What is Inflation?

Inflation, as you have probably heard, is a situation where too much money is chasing too few goods. However, that only tells one part of the story.

Economists describe two types of inflation, namely

• Demand-Pull Inflation
• Cost-Push Inflation

Demand-Pull Inflation

Demand-pull inflation occurs when aggregate demand in an economy outstrips aggregate supply. It usually involves inflation, real GDP, and capacity utilisation rising as unemployment falls. Human wants are insatiable, and the resources needed to satisfy them are limited. Thus, while the capacity utilisation of production resources is very efficient, demand continues to grow at a higher rate than supply can match because of the increased purchasing power of the consumers, leading to a situation where too much money is chasing too few goods. To simplify the demand-pull scenario, imagine that at full production capacity, Country A has the capacity to produce 900,000 cars annually. Country A is currently producing 850,000 cars annually, but the total demand for cars by consumers in Country A is 1,200,000 cars. Country A cannot meet this demand for cars, and as such, the extra demand will drive up the prices of the already-produced cars. If this demand continues to rise such that more and more people continue to demand cars, then we have a demand-pull inflation scenario.

To tackle demand-pull inflation, Central Banks implement one or more of the following:

• raise interest rates and Cash Reserve Ratios (CRR) for banks;
• Engage in Open Market Operations by selling securities to the public and
• Increase bank liquidity ratios.

The overall aim of these policies is to:

• encourage more consumers to save and take advantage of high interest rates;
• reduce borrowing, therefore slowing consumer consumption and business expansion;
• reduce the amount of money available to the banks to lend to businesses.

Cost-Push Inflation

Cost-push inflation occurs when there is a decrease in the aggregate supply in an economy, usually due to an increase in the costs of production. Suppliers, thereafter, simply pass the increased costs to the final consumer by increasing the prices of the goods and services in order to maintain their gross profit margins and cover other operating expenses. Issues like rising energy costs, increased raw material costs, insecurity, and imported inflation can be the driving factors behind cost-push inflation. When this happens, governments will:

• Minimise taxes, duties, and levies to lower production costs/costs of goods and, in turn, encourage companies to reduce the prices of goods and services;
• Introduce subsidies on essential products;

The Central Bank of Nigeria (“CBN”) and Inflation

Inflation in Nigeria currently stands at 33.69%, 11.47% higher than the 22.22% recorded in April 2023. To tackle inflation, the CBN has, over the last twenty-four months:

• Raised the MPR by a whooping 1,475 basis points from 11.5% to 26.25%;
• Raised the CRR from 27.5% to 45%;
• Increased liquidity ratio to 30%; and
• Regularly conducted OMO auctions.

Despite the CBN’s efforts, inflation has continued to rise, growing from 17.71% in May 2022 to 33.69% in April 2024.

Reasons for the CBN’s Strategy

Money Supply

According to the latest money and credit statistics data from the CBN, N3.6 trillion of the N3.87 trillion currency in circulation was held outside the banks, with the percentage of currency in circulation outside the banks rising from 87.4% in April 2023 to 93.8% in March 2024.

As stated above, when Central Banks engage in rate hikes, they do this in the hope that consumers will save more of their disposable income rather than consume it. The reverse is the case in Nigeria as consumers, especially in the largely unbanked informal sector and where cash is king, are not taking advantage of the high interest rates on offer by saving their funds in the bank. This should not be surprising as according to a 2023 report on financial and economic inclusion, only 52% of the total adult population in Nigeria is banked and only 4% of the adult population in Nigeria was able to borrow from a bank in 2023 even as an estimated 38.9% of Nigerians are living below the poverty line. They, thus, have no need to save as savings are for consumers who possess excess disposable income after taking care of the basic needs of living.

Thus, even as the CBN continues to hike the MPR, there is little to no effect on consumer demand, as the consumers had little to no links to the banks in the first place. In reality, aggregate demand likely continues to increase as both the currency in circulation that is outside banks and the percentage of the currency in circulation that is outside the banks continues to increase.

Open Market Operations

Open market operations refer to the selling and purchasing of government securities by a country's central bank to regulate the money supply in the economy. In an inflationary scenario, the respective central bank will adopt a contractionary monetary policy and sell government securities to the public to reduce the liquidity in the economy.

Available data shows that in 2024 alone, the CBN has conducted OMO auctions seventeen (17) times with maturities of roughly 90 days, 180 days, and 360 days. Of the issued bills, the 90-day and 180-day bills have suffered massive under-subscription with an average subscription rate of less than 30%. On the other hand, the 365-day OMO auctions are always oversubscribed. With global economies struggling with inflation and the US Federal Reserve (“US Fed”) in no hurry to cut rates, the CBN has to keep hiking its rates to remain attractive to foreign investors who are largely the focus of its OMO auctions, having banned non-bank locals (individuals and corporates) from participating in OMO auctions from 23 October 2019. For example, for OMO auctions held on March 1 and 6, 2024, the CBN disclosed that over 75% of the bids received were from foreign investors.

The effect of this is that in its current format, OMO operations carried out by the CBN are not so much a way to mop up liquidity in the economy as they are a means to attract foreign portfolio investment into the country. Thus, inflation cannot be affected as there is little to no mop-up of the liquidity in the economy. The trend also sees the investors go for the bills with the longest maturity and the highest interest rates.

With the US Fed expecting rate cuts to materialise by the end of the year, the CBN is playing a dangerous game with Nigeria’s already strained reserves. Total principal + interest payments that are expected to mature from November 2024 to February 2025 alone is about the sum of N3.23 trillion. If we assume that 70% of this was sourced from foreign investors, and the naira trades at an average of N1,500/1 USD at the time, then we are looking at potential outflows of about $1.6bn for the period. Based on the current trends of massive under-subscription of the 90-day and 180-day bills, the CBN may not be able to cut rates even when the US Fed cuts rates at the end of the year because of the risk that investors in the long-term OMO bills may simply move to less risky environments, rather than channel their funds to Nigeria.

References

CBN (2024). Government Securities Summary. https://www.cbn.gov.ng/rates/govtsecurities.asp

CBN (2024). Money and Credit Statistics. https://www.cbn.gov.ng/rates/mnycredit.asp?year=2024

Faisal Islam (2024). US rate setter tells BBC 'no hurry' to cut interest rates, https://www.bbc.com/news/business-68849498

EFInA, A2F (2023). A2F 2023 Survey - Key Highlights. (pp. 14, 25) https://efina.org.ng/wp-content/uploads/2024/03/A2F-2023-Event-Day-Presentation-Version4-1.pdf

NBS (April 2024). CPI and Inflation Report. https://nigerianstat.gov.ng/elibrary/read/1241497

Sami Tunji (2024). Foreign investors dominate bids for OMO, treasury bills by 75% – CBN. Nairametrics,

World Bank (2024). Nigeria Overview. https://www.worldbank.org/en/country/nigeria/overview