## _wp0497

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### I. Introduction — framing the policy question
- Objective: Assess whether announcing and pursuing a long-run target for inflation would be a good monetary policy strategy for Nigeria and whether this would be superior to fixing the exchange rate.
- Comparative benchmark: Nigeria judged against emerging market economies and developed economies that have pursued price stability under a free float.
- Core finding: Neither the stable prices/free float nor the fixed exchange rate solutions are particularly appealing for Nigeria in the long run. However, inflation targeting with a free float still seems to be a superior option on various grounds.
- Counterfactual insight: Had the Central Bank of Nigeria (CBN) been granted independence and followed a Taylor rule consistent with a single-digit inflation target over the past 20 years, monetary conditions might have been less accommodative and inflation in Nigeria might have been lower and less volatile.

### II. Historical inflation performance and fiscal drivers (1980–2003)
- Inflation history:
  - Early 1980s to second half of the 1990s: annual inflation averaged around 30 percent.
  - Subsequently: average annual inflation came down to one-digit rates.
  - Since 2001: inflation returned to two-digit territory, with an average of about 18 percent over 2000–2002.
  - Forecasts mentioned: IMF and EIU penciled in an inflation forecast of 12–14 percent for 2003; Standard Chartered forecasted around 19 percent year-on-year for 2003.
- Fiscal and oil sector linkages:
  - Oil extraction accounts for 40 percent of GDP, 70 percent of government revenue, and 95 percent of foreign exchange earnings.
  - Absent suitable fiscal rules and proper finance-management for oil-related risks, variable oil and fiscal revenues produced boom-and-bust fiscal policies and large, unpredictable movements in government deposits and ways and means accounts.
- Institutional/operational impediments complicating monetary policy implementation:
  - Fiscal largesse and weak fiscal framework.
  - Lack of operational autonomy of the central bank.
  - Insufficient and low-quality statistics.
  - Weak transmission mechanism.
  - Weak financial system.
- Operational consequence: Liquidity surprises combined with the federal government’s ability to borrow freely from the CBN at below market-clearing interest rates severely impaired the CBN’s conduct of monetary strategy and were major drivers of inflation instability since 1980.

### III. Regime choice, openness, and the “impossible trinity”
- Exchange rate arrangement: managed float.
- Policy move: July 2002 reintroduction of a bi-weekly Dutch Auction System (DAS) replacing the Interbank Foreign Exchange Market (IFEM).
  - DAS: exchange rate determined through auction where bidders pay according to their bid rates and the ruling rate is the last bid rate that clears the market.
  - Interpretation: move back to DAS signals a preference for more flexibility in the exchange rate, suggesting an inclination toward stable prices with a freely floating exchange rate.
- Theoretical constraint: “impossible trinity” — free capital mobility, fixed exchange rates, and independent domestic monetary policy cannot all be achieved simultaneously.
- Crisis precedent: major international capital market-related crises involved some form of exchange rate fixity (Mexico 1994; Thailand, Indonesia, Korea 1997; Brazil, Russia 1998; Argentina, Turkey 2000).
- Policy alternatives:
  - Corner solutions include official dollarization/euroization (giving up national monetary policy) or strengthening the national currency via inflation targeting combined with a float.

### IV. Preconditions and institutional reforms required for successful inflation targeting
- Initial reforms needed:
  - Design a workable fiscal-monetary policy mix so government borrowing no longer dominates monetary policy decisions.
  - Grant operational autonomy to the CBN while ensuring checks and balances for accountability.
  - Develop timely and consistent macroeconomic statistics.
  - Document the monetary transmission mechanism.
  - Strengthen transmission and the financial system, including reform of the foreign exchange market to prevent multiple markets.
- Emerging-market-specific concerns to address:
  - Susceptibility to external shocks.
  - Sensitivity of output and inflation to exchange rate movements (“external dominance”).
  - Credibility of the central bank.
  - Fiscal dominance.
  - Soundness of the financial sector.

