cool down inflation.

Globally, it has been accepted that monetary policy required some time to exact an impact on the real economy, and thus, central banks might need to take certain policy actions based on inflation forecasts rather than its current value.

This meant that the central bank may need to forecast the future path of inflation, which is then compared with a specified tool that could address it. This is in line with central bank’s major function of ensuring price stability, which is the primary goal of monetary policy in almost every jurisdiction.

High rates of inflation impact negatively on a country’s economic performance as it prevents rational decisions on the part of savers and investors, and tends to divert scarce resources away from productive uses.

An environment of sustained price stability helps economic agents to plan and form better expectations of the future path of the economy. It also enables them to make informed and better long term economic decisions. The consensus is that the best contribution a central bank could make to sustainable economic growth and enhance the welfare of the citizenry is to achieve and sustain price stability. This is why some economists hold the view that the worst gift to an ordinary citizen is high rate of inflation.

To achieve this objective, a typical central bank’s toolkit is enriched with diverse monetary policy strategies, which evolve from its monetary policy framework.  

However, with spiraling inflation after decades of quiescence, central banks are presently rethinking their approach to monetary policy.

Monetary theory in Economics is consisted of various schools of thought rather than a single unified model. Each of these schools emphasise different forces that drive inflation and recommends a distinct policy response. The International Monetary Fund (IMF), in a recent report, stated that different times have raised different challenges—and each requires its own policy approach.

The multilateral institution stressed that a resurgence of inflation requires yet another shift in emphasis in monetary policy and imposes on central banks the need to review their monetary policy tools.

These clearly were some of the reasons that necessitated a two-day retreat by the Monetary Policy Department of the CBN that took place in Lagos last weekend.

The theme of the retreat was “Monetary Targeting Policy Framework in Nigeria – An Appraisal of its Continued Relevance to the Price Stability Mandate.” The annual gathering was for the regulators to appraise its monetary policy framework. It also afforded the central bank officials to look at money supply, base money, its open market operations and other liquidity instruments in the banking industry.

Monetary targeting is a policy framework that involves setting a target for monetary aggregate, such as the money supply, and adjusting monetary policy to achieve that target. In the case of Nigeria, monetary targeting has been adopted as the main policy framework since the 1990s. It focused on controlling the growth of money supply to achieve price stability.

The framework for monetary policy consists of its objectives as well as the instruments and operating procedures for achieving the stated objectives. Globally, there are different strategies used by central banks in the conduct of monetary policy. These strategies affect the operating, intermediate, and ultimate targets through different channels.

The common strategies include monetary targeting, exchange rate targeting, interest rate targeting, nominal gross domestic product or output targeting, and inflation targeting.

Generally, as monetary policy objectives have evolved over time, so also have the strategies (frameworks) used to attain them. As the names imply, those policy regimes could target a monetary aggregate, exchange rate, and inflation measure, output, or interest rate in the bid to achieve the goal of price stability.

On the other hand, inflation targeting is a monetary policy strategy in which a central bank forecasts and makes public a target inflation rate and then, attempts to steer actual inflation towards the target through the use of key monetary policy instruments, such as central bank policy rate, OMO bills, repo and reverse repo and other monetary policy tools.

It is, therefore, a framework in which the primary goal of monetary policy is to achieve price stability in accordance with an inflation target. In Nigeria, under the inflation-targeting framework, the target was set by the government between three to six per cent per annum, but presently inflation is at 22 per cent.

The Deputy Governor, Economic Policy Directorate, Dr. Kingsley Obiora, pointed out that the key objectives of monetary policy, whether in the university, the central bank or a global financial institution, remained price stability.

He, however, noted that from what is going on in the world today, global inflation is anything but stable. “We know that right now global inflation is projected to be at 6.6 per cent for 2023. But if you look at country by country, you will find out that we are really in dire strait when it comes to global inflation. For example, 32 per cent of countries in the world today have registered inflation at greater than 10 per cent.

“If you look at Europe for example, over 45 per cent of European countries have inflation that is greater than 10 per cent and within the countries that account for 85 per cent of global Gross Domestic Product (GDP), 65 per cent of that slice have inflation greater than 5.0 per cent. So, that is a big headache that monetary policy is trying to grapple with at this point in time.

“Of course, inflation is not an end in itself, it is a means to an end. You moderate inflation so that output would have meaning on the lives of people. But if you look at GDP, we are also struggling. The last World Economic Outlook (WEO) of the IMF projects that global GDP growth this year would be 2.8 per cent and three per cent next year.

“For the advanced countries, they projected that it would be 1.8 per cent this year and 2.2 per cent next year and obviously emerging countries are projected to grow at 3.9 per cent this year and 4.2 per cent next year and within that bucket, Nigeria is projected to grow at 3.2 per cent this year and three per cent next year.

