The benchmark lending rate at the Central Bank of Nigeria (CBN) has increased by 0.5% to 18%. The stated reasons were to control price increases and exchange rate fluctuations. Despite recent efforts to reduce liquidity in the economy, inflation accelerated again in February. The committee of the central bank reached a unanimous decision to raise interest rates.
The CBN’s ability to increase interest rates as a tool for controlling inflation is hampered by the currency’s inherent structural challenges. The majority of the country’s currency, the naira, is held outside of the formal banking system, so interest rate policy has only secondary effects on the currency in circulation or in storage. Increasing interest rates will have secondary effects on point-of-sale (POS) currency transactions, as the increase in the base rate will cause all other interest rates to rise. Businesses and affluent individuals will face a credit crunch in terms of available leverage. Businesses will be required to pay a greater proportion of their available cash flows to meet their financial obligations, reducing their capacity to expand or acquire additional inputs. On the consumer side, it will affect cash transactions and credit card payments. When rates increase, the proportion paid on loaned credit rises, reducing the total amount that individuals can borrow.
Nevertheless, the majority of Nigerians live paycheck to paycheck and lack access to formal financing. The tightening of interest rates will primarily affect those with access to financial institutions and those reliant on foreign exchange rates. As the effects of interest rate changes ripple through the formal economy, those whose lives are entirely dependent on cash transactions will feel the effects much later.
Additionally, the central bank has begun to openly discuss the elimination of oil subsidies. Nigeria spent $10 billion last year on fuel subsidies. The elimination of such a costly subsidy will substantially increase the CBN’s foreign currency reserves and reduce international inflationary pressure on the naira. The 0.5% interest rate increase is more of a signalling move by the CBN.
Financial markets frequently rely on signal language to gauge expectations, discount rates, and other variables that are forecasted. The CBN’s decision to increase interest rates by 0.5 percentage points will have a significant impact on inflation and currency value due to its implied significance rather than its actual effects. It indicates that the CBN is committed to combating inflation without destabilising Nigeria’s financial economy as the country transitions to a new administration and away from fuel subsidies.
