FROM THE OFFICE OF PUBLIC AFFAIRS

To view or print the PDF content on this page, download the free Adobe® Acrobat® Reader®.

May 27, 2004
JS-1712

John B. Taylor
Under Secretary for International Affairs
United States Treasury
Keynote Address
Money Market Association of Nigeria
Abuja, Nigeria
May 27, 2004
Improvements in Monetary Policy and
Implications for Nigeria

 Thank you very much for inviting me to speak at this important conference on monetary policy. And thanks to the Money Market Association of Nigeria for sponsoring it.  I am delighted to be here in Abuja to talk about monetary policy.  I have had a very long interest in monetary policy, and, my current international affairs job at the U.S. Treasury often requires that I get involved in discussions about monetary policy issues in other countries, especially those with international implications.  So being here is not only enjoyable, it is part of my job.  

I have an even greater interest in this particular conference because it is about monetary policy in Africa, a continent to which President Bush has asked those in his administration to pay particular attention, by increasing foreign assistance, by urging the multilateral development banks to provide more grants rather than loans, by insisting on measurable results in all assistance projects, and by encouraging pro-growth economic policies. In fact, this is my sixth trip to Africa since I joined the Bush administration just over three years ago.

Monetary policy is a key component of any pro-growth strategy.  That is why it is one of the indicators in President Bush's new Millennium Challenge Account, which endeavors to direct more economic development assistance toward countries that are following good pro-growth policies.  Now is an opportune time to build on recent improvements in monetary policy in many parts of the world and create a legacy of growth-enhancing price stability for Nigeria and the whole continent.  In this way, monetary policy will play an important role in the continent's economic rejuvenation.  Today I would like to describe recent improvements in monetary policy around the world and then indicate ways to build on these improvements in Nigeria and in all of Africa.  

Recent Improvements in Price Stability

One of the best good news stories about monetary policy in recent years is that there has been a great reduction in inflation--an increase in price stability.  I have three charts to illustrate this improvement.  One (Figure 1) shows the inflation rate in the United States going back several decades. The second (Figure 2) shows the inflation rate in the United Kingdom over a similarly long time period.  And the third (Figure 3) shows the inflation rate in Africa and other parts of the world.

All three charts tell the same remarkable story.  Starting about 20 years ago, and then gaining momentum, there has been a dramatic reduction in the rate of inflation around the world.  This reduction followed a nearly simultaneous increase in inflation in the late 1960s and 1970s. Many people have discussed the great disinflation in the United States in the late 1970s and early 1980s and the period of relative price stability ever since then.  And many--myself included--have concluded that the improvements in overall economic performance in the United States--smaller, less frequent business cycles, sometimes called the "great moderation"--has been closely related to the improvements in price stability.

But as the charts show, this phenomenon of greater price stability is good news heard around the world.  The chart of the United Kingdom is very similar to the United States.  One difference is that the inflation came down a bit earlier and faster in the United States. And the data in the third chart documents the decline in Africa and compares it with other parts of the world. 

If you look more closely at the data in individual countries in Africa you can see positive trends in inflation in many countries in recent years.  In 1990, 22 countries in sub-Saharan Africa had inflation rates in double digits.  In 2003, only 12 countries had inflation in double digits.  I note in particular that inflation in South Africa has been cut in half from 14 percent to around 7 percent in the last ten years.

Accompanying Changes in Monetary Policy

Accompanying this improvement in price stability, have been some equally dramatic changes in monetary policy in many countries around the world.  It is important to first note that there has been a major reduction in the rate of money growth in many countries.  This is implied by the fourth chart (Figure 4), which shows the high rates of money growth on average in the last thirty years. Clearly money growth has come way down off these high levels. For example, none of the three Latin American countries in the chart have anything near triple digit money growth now.

This chart is also a useful reminder that inflation is truly a monetary phenomenon.  It would certainly be a mistake to ignore money growth in analyzing trends in inflation around the world. But the relevant question is what why did money growth and inflation fall so much in many countries in the recent years.  In my view there are three factors to consider.

Exchange rate policy

First, let us focus on the big changes in exchange rate policy. Of course there was the end of the Bretton Woods international system of fixed exchange rates in the early 1970s, but since then we have seen the international monetary system evolve further with several marked trends.  Many countries have chosen to abandon pegged exchange rates and instead either (1) use a monetary policy based on flexible exchange rate or (2) permanently connect monetary policy to other countries through a monetary union or dollarization.  By our count at the U.S. Treasury, 47 countries now operate a monetary policy with a flexible exchange rate and 50 countries are either dollarized, in currency unions, or using currency boards.  The number with fixed or heavily managed exchange rates is falling and is now at 75.  Fortunately, there are now only 7 countries with multiple exchange rates. In sum, there are now 97 countries that have dollarized, joined a currency union, created a currency board, or chosen a flexible exchange rate.  There is a common feature in all 97 countries: They are either tying their monetary policy to a central bank with good price stability goals and instrument setting procedures, or they are trying to pursue an independent monetary themselves.