### V. Analytical checklist for assessing suitability of inflation targeting in Nigeria
- A rigorous assessment should examine:
  - (i) degree of openness of the Nigerian economy;
  - (ii) extent to which changes in the exchange rate are “passed through” into domestic prices;
  - (iii) extent of existing indexation in price and wage contracts;
  - (iv) potential ability of the CBN to forecast inflation given long and variable monetary policy lags;
  - (v) degree of commodity-price sensitivity of Nigerian consumer price inflation;
  - (vi) sensitivity of domestic financial conditions to international capital flows;
  - (vii) extent of liability dollarization/euroization;
  - (viii) credibility of the central bank;
  - (ix) severity of “fiscal dominance” and the soundness of the financial sector.

### VI. Stylized facts and volatility considerations (lead into empirical section)
- Rationale: Emerging market economies generally face more volatile macroeconomic environments and weaker institutional credibility than developed economies, making price stabilization harder.
- Purpose: Compare volatilities of consumer price annual inflation, the nominal effective exchange rate, GDP growth, and the short-term nominal interest rate for groups of inflation-targeting developed economies and emerging market economies from 1997 Q1 to 2002 Q2 to gauge Nigeria’s relative volatility and susceptibility to external shocks.

### Volatility and Averages (1997 Q1–2002 Q2)
- Developed economies (average and median):
  - Average volatility: Inflation 1.24, Exchange Rate 0.09, GDP Growth 1.86, Interest Rate 1.27
  - Average GDP Growth 3.05, Average Inflation 2.11
  - Median: Inflation 1.02, Exchange Rate 0.08, GDP Growth 1.85, Interest Rate 1.14, GDP Growth 2.77, Inflation 2.11
- Emerging market economies (average and median):
  - Average volatility: Inflation 3.61, Exchange Rate 0.14, GDP Growth 3.15, Interest Rate 5.07
  - Average GDP Growth 2.50, Average Inflation 7.02
  - Median: Inflation 3.25, Exchange Rate 0.13, GDP Growth 3.16, Interest Rate 5.50, GDP Growth 2.69, Inflation 5.99
- Nigeria-specific findings:
  - Nigeria exhibits the highest inflation volatility 6.49 and exchange rate variability 0.31 among listed emerging market economies.
  - Nigeria has the lowest output volatility 0.58 in the emerging market sample.
  - Nigeria’s interest rate volatility 3.45 is slightly smaller than South Africa’s and much smaller than Brazil’s but slightly larger than Chile’s.
  - Nigeria’s average inflation over the period is the fourth highest in the emerging market group, following Colombia, Mexico and Hungary.
  - Nigeria’s GDP growth 3.28 is among the most buoyant in the emerging market group, second only to South Korea, Mexico, and Poland (all grew on average around 4 percent a year between 1997 and 2002).

### Openness
- Openness measure: ratio of total trade (average imports of goods and services plus exports of goods and services) to GDP.
- Total trade-to-GDP ratios (memo 1997-2002 and averages):
  - Brazil: Average Past 5 years 0.24; Average Past 10 years 0.20; Memo 1997-2002 0.23
  - Chile: Average Past 5 years 0.21; Average Past 10 years 0.15; Memo 1997-2002 0.20
  - Nigeria: Average Past 5 years 0.69; Average Past 10 years 0.63; Memo 1997-2002 0.70
  - South Africa: Average Past 5 years 0.55; Average Past 10 years 0.49; Memo 1997-2002 0.54
- Implications:
  - Nigeria’s total trade-to-GDP ratio around 70 percent is almost three times Brazil’s and Chile’s and one-third larger than South Africa’s.
  - High openness exposes Nigeria to commodity and financial market shocks, complicating achievement of stable prices and requiring the monetary authority to discern shock sources and durations.

