Excerpts from the September 2015 MPC

At the last MPC, the Central Bank of Nigeria voted to cut reserve ratio requirements by 600bps to 25%. My favourite MPC character voted in the minority and here’s his view.


Context of Decision

The greatest danger to economies (large, emerging and small) in the post-2007 global economy is the risks posed by a lack of depth, scope, memory or foresight in the analysis that supports policy decisions. As I wrote in my personal statement of March 2014 MPC: ‘’these are challenging times for all monetary authorities all over the world primarily because the world is in unfamiliar territories in which unconventional monetary policy instruments have been deployed in the post-2007 global financial crisis by the most powerful Central Banks. In the process, they have created financial and economic challenges of unprecedented depths, scope and length.’’ A key consequence is the emergence two twin traps – a low interest rate and quantitative easing trap (large economies) and high interest rate and tightening trap (small and ‘’emerging’’ economies). In addition, the balance of power in the policy game has shifted in favour of the ‘’market’’ such that if policy makers fail to understand the new policy environment, they would be prone to short-sighted and catastrophic policy choices. To safeguard the medium and long term health of economies, policy makers must avoid short memories, lack of depth, scope and foresight in the very difficult policy environment of the new epoch. I first warned about the dangers of the two related interest rate traps in my personal statement of November 2013 MPC when I wrote: ‘’Available evidence leads me to conclude that the major economies (United States, United Kingdom and the Euro Zone) are sinking into a low interest rate trap. The decision of the European Central Bank (ECB) to cut its Monetary Policy Rate by 0.25% exemplified my point. The President of the ECB justified the rate cut on the ground that the annual inflation rate fell below 1% – (the target rate is 2%). The forward guidance was to the effect that as long as there was fear of deflation, monetary authorities will cut rate and sustain the policy of monetary accommodation. The forward guidance traps the ECB and similar Central Banks to (persistent) low interest rates and quantitative easing (QE) trap’’. The evidence then showed ‘’that several episodes of monetary accommodation since 2007 (had) failed to stimulate aggregate demand to the degree of the QEs.’’ Analysis of the transmission mechanisms of monetary policy in large, emerging and small economies convinced me that ‘’much of the monetary accommodation (was) “dammed” in the financial markets causing (i) inverted intermediations between central banks and financial market players; (ii) distortions in asset and commodity pricing and allocation and (iii) concentration in wealth.’’ It was clear to me that in the case of ‘’Nigeria, the low interest rate trap is a danger to financial stability (because) the high interest rates and stable currency in Nigeria (had) been attracting portfolio flows into equity and money market instruments well beyond their optimum levels.’’ The flip side was the attractiveness of borrowing by DMBs and Nigerian firms in foreign currency raising the risks of currency mismatch when the exchange rate comes under pressure. The analysis led me to warn that ‘’such flows in a globalized asset price bubble environment (can mislead) many players (to) become complacent on the false expectations that the flows will continue (and that) Nigeria has gone through painful “bubble asset” withdrawal syndromes before . . . (and) it will be costly to go through a full scale bubble asset withdrawal syndrome again. The greatest danger to policy effectiveness, financial and economic stability (was) the high likelihood that global low interest rate trap and, domestic fiscal dominance (were) leading monetary policy into a high interest rate regime. It was clear to me then in November 2013 that it ‘’was of the outmost importance that Nigeria avoids a high interest rate trap and its twining with the low interest rate trap.’’ In the personal statement of January 2014, I re-emphasized my concerns about the two interest rate traps and their structural hysteresis (long term consequences). By digging themselves into the low interest rate and quantitative easing trap I was and still am convinced that the large economies, have weakened the transmission mechanisms of policies (monetary and fiscal) globally, distorted the financial-real economy relationships and caused financial markets to malfunction in the allocation and pricing of financial assets. The episodic volatilities and the large amplitude observed in August 2015 in global financial and commodity markets are some of the consequences of the uncertainties and risks generated by the low interest rate trap. It was not a surprise that the US Fed, Bank of England, the European Bank, Bank of Japan are unable to raise rates nor are they able to stimulate upward movements in aggregate demand and prices. The recovery of employment in the US has proceeded without growth in income and with uncertainties in the global economy; forward looking economic agents are unlikely to spend without concern about future risks. The global concentration in wealth clearly, weakens growth in aggregate demand hence, the possibility of inflation. Emerging and some small economies including Nigeria imprudently walked themselves into a high interest rate trap in their scramble to attract portfolio flows despite the short term trade trade-offs (job, efficiency and growth) and medium to long term trade-offs (jobs, efficiency, growth and macroeconomic and financial market instability). The danger was most acute for economies committed to exchange rate stability and free capital flows because the monetary policy was easily trapped into a high interest rate regime: the fear being that easing will trigger devaluation pressures on the exchange rate as Nigeria is currently experiencing. Those who underplay the importance of a loss of capacity for independent monetary policy that most central banks (large, emerging and small) have walked themselves into cannot provide the light for restoring the transmission mechanism of monetary policy, the stability of markets (financial, labour and product) or the stability of the macro-economy. It was clear to me that a stable exchange rate and price regime could very easily unravel if a forward looking economic management strategy comprising of a creative mix of complementary macroeconomic policy (monetary and fiscal), macro-prudential policy and micro-prudential were not developed in time and effectively implemented. I warned that it was ‘’in the best interests of Nigeria that its policy makers are not caught unprepared.’’ This was partly why I voted for the discriminatory CRR on public deposit in July 2013 and January 2014 (to impose fiscal prudence and shut down the game of corporate welfare and unnecessary accumulation of public debt when government had deposits of about three trillion Naira in Deposit Money Banks). This was why I also consistently expressed my preference for ‘’a forward looking fiscal policy regime . . . (anchored in a commitment to the fiscal rules in the Fiscal Responsibility Act of 2007 and ‘’a strategic and forward looking management of oil and gas resources’’ to build forex reserves required to support a stable currency. Had fiscal policy been forward looking, public savings would have been built up and the fiscal buffers would have minimized the effects of the shocks (commodity price collapse, bubble corrections and reverse flows) whose likelihood of occurrence were obviously very high. The path of Nigerian money, capital and forex markets particularly since October 2014 justify the concerns raised in my personal statement of November 2013 about the twin traps and the vulnerabilities they pose to large, small and emerging economies. In my personal statement after the March 2014 MPC, I had expressed concerns that ‘’many global players do not (1) see the linkages and the medium term strategic implications and/or (2) have no interest in the global commonwealth. For such short-sighted players, exploiting the asymmetries at the nexus points is fair game (rational) regardless of the resulting turbulence and the social, political and economic consequences. Yet, unless many Central banks and market players see, understand and submit to the good of the global commonwealth, the turbulence in the global economy and its disturbing consequences will persist for a very long time to come. A beggar thy neighbour policy environment is globally inferior to a mutually beneficial cooperative environment.’’ I had argued for a global cooperative process to solve the problems of the twin traps because I was convinced that the ‘’two traps demand (1) a forward looking monetary policy process within a broader and longer spacetime horizon and (2) greater mutually beneficial policy coordination between monetary and fiscal authorities and between Central Banks regionally and globally. Otherwise, exiting the abnormalities of the last few years will be painful for most and unsettling for all.’’ I pointed to the fact that ‘’the various options for disposing the toxic assets (mortgage backed securities) that the US Fed and most Central Banks had accumulated on their balance sheet . . . (were) fraught with dangers for monetary policy, for global financial markets (asset prices, interest rates and yields), for the housing markets and for growth and employment.’’ I was convinced that fiscal-monetary policy coordination in Nigeria would have helped to build buffers and made both policies more effective and more compatible to medium and long terms economic goals of Nigeria.