If we focus on sub-Saharan Africa, this change is quite evident. There has been a general movement away from pegging toward flexible exchange rates.  In 1990 there were 10 countries with a flexible exchange rate regime, while in 2003 there were 23. At the other extreme, currency zones, including the CFA zone, have offered a viable approach to monetary policy for many countries in Africa. By tying to the Euro, the CFA zone provides institutional discipline that keeps inflation low.  Note that a monetary union could be a collective float such as the euro zone in which the Euro floats against the dollar and other currencies.  The CFA zone is tied to the euro and thus offers the monetary discipline of the European Central Bank. I note with great interest efforts to create a West Africa monetary zone, which would include Nigeria. However, creating a credible monetary framework in Nigeria is an essential pre-condition to any such union, since Nigeria would play an important anchoring role.

Price Stability Goals

A second important change in monetary policy is the increased emphasis on price stability that began in the early 1980s and has picked up momentum.  This emphasis followed from the growing consensus that there is no long-run trade off between inflation and unemployment or economic growth, a view that had been common in the 1960s and the 1970s. The modern view, to the contrary, is that inflation is harmful to economic growth.  It creates volatility and raises interest rates.  It reduces private investment.  And, inflation hurts the poor, who are least able to hedge. 

In the United States the greater emphasis on price stability began early in the 1980s and has continued under the chairmanship of Alan Greenspan. The success of monetary policies with a greater focus on price stability has been noted and the ideas of spread. The inflation targeting movement has helped spread these ideas.  New Zealand was one of the first countries to adopt inflation targeting.   Chile was another one of the first movers in the inflation targeting movement.  Inflation targeting has been especially helpful for countries that started with very high inflation rates. As the example of the United States makes clear, it is not necessary to have an explicit numerical target for inflation in order to have a clear goal for monetary policy.

Systematic, transparent, procedures for setting the policy instruments

A third important change is in the way the instruments of policy are set.  There are two main choices for the instrument of monetary policy: the interest rate and the monetary base, and there has been an increased focus on the interest rate in recent years.  In part this reflects increased transparency; in the past many central banks had been implicitly setting interest rate.  In 1994 the Fed, for example, began issuing public statements about its interest rate decisions. Similar developments occurred at other central banks.  

Now, with the focus increasingly on the interest rate as the policy instrument, there has been a shift in how monetary economists analyze central bank decisions.  Rather than evaluate each decision as an isolated one-time adjustment in the instrument, the evaluation is about the overall dynamic strategy for setting the instrument.  In other words, policy analysis places greater emphasis on the process for setting the interest rate.   This change in thinking about monetary policy has occurred both inside and outside of central banks. When economists evaluate monetary policy, they simulate models with policy rules inserted in them rather than simply simulating one-time changes in the instruments. When financial market analysts try to determine what a central bank should or should not do, they usually consider a monetary policy rule.  And central banks frequently use policy rules as an input to their actual decisions.  

An unexpected benefit of this approach to policy evaluation is that it has revealed changes in the decisions making processes at central banks.  For example, during the late 1960s and 1970s the response of the interest rate to inflation appeared to be less than one; during the period since the mid 1980s the coefficient has been greater than one. An illustration of the change can be seen in the inflation figure (Figure 5) for the United Kingdom. When the inflation rate approached nine percent in 1971, the interest rate was only six percent. When the inflation rate approached nine percent in 1990, the interest rate was fifteen percent, clearly a much larger response. The same change has occurred in the United States and other countries.

Another indication of the greater transparency about monetary policy is the reduction in dual exchange rate regimes in Africa over the last decade.  Compared to 1990, roughly half as many countries now have multiple official exchange rates.  Central planning is disappearing in Africa as almost everywhere else, and along with it the comprehensive foreign exchange controls.  In addition, more transparent procedures for setting the instruments of monetary policy such as open market operations have replaced direct controls in recent years.  For example, South Africa unified exchange rates in 1995.  And here in Nigeria a Dutch auction system  was introduced in 2002 which has narrowed the parallel exchange rate from a 20 percent premium to under five percent in 2003. 

General Implications for Monetary Policy

This review of improvements in inflation and the accompanying changes in monetary policy has clear policy implications. It is clear that the choice of an exchange rate is by no means the only factor to consider in deciding how to achieve a successful monetary policy.  Perhaps most relevant for this conclusion is the performance of the United States and United Kingdom I have reviewed here. Both countries showed an increase in inflation and price instability in the years immediately following the end of the Bretton Woods fixed exchange rate system. It was not until the two other changes were instituted in the 1980s and 1990s--clear price stability goals and a systematic procedure for setting the instruments of policy--that low inflation and price stability were achieved. 