### Exchange Rate Pass-Through
- VARs estimated for Brazil, Chile, Nigeria, South Africa, and a set of inflation-targeting developed economies (1990 Q1–2002 Q4) with variables: consumer price inflation; (log) real output deviations from HP trend (λ = 1,600); exchange rate (levels or changes); short-term nominal interest rate. Identification via Choleski decomposition ordering exchange rate→output gap→inflation→interest rate.
- Variance error decomposition (percentage of inflation forecast error explained by exchange rate shocks) — VAR with Exchange Rate in Levels (4-, 8-, 12-quarter):
  - Brazil: 58* / 44* / 38*
  - Chile: 1 / 2 / 4
  - Nigeria: 1 / 14 / 17
  - South Africa: 4 / 3 / 5
  - Developed economies (examples): Australia 12 / 3 / 1; Canada 0 / 1 / 2; New Zealand 1 / 0 / 5; Sweden 4 / 1 / 4; United Kingdom 0 / 0 / 1
- VAR with Exchange Rate in First Differences (4-, 8-, 12-quarter):
  - Brazil: 79* / 75* / 78*
  - Chile: 3 / 3 / 2
  - Nigeria: 3 / 88* / 87*
  - South Africa: 18 / 16 / 15
- Findings:
  - Exchange rate shocks explain a much larger share of inflation forecast error in emerging market economies than in developed economies.
  - For Brazil: exchange rate explains between 38 percent and 79 percent of inflation forecast errors depending on specification and horizon.
  - For Nigeria: using first differences of exchange rate, the exchange rate explains around 88 percent and 87 percent of inflation forecast errors at 8- and 12-quarter horizons (significant at 5 percent).
  - Conclusion: Nigerian inflation is highly influenced by exchange rate fluctuations, with substantial pass-through and long variable lags; this complicates building credibility for price stabilization and may induce interventions (“fear of floating”).

### Commodity-Price Sensitivity
- Oil’s role in Nigeria:
  - Oil accounts for 40 percent of Nigerian GDP and 95 percent of foreign exchange earnings.
- VAR variance decomposition including first difference of log price of oil (US$) for Nigeria; first difference of log price of gold for South Africa.
- Results:
  - Changes in the price of oil explain (not significantly) 13 percent, 15 percent, and 15 percent of forecast errors in Nigerian CPI inflation at 4-, 8-, and 12-quarter horizons, respectively.
  - Corresponding percentages for Nigeria’s output gap: 1 percent, 0 percent, and 2 percent.
  - Changes in the price of gold explain (significant at 12-quarter) 16 percent, 16 percent, and 22 percent of forecast errors in South African CPI inflation at 4-, 8-, and 12-quarter horizons, respectively.
  - Corresponding percentages for South Africa’s output gap: 2 percent, 8 percent, and 31 percent.
- Interpretation:
  - Nigerian CPI inflation appears not too sensitive to international oil price changes; Nigeria seems less sensitive to commodity price changes than South Africa.
  - Possible explanation: Nigeria may be more sensitive to changes in oil quantities exported (e.g., OPEC quota) rather than world oil price movements.
  - Implication: oil price fluctuations may not be a severe hindrance to central bank attempts to stabilize consumer price level.

### Fiscal Sustainability and Risk Premiums on Sovereign Debt
- EMBI+ spread (monthly averages, January 1997–December 2002) measures investor risk premium on dollar-denominated sovereign debt (J.P. Morgan EMBI+).
- EMBI+ statistics:
  - Brazil: Average 879.35; Standard Deviation 389.07; Coefficient of Variation 0.44
  - Colombia: Average 651.18; Standard Deviation 118.48; Coefficient of Variation 0.18
  - Mexico: Average 443.40; Standard Deviation 150.03; Coefficient of Variation 0.34
  - Nigeria: Average 1634.52; Standard Deviation 129.83; Coefficient of Variation 0.08
  - Peru: Average 601.75; Standard Deviation 120.64; Coefficient of Variation 0.20
  - Poland: Average 233.03; Standard Deviation 38.17; Coefficient of Variation 0.16
  - South Korea: Average 236.37; Standard Deviation 145.39; Coefficient of Variation 0.62
- Key points:
  - Nigeria’s EMBI+ spread is the highest in the group 1634.52 basis points, around 670 basis points higher than Brazil (the second highest).
  - Spreads are volatile; Nigeria’s spread is also volatile though its coefficient of variation is relatively low 0.08 due to high average.
  - Market perception: Nigerian government debt seen as highly risky; fiscal stance appears extremely vulnerable.
  - Consequences for monetary policy:
    - High and volatile risk premium increases exchange rate volatility via capital flow reversals.
    - EMBI+ changes affect inflation expectations, exchange rate, and short-term policy rates.
    - Fiscal vulnerability implies central bank may be “fiscally dominated,” limiting scope for active monetary policy aimed at price stability.