I have provided this rather detailed chronology of my personal statements to underscore the real challenge of macroeconomic management in the post-2008 world and the risks of policy making within a narrow scope and a short time horizon. The greatest danger which most leading policy makers chose to underplay is deeper, long-termed and deeply structural: the challenge of traps. Listening to and watching Fed Chair Janet Yellen’s press conference after the September 17 2015 Federal Open Market Committee (FOMC) meeting I was struck by an unwillingness to confront the new post- 2008 global economic realities. As much as Fed Chair Janet Yellen tried to downplay the threat of the Fed being in a zero interest rate trap, she did not rule it out but had no plan B. She was asked ‘’Are you worried that, given the global interconnectedness, the low inflation globally, all of the other concerns that you just spoke about, that you may never escape from this zero lower bound situation?’’ Fed Chair Janet Yellen answered ‘’So I would be very—I would be very surprised if that’s the case. . . Can I completely rule it out? I can’t completely rule it out.’’ Clearly, there is no Fed strategy to dig itself out of such a trap and the associated costs. Japan which entered into such a trap in the aftermath of its asset market bubbles of the late 1980s is yet to exit the deflation trap. Now the major economies had joined it. To ignore the current realities of the global economy and its implications for economic and financial outlook is to increase the chances of dangerous policy errors. As I pointed out in my personal statement after the July 2015 MPC, the real policy choice is not between tightening or easing. It is far ‘’more fundamental. It is about institutions, incentives, strategy, coordination and forward looking. At the heart is the primacy of mechanism design and about leveraging on the new government’s positive signals about fiscal prudence, consolidation of NNPC Accounts in the Central Bank and possibility of re-starting production in the refineries to develop a macroeconomic management strategic framework for Nigeria.’’ This remains my position at this MPC meeting.