Hence, all three of the factors mentioned above appear to be essential: For countries that do not choose a policy of a "permanently" fixed exchange rate, a successful monetary policy must include the trinity of a flexible exchange rate, a price stability goal, and a systematic procedure for setting the instruments of policy.  For countries that choose a "permanently" fixed exchange rate regime, monetary conditions will be determined largely by the central bank of the anchor currency

While originally implemented by some advanced economies, research and experience increasingly show that these same three factors are essential for emerging markets too.  The experience of Chile, Indonesia, and Mexico, as compared to Nigeria, highlights the macroeconomic benefits associated with this approach. After instituting a flexible exchange rate regime, a goal for inflation, and a more systematic approach to monetary policies, the average rates of inflation decreased significantly in Chile, Indonesia, and Mexico.  Moreover, real GDP growth accelerated.  I believe that the establishment of such a monetary policy in Nigeria can be equally successful.

Implementation challenges

To be sure, actually implementing such a monetary policy can present challenges, especially in emerging market countries.  I reviewed these issues in a paper I presented at a conference at the Bank of Mexico several years ago. It is often difficult to estimate the potential growth rate, the output gap, or the equilibrium interest rate.  These challenges are made more difficult where the informal sector is large and statistical coverage is limited. 

In using the interest rate versus the monetary base as the instrument, one must consider the difficulty in measuring the real interest rate in a high growth, high-risk premium environment.  If financial markets are weak, the effectiveness of transmitting policy through interest rates will be limited.  In such cases, policy makers might chose to use the money supply instrument.  The monetary base, however, can also faces challenges, such volatility in velocity.  For example, an emerging economy experiencing rapid and successful reform may witness a surge in demand for money to transact as well as to serve as a store of value coincident with greater confidence and activity.  

Emerging markets also need to consider the importance of exchange rate stability.  In small open economies, sharp changes in nominal exchange rates can have significant effects.  In general, it is best to react to exchange rate changes only to the extent that they effect inflation or inflationary expectations.  However, debt sustainability can be adversely affected by sudden depreciations, especially in the case of mismatched denominations and terms. 

Some Implications for Monetary Policy in Nigeria

I believe that the implications of this review for Nigeria are clear: Establishing a monetary policy framework that follows and builds on recent historical experience around the world would greatly improve economic stability and growth.  And implementing such a policy will be easier if there are further institutional and operational changes. 

Of course, it would help if the pressures on the central bank to finance the government budget deficit were reduced.  The Central Bank of Nigeria has had to accommodate high fiscal deficits in the past; deficits averaged 5 percent of GDP from 1989 to 2002.  These deficits were largely financed through an increase in the money supply. The growth rate of M2 has been consistently higher than the Central Bank's targets in each of the last several years.  In 1999 and 2000, the actual growth rate was three times the target; more recently it was twice the target.  In 2003, monetary base growth was 26 percent compared with a target of 15 percent.  This high rate of money growth has fueled inflation, which averaged almost 22 percent a year between 1971 and 2002.  In 2003 alone, the inflation rate increased to 24 percent from 12 percent in 2002.

For this reason, we welcome the budget that was recently signed by President Obasanjo, which targets a deficit of around 2 percent, compared to the recent historical average closer to 5 percent.  I have been very pleased to hear on this visit to Nigeria that implementation of this budget is going very well. The Fiscal Responsibility Act will play a key role in smoothing out volatile expenditure.

Establishment of primary and secondary government bond markets can also increase the efficiency of monetary policy and reduce the government's need to rely on the central bank for direct financing.  In the presence of high volumes of credit to the government, private sector credit is stifled.  In Nigeria, outstanding private sector credit as a share of GDP is only about 12 percent, far below comparison countries.  The efforts to establish a debt management office in the Ministry of Finance and efforts to launch the first sovereign bond offering in Nigeria in 17 years are signs that Nigeria is moving towards better debt management and the possible establishment of a yield curve and some alternative instruments to the 91-day T-bill. 

Better and more timely monetary and national income statistics are also needed in order to better understand the relationship between economic variables and inflation, develop a more robust inflation forecasting model, and give monetary authorities more high frequency data for making quicker decisions about needed adjustments.

Conclusion

I have tried in this speech to share my thoughts on the implications of recent changes in monetary policy for Nigeria.  Of course, monetary policy is only one part of a good pro-growth economic policy.

There are good reasons to be optimistic about increasing economic growth in Nigeria. In Nigeria in particular, there is a new economic team.  It has been a pleasure to meet with Finance Minister Ngozi Okonjo-Iweala and other members of the economic team during my visit to Nigeria. I look forward to following the continued implementation of the Nigeria Economic Empowerment and Development Strategy (NEEDS).  It is a clear welcome departure from the past. 

REPORTS

• Nigeria Monetary policy Charts