### Policy Implications and Regime Choice
- Assessment:
  - Nigeria does not enjoy ideal conditions for a stable prices/free float regime focused on price stabilization under a freely floating exchange rate because:
    - Very volatile macroeconomic environment and more acute inflation-output trade-off than other emerging market economies that have abandoned exchange rate anchors.
    - High openness and exposure to external shocks due to oil-export orientation.
    - High exchange rate pass-through to consumer prices.
    - Large and volatile sovereign risk premia and fiscal vulnerability implying fiscal dominance.
- Alternative corner solution — unilateral dollarization/euroization — drawbacks:
  - Sacrifices seigniorage revenue (important given Nigeria’s weak tax system).
  - Complicates relative price adjustments and requires domestic price deflation under external shocks, causing output losses and worsening public finances.
  - Limits policy flexibility and surrenders monetary policy to foreign authority.
  - Exposes reserves and a fixed parity to speculative attacks; implicit insurance against currency risk may induce unhedged foreign liabilities and severe contagion on forced devaluation.
- Practical recommendation:
  - Stable prices/free float remains the less dangerous, practical second-best for Nigeria.
  - Preferable long-run form: inflation targeting, ideally “full-fledged” inflation targeting with institutional commitment.
  - Justifications:
    - Can raise institutional commitment to price stability and align fiscal policy with monetary policy.
    - Consistent with Nigeria’s role in the West African Monetary Zone (WAMZ) and ECOWAS plans (e.g., reduction of inflation below 5 percent as a convergence criterion).
    - Does not rule out occasional, sterilized exchange rate interventions or a crawling band for the exchange rate while keeping inflation target priority.

### Operationalizing Price Stability: Targets and Instruments
- Recommended long-run inflation target:
  - International practice: long-run inflation goals slightly above zero, midpoints of long-run target ranges lying between 1 and 3 percent.
  - For Nigeria: a similar long-run target between 1 percent and 4 percent would be appropriate; given current double-digit inflation, interim targets would be needed.
- Rationale and caveats:
  - Zero percent target debated; arguments for positive low target include avoiding downward nominal wage rigidity and deflation risk.
  - Targets above 3–4 percent generally discouraged due to adverse effects on growth, credibility, and inflation volatility.
  - Interim targets should be calibrated to central bank credibility and Nigeria’s inflation-output trade-off.
- Institutional prerequisites for full-fledged inflation targeting (per Mishkin (2000)):
  - (i) Public announcement of medium-term numerical targets for inflation.
  - (ii) Institutional commitment to price stability as primary objective.
  - (iii) Information-inclusive strategy (many variables used for decisions).
  - (iv) Increased transparency and communication with public and markets.
  - (v) Increased accountability of the central bank for attaining objectives.
- Operational tools:
  - A simple rule (e.g., Taylor rule) can serve as a benchmark for setting short-term nominal interest rates while pursuing the inflation target.
  - Inflation forecasting plays a critical role; policy should focus on stabilizing expected inflation.

### Taylor Rule Application and Historical Findings for Nigeria
- Taylor rule specification (pseudo-formula):
  - Nominal interest rate = a + b × (actual inflation – inflation target) + c × (percentage difference between real and potential output)
  - a is the nominal equilibrium interest rate; b and c are positive parameters.
- Principles for emerging market adaptation:
  - b (response to inflation) may need to be larger due to lower credibility and weaker term-structure transmission.
  - Expected inflation (not lagged inflation) should be used; absent data, current inflation can be used.
  - Equilibrium real interest rate must align with expected potential growth (typical range 2 percent to 6 percent).
  - De-emphasize or eliminate feedback on output gap (set c = 0) due to measurement problems.
  - Consider augmenting the rule with exchange rate feedback given strong exchange rate channel.
  - In some cases, consider money-based rules rather than interest-rate-based ones if investment/export shocks dominate or interest rate measurement is unreliable.
- Historical Taylor-rule-implied analysis:
  - Parameter permutations: a (real equilibrium interest rate 2–5 percent), b (0–1), c (0–1); inflation target choices included implicit subperiod midpoints and a hypothetical 4 percent long-run target after 1996.
  - Findings:
    - 1991–1996: actual Minimum Rediscount Rate (MRR) was “exceptionally loose” relative to Taylor-implied rates; deviations up to 9000 basis points (90 percentage points). Monetary financing of deficits averaged 5.6 percent of GDP annually.
    - Post-1996 to about end-1999: monetary policy aligns more closely with Taylor-rule prescriptions under stationary 4 percent inflation goal; monetary policy tightened in 1998 H2–1999 H2.
    - Post-1999/early 2000s: monetary conditions again appear “too loose” relative to rule, reflecting fiscal largesse and administratively-set interest rate ceilings.
  - Corollary: Greater institutional CBN autonomy and fiscal prudence would be necessary to maintain or achieve sustainable one-digit inflation rates.
- Cross-country comparisons:
  - Brazil, Chile, South Africa: interest rates diverged more from Taylor-implied rates before adoption of inflation targets than after, suggesting inflation targeting can discipline policy.