Decision I vote to hold. However, my vote to hold is not a vote to do nothing. Rather, it is a vote to harness and direct all available intellectual and political resources to engage the fiscal authorities to develop a macroeconomic management strategic framework for Nigeria urgently to meet the real challenges of macroeconomic management in this new epoch. The CBN Act makes it clear that the primary mandate of the CBN is price stability and its secondary mandate is to support the policies of the government. Neither mandate could be successfully achieved without a dynamic and efficient and effective coordination of fiscal and monetary policy and without a comprehensive and consistent strategic framework for monetary policy, macro-prudential policy, micro-prudential policy and development finance policy. Developing the frameworks for me, are the real and urgent challenges.

It is true that the macroeconomic and financial market outlooks are precarious for Nigeria and for most small and emerging economies and indeed for most of the global economic zones besides the US. However, doing something is not necessarily prudent. Similarly, a reactive one issue driven monetary policy in the current policy environment is most likely short sighted and prone to costly errors. For instance, had the discriminatory CRR prevailed until the policy of Treasury Single Account (TSA) came into force under the new regime, there would have been no need to raise private sector CRR to 31% at the May 2015 MPC. The process of adjusting to the TSA after September 15 deadline would have generated less ‘’noise’’ since 75% would already have been in the CBN and with CRR at 20% the effect of TSA on system liquidity would have been marginal if at all. In any case, there was sufficient forward guidance between July 2013 when the CRR on public deposit was increased to 50% about the need for Deposit Money Banks to gradually change their business model from one that depended on profits from lending public deposits to government to one that depends on intermediation between borrowers and savers for their profits.

Clearly, their preference for ‘’financial subsidy’’ was rational but short sighted and very costly for fiscal and monetary operations. In addition, the ‘’strategic noise’’ about illiquidity is not supported by the data on the average Liquidity Ratio which was at least 10% above the required rate. The expectation that a reduction in CRR will lower short term rates is not rooted in sound analysis or evidence. The strongest argument for lowering CRR is the profit argument. Yet, there is the unresolved profit puzzle: rising profits of DMBs while growth in credit, assets and deposits are slowing and inefficiencies are rising (interest rate spreads, operating costs and forex arbitrage opportunities). In any case, liquidity management implies that OMO could be used to mop-up excesses liquidity or to inject liquidity when necessary. The size of the projected injections through reduction in CRR to 25% increases in the risks of exchange rate pressures given the asset structure of the DMBs in the last few years. It will be imprudent to begin to raise CRR in subsequent MPC meetings when the liquidity injected begins to exert pressures on the forex market. This is more so, since OMO could be used inject liquidity and reduce the cost of mopping up later. Given the risks to the forex market and to financial system stability of further pressures on the Naira, I could not vote for a reduction in CRR. I could also not vote for tightening to reduce inflation pressures because tightening could not be justified by the already high sacrifice ratios of the ‘’tightening-quantitative easing’’ conundrum (tightening the massive AMCON injections) of the last few years. I expressed cautious optimism in my personal statement of July 2015 MPC. I remain cautiously optimistic. As I emphasized then, ‘’policy and strategy should not be based on pessimistic outlooks because nothing in the future is inevitable: it is the quality of current choices that will shape future paths.’’ As the new cabinet takes shape, it is important that monetary and fiscal authorities meet as soon as possible to begin the hard-work of designing the appropriate macroeconomic management strategy for Nigeria that builds the resilience, efficiency and effectiveness required to achieve the complementary mandates of the CBN and the fiscal authorities. I had argued that resumption of refining at full capacity would help to reduce petroleum subsidy payments which will bring about significant reductions in fiscal deficits, public borrowing and public debt and the need for portfolio flows. These changes would significantly reduce the cost of liquidity management, reduce pressures on the forex and money markets and help to bring about improvements in the pricing, allocative, rationing and discovery functions of the money and forex markets. Indeed, improvements in refining and distribution efficiencies could bring to an end the game of petroleum subsidy and its destructive effects on the efficiency and effectiveness of markets and policies (fiscal and monetary). Similarly, a successful war on corruption would increase government revenue (as leakages and theft are reduced), reduce government expenditure, budget deficit, public borrowing and public debt. These would scale-up the effects of the reduction in petroleum subsidy. The future effectiveness of macroeconomic management in my view hinges strongly on effective and efficient policy coordination. Without that, weathering the inevitable storms of the twin traps will be difficult and very costly. My vote therefore, is for medium to long term efficiency and effectiveness of markets, of macroeconomic management and of the stability of the economy.

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