“The second largest economy in Africa is 0.1 per cent this year, which for me is a stagnation because statistically you really cannot measure 0.1 per cent, and only 1.8 per cent next year. So, you will find that we are dealing with a twin evil of very slow growth and high inflation and there are other difficulties that the global economy is grappling with,” the deputy CBN governor stated in his presentation.

He also noted the tightness in the labour market, where many employers have job openings that they could not find the right people with right skill sets to fill.

“Obviously, we know that a lot of central banks have been going through aggressive tightening to fight inflation. But that aggressive tightening, including from the CBN, seems to be having an effect on financial stability around the world.

“We have seen for examples, one of the most iconic financial institutions in the world, Credit Swiss of Switzerland, disappear last month; in the United States, three significant, although regional commercial banks filed for bankruptcy – the Silicon Valley Bank, Signature Bank and First Republic Bank.

“Now, in the last 40 years, we have had about 90 banks in the US, with assets of over $1 billion collapse. Just to put it in perspective how difficult or how bad things are right now, of those 90 banks with assets of over $1 billion actually collapsed in the last one month, look at the amount of assets that these three that collapsed own. They are actually in the top four of the largest banks that collapsed in the United States.

“The only bank that is larger than them that collapsed was Washington Mutual that collapsed in 2008, during the global financial crisis of 2007/2008.

“So, my point is that the three banks that collapsed in the last one month are seriously significant banks, holding assets of over $200 billion each. So, when you come back to Nigeria and look at the fact that in all of these, our financial system is still stable, but we cannot deny that there are spillovers from these global issues occurring all around the world.

“Inflation in Nigeria is not anywhere where we want it to be. A child that was born the last time we had single-digit inflation is already in primary two. So, you can imagine having double-digit inflation for the last seven or eight years, that is a lot,” Obiora added.

In his remarks, the Director, Monetary Policy Department, CBN, Dr. Hassan Mahmud, explained that in recent years, monetary policy has had to contend with shocks of increasingly new dimensions, ranging from the global financial crisis between 2007 and 2009; various oil price shocks, the COVID-19 pandemic and most recently, the war between Russia and Ukraine.

“These developments have resulted in various shocks to the global economy, requiring changing responses to subdue both the monetary and fiscal authorities in the advanced and emerging economies.

“At the CBN, we migrated over the years from the exchange rate targeting framework to a monetary targeting framework and a subsequent veiled attempt at a phased migration to inflation targeting, adopting a hybrid approach of monetary targeting framework with elements of inflation targeting.

“Over time, the effectiveness of monetary targeting in achieving price stability in Nigeria has been called into question. One of the main challenges has been the difficulty of accurately measuring and controlling money supply in the face of financial innovation and the growth of non-bank financial institutions.

“In addition, the relationship between money supply and inflation has become less predictable in recent years, further complicating the use of monetary targeting as a policy tool.

“Despite these challenges, some argue that monetary policy targeting still remains a relevant policy framework in Nigeria. Proponents of monetary targeting argue that it provides a clear anchor for monetary policy and that the central bank can adjust its operations to measure better and control the money supply. In addition, they argue that monetary targeting can help to anchor inflation expectations, which is important for maintaining price stability,” he added.

According to the CBN director, the continued relevance of monetary targeting depended on several factors, including the effectiveness of the central bank’s operational framework, the accuracy of monetary aggregates as a measure of inflationary pressures and the ability of monetary policy to influence the behavior of economic agents.

Ultimately, the central bank will need to interrogate the continued relevance of monetary targeting framework to address the series of new and developing shocks impacting the Nigerian economy, as well as the advantages the inflation targeting framework may hold for us as a central bank, he added.

To the Director-General of the West African Institute for Financial and Economic Management (WAIFEM), Dr. Baba Musa, there are presently so many uncertainties in the world. Musa pointed out that “you cannot do inflation targeting where there is this level of uncertainty.”

“Even the mandate of central banks is being questioned because now with the experience of the COVID-19, the mandate of central banks have expanded beyond price stability. There are so many things central banks have delved into, which are actually fiscal policy.

“Janet Yellen in her first interview gave a big summary of the role of central banks today. In her own thinking, central banks’ responsibility is to worry about everything. If there is unemployment, it is the central bank that worries, so with foreign reserves, price stability and they worry virtually about everything in the economy,” Musa added.

However, a Professor of Economics at Princeton University, USA, Professor Markus Brunnermeier, noted that to address these problems, central banks should return to a monetary approach in which stabilising inflation expectations is a central priority.

Policy cannot tighten only after inflation occurs. Instead, central banks should take action as soon as there are warning signals. Central banks must incorporate both households’ and financial markets’ expectations of future inflation, since those expectations shape both aggregate demand conditions and asset prices, Brunnermeier added.