### Concluding Remarks and Policy Recommendations
- Overall assessment:
  - A stable prices/free float regime focused on inflation targeting, ideally full-fledged, is the recommended long-run option for Nigeria despite imperfect initial conditions.
  - Neither stable prices/free float nor unilateral dollarization/euroization is an obvious panacea; each has significant drawbacks in Nigeria’s context.
- Recommended policy package:
  - Adopt inflation targeting with a long-run numerical target between 1 percent and 4 percent, with interim targets to transition from current double-digit inflation.
  - Institutional reforms to clarify CBN mandate, enhance operational independence (instrument independence), transparency, accountability, and communication.
  - Fiscal consolidation to reduce fiscal dominance: reduce fiscal deficits, strengthen tax system, build financial buffers against oil price shocks.
  - Use a modified Taylor-rule-like plan as a benchmark for short-term policy setting, adapted for emerging market characteristics (stronger inflation response, cautious use of output gap, consideration of exchange rate channel).
  - Allow limited, sterilized exchange rate interventions (e.g., crawling band) while keeping inflation target priority.
- Final policy implication:
  - Had Nigeria followed a rule-consistent, independent monetary policy in past decades, monetary conditions might have been tighter and inflation lower and less volatile; achieving sustainable low inflation now requires combining institutional commitment, credible policy rules, and fiscal discipline.

*Source: IMF Working Paper — Author’s calculations and analysis based on IMF IFS data and J.P. Morgan EMBI+ data as presented in the source document.*

### 1. Volatility and Average of Selected Variables for 1997 Q1-2002 Q2 ..........................10

### 1. Volatility and Average of Selected Variables for 1997 Q1-2002 Q2

### I. Introduction — framing the policy question
- Objective: Assess whether announcing and pursuing a long-run target for inflation would be a good monetary policy strategy for Nigeria and whether this would be superior to fixing the exchange rate.
- Comparative benchmark: Nigeria’s stance is judged against emerging market economies and developed economies that have pursued price stability under a free float.
- Core finding (summary from analysis): Neither the stable prices/free float nor the fixed exchange rate solutions are particularly appealing for Nigeria in the long run. However, inflation targeting with a free float still seems to be a superior option on various grounds.
- Counterfactual insight: Results suggest that, had the Central Bank of Nigeria (CBN) been granted independence and followed a Taylor rule consistent with a single-digit inflation target over the past 20 years, monetary conditions might have been less accommodative and inflation in Nigeria might have been lower and less volatile.

