Evaluating CBN's Prospects for Monetary Easing: Why the CBN shouldn't Rush to Cut

By Chinedu Okoye 

Central Bank Hints at Monetary Easing:

The year 2024 has seen an extremely aggressive tightening by the Central Bank in reaction to exchange rate and energy costs fueled inflation. Pursuing a dual strategy, the Bank has simultaneously raised benchmark rates and increased cash reserve ratio making for a reduced the money multiplier (explained below).

The Central Bank Governor hinted in the first week of December, at the prospects for monetary easing, as inflationary pressures ease . This could also be supportive of economic growth, but only in principle. Whilst this policy thinking has merits, there has been a muted impact of interest rate hikes on prices as inflation persists, even after an 875 basis points hike in the year, barring a 2 month disinflationary stint.

In the same vein there could also be a muted impact of interest rate cutting monetary easing strategy. That is businesses might not feel the impact of the cuts, leaving prices fairly unchanged as inflation has a larger exchange rate component than it does interest rates.

We however make a case for the merits of this prior tightening based on the understanding (and observation) that the hikes are aimed at addressing inflation indirectly by stabilizing exchange rates, as ultimately inflation is driven by; lower exchange rates; and higher energy and food.

We find that, the medium through which money supply is altered matters a great deal, and affect prices in unique (almost non conventional) ways. Furthermore, we posit that, interest rate cuts would not automatically lead to stable or lower prices just as the hikes wasn't sufficient to tame inflation. We explain how by analysing the rationale and effects behind the dual (MPR & CRR) tightening instruments seen this year.

CBN's Dual Monetary Tightening Strategy in Response to Naira Inflation:

The Naira devaluation saw the Naira shed over 90% of it's value from Q3 2023 leading up to this year. This affected energy and food prices as well as input costs for component goods and other imports.

Prior increases in Money supply which partly led to the depreciation had more Naira chasing few dollars – Naira flights was imminent. To combat this, the Central Bank opted to aggressively tighten money supply to stem the flight from NGN denominated assets and attempt to stabilize prices in the process.

The monetary policy response was two-faceted; 

1. Monetary Policy Rates: (875 basis points from February to September 2024)

- July 23, 2024: The MPR was 26.75% 

- September 24, 2024: The MPR was 27.25% 

- November 26, 2024: The MPR was raised by 25 basis points to 27.50%.

The CBN Monetary Policy Rates now stand at 27.50%.

2. Cash Reserve Ratio: The CRR was increased to 50% from 45%.

Rationale & Impacts of the Instruments (CRR and MPR):

The increase in cash reserve ratio reduces the money multiplier (the amount of loans banks can create with one Unit of Naira deposits), thereby putting a limit on how much money can be created through loans, leading to a credit squeeze.

Businesses are less responsive to interest rates changes — as interest costs are passed down to the consumer in business pricing systems. They react more to a reduced availability of credit (money supply). CRR then becomes the tool employed to check interest/credit fueled inflation (not MPR).

Thus, MPR hikes was aimed at taming the Naira flight and addressing exchange rate depreciation (the foundational inflationary driver amongst other factors), by addressing the root cause —inadequate FX supply.

Higher benchmark rates increases the yield differential with US (and reserve currency) risk free yields. The higher the monetary policy rates, the higher the yield on Nigerian sovereigns making shorterm debt appealing for yield seeking foreign investors. MPR, under these circumstances is basically an exchange rate stabilization tool.

Because the US Federal Reserve was slower to cut rates, MPR increases where necessary to stabilize prices via exchange rates by attracting shorterm FX inflows. However the limitations to this has been the sluggish or no improvements in Naira 's core FX Fundamentals, which kept it underbid up until recently below the N1,500/$1 level.

But businesses and consumers need credit more given the fall in disposable income, as a result an exit from an overly restrictive monetary policy is required. 

A Strategy For Easing:

The unique structural challenges in the financial and real sector make conventional monetary policy seem ineffectual, and this is especially so given rate hikes hasn't translate to lower prices. This suggests need to for innovative policies tailored to the unique characteristics of the Nigerian economy.

The economy isn't as responsive to interest rates changes so rate cuts will not have the desired effect of stimulating production just as it was ineffectual (surface level wise), in reducing prices. A deep and/or early cut would bring Naira exchange rate under pressure as real yields which attract FPIs, decline.

So money supply has to increase without reductions to interest rates (at least not initially or mildly, if need be). This places CRR reductions (and other lending incentives), as the first step to commence the easing. 

CRR Easing to Stimulate Credit Expansion:

The cash reserve ratio has taken the role of dampening credit fueled demand in the tightening cycle as availability of credit matters more to Nigerians than cost — even though the cost of credit isn't to be overlooked.

A reduction in the Cash reserve ratio enables banks create more money, from its deposis (via credit), especially as they face a lending incentives (there is now a 50% Levy on banks who fall short of the 65% Loan-to-Deposit Ratio). With credit market liquidity improved, business and consumers can plan around a high nominal interest rates.

This can lead to increased competition amongst lenders for depositor funds and loans, which will help with efficient and fair pricing as banks —which have more capital at their disposal following the recapitalization and the windfall FX gains — endeavor to meet LDR ratios to avoid penalties.

Stimulating Credit Expansion and Stabilizing Exchange Rates:

The suggested course of action would be to cut cash reserve ratio, giving banks more leeway to expand credit issuance without much changes to monetary policy rates. Money supply increases is checked by high nominal rates.

With CRR reduced by a reasonable amount, more credit could flow to the real sector, this now sets the stage for a more pronounced price stability effect when monetary policy rates are further eased as well later in the year. 

Zero Equilibrium Monetary Easing Recommendations:

We advocate a reduction in CRR by 1,500 basis points to 35%. In addition to a reduced CRR, we suggest a single 150 basis points cut through 2025, or a triple 50 basis points cut.

MPR is needed to stay at levels that would keep shorterm bills attractiive and draw in foreign portfolio investments.

MPR as stated above is needed for exchange rate stability and a premature (or too deep a cut) could undo to marhinal progress made in that regard. Any cuts to benchmark rates should be promoted by considerable price stability improvements.