### II. Historical inflation performance and fiscal drivers (1980–2003)
- Recent inflation dynamics:
  - From the early 1980s to the second half of the 1990s, annual inflation averaged around 30 percent.
  - Subsequently average annual inflation came down to one-digit rates.
  - Since 2001, inflation returned to two-digit territory, with an average of about 18 percent over 2000–2002.
  - Forecasts mentioned in the period: IMF and EIU penciled in an inflation forecast of 12–14 percent for 2003; Standard Chartered forecasted around 19 percent year-on-year for 2003.
- Fiscal and oil sector linkages:
  - Oil extraction accounts for 40 percent of GDP, 70 percent of government revenue, and 95 percent of foreign exchange earnings.
  - Absent suitable fiscal rules and proper finance-management for oil-related risks, variable oil and fiscal revenues have produced boom-and-bust fiscal policies and large, unpredictable movements in government deposits and ways and means accounts.
- Institutional/operational impediments highlighted as complicating monetary policy implementation:
  - Fiscal largesse and weak fiscal framework.
  - Lack of operational autonomy of the central bank.
  - Insufficient and low-quality statistics.
  - Weak transmission mechanism.
  - Weak financial system.
- Operational consequence: Liquidity surprises combined with the federal government’s ability to borrow freely from the CBN at below market-clearing interest rates severely impaired the CBN’s conduct of monetary strategy and were major drivers of inflation instability since 1980.

### III. Regime choice, openness, and the “impossible trinity”
- Exchange rate arrangement: Classified as a managed float.
- Policy move: In July 2002, Nigeria reintroduced a bi-weekly Dutch Auction System (DAS) for the foreign exchange market to replace the Interbank Foreign Exchange Market (IFEM).
  - DAS mechanism: Exchange rate determined through auction where bidders pay according to their bid rates and the ruling rate is the last bid rate that clears the market.
  - Interpretation: The move back to DAS signals a preference for more flexibility in the exchange rate, suggesting an inclination toward stable prices with a freely floating exchange rate.
- Theoretical constraint: The “impossible trinity”—an open economy cannot simultaneously have free capital mobility, fixed exchange rates, and an independent domestic monetary policy—implies trade-offs for Nigeria.
- Crisis precedent: Major international capital market-related crises involved some form of exchange rate fixity (examples cited: Mexico 1994; Thailand, Indonesia, Korea 1997; Brazil, Russia 1998; Argentina, Turkey 2000).
- Policy alternatives distilled:
  - Corner solutions include official dollarization/euroization (giving up national monetary policy) or strengthening the national currency via inflation targeting combined with a float.

### IV. Preconditions and institutional reforms required for successful inflation targeting
- Institutional and operational issues Nigeria must initially address to pursue a stable-prices/free float regime:
  - Design a workable fiscal-monetary policy mix so government borrowing no longer dominates monetary policy decisions.
  - Grant operational autonomy to the CBN while ensuring checks and balances for accountability.
  - Develop timely and consistent macroeconomic statistics.
  - Document the monetary transmission mechanism.
  - Implement measures to strengthen transmission and the financial system, including reform of the foreign exchange market to prevent multiple markets.
- Emerging-market-specific concerns for inflation targeting that require attention:
  - Susceptibility to external shocks.
  - Sensitivity of output and inflation to exchange rate movements (“external dominance”).
  - Credibility of the central bank.
  - Fiscal dominance.
  - Soundness of the financial sector.

### V. Analytical checklist for assessing suitability of inflation targeting in Nigeria
- A rigorous assessment should examine:
  - (i) the degree of openness of the Nigerian economy;
  - (ii) the extent to which changes in the exchange rate are “passed through” into domestic prices;
  - (iii) the extent of existing indexation in price and wage contracts;
  - (iv) the potential ability of the CBN to forecast inflation given long and variable monetary policy lags;
  - (v) the degree of commodity-price sensitivity of Nigerian consumer price inflation;
  - (vi) the sensitivity of domestic financial conditions to international capital flows;
  - (vii) the extent of liability dollarization/euroization;
  - (viii) the credibility of the central bank;
  - (ix) the severity of “fiscal dominance” and the soundness of the financial sector.

### VI. Stylized facts and volatility considerations (lead into empirical section)
- Rationale: Emerging market economies generally face more volatile macroeconomic environments and weaker institutional credibility than developed economies, making price stabilization harder.
- Purpose of empirical comparison (reported later in the paper): Compare volatilities of consumer price annual inflation, the nominal effective exchange rate, GDP growth, and the short-term nominal interest rate for groups of inflation-targeting developed economies and emerging market economies from 1997 Q1 to 2002 Q2 to gauge Nigeria’s relative volatility and susceptibility to external shocks.

*Source: IMF Working Paper — 1. Volatility and Average of Selected Variables for 1997 Q1-2002 Q2*

### 3.7 percent to 2.5 percent after the adoption of the targets (up to 2002 Q2). Results in

### _wp0497 - 3.7 percent to 2.5 percent after the adoption of the targets (up to 2002 Q2). Results in

### Volatility and Averages (1997 Q1–2002 Q2)
- Table 1 summarizes volatilities and averages for inflation, exchange rate (units of US$ to domestic currency), GDP growth (SD of growth in GDP at constant prices (1995Q1=100)), interest rate, and average GDP growth and inflation for selected developed and emerging market economies.
- Developed economies (average and median):
  - Average volatility: Inflation 1.24, Exchange Rate 0.09, GDP Growth 1.86, Interest Rate 1.27
  - Average GDP Growth 3.05, Average Inflation 2.11
  - Median: Inflation 1.02, Exchange Rate 0.08, GDP Growth 1.85, Interest Rate 1.14, GDP Growth 2.77, Inflation 2.11
- Emerging market economies (average and median):
  - Average volatility: Inflation 3.61, Exchange Rate 0.14, GDP Growth 3.15, Interest Rate 5.07
  - Average GDP Growth 2.50, Average Inflation 7.02
  - Median: Inflation 3.25, Exchange Rate 0.13, GDP Growth 3.16, Interest Rate 5.50, GDP Growth 2.69, Inflation 5.99
- Nigeria-specific findings:
  - Nigeria exhibits the highest inflation volatility (6.49) and exchange rate variability (0.31) among listed emerging market economies.
  - Nigeria has the lowest output volatility (0.58) in the emerging market sample.
  - Nigeria’s interest rate volatility (3.45) is slightly smaller than South Africa’s and much smaller than Brazil’s but slightly larger than Chile’s.
  - Nigeria’s average inflation over the period is the fourth highest in the emerging market group, following Colombia, Mexico and Hungary.
  - Nigeria’s GDP growth (3.28) is among the most buoyant in the emerging market group, second only to South Korea, Mexico, and Poland (all grew on average around 4 percent a year between 1997 and 2002).

### Openness
- Openness is measured as the ratio of total trade (average imports of goods and services plus exports of goods and services) to GDP.
- Table 2: Total trade-to-GDP ratios
  - Brazil: Average Past 5 years 0.24; Average Past 10 years 0.20; Memo 1997-2002 0.23
  - Chile: Average Past 5 years 0.21; Average Past 10 years 0.15; Memo 1997-2002 0.20
  - Nigeria: Average Past 5 years 0.69; Average Past 10 years 0.63; Memo 1997-2002 0.70
  - South Africa: Average Past 5 years 0.55; Average Past 10 years 0.49; Memo 1997-2002 0.54
- Key implications:
  - Nigeria’s average ratio of total trade to GDP (around 70 percent in the past 5 to 10 years) is almost three times Brazil’s and Chile’s and one-third larger than South Africa’s.
  - High openness exposes Nigeria to commodity and financial market shocks, complicating achievement of stable prices and requiring the monetary authority to discern shock sources and durations.

### Exchange Rate Pass-Through
- VARs estimated for Brazil, Chile, Nigeria, South Africa, and a set of inflation-targeting developed economies (1990 Q1–2002 Q4), with variables: consumer price inflation; (log) real output deviations from HP trend (λ = 1,600); exchange rate (levels or changes); short-term nominal interest rate. Identification via Choleski decomposition with ordering exchange rate→output gap→inflation→interest rate.
- Table 3: Variance error decomposition (percentage of inflation forecast error explained by exchange rate shocks)
  - VAR with Exchange Rate in Levels (4-, 8-, 12-quarter):
    - Brazil: 58* / 44* / 38*
    - Chile: 1 / 2 / 4
    - Nigeria: 1 / 14 / 17
    - South Africa: 4 / 3 / 5
    - Developed economies (examples): Australia 12 / 3 / 1; Canada 0 / 1 / 2; New Zealand 1 / 0 / 5; Sweden 4 / 1 / 4; United Kingdom 0 / 0 / 1
  - VAR with Exchange Rate in First Differences (4-, 8-, 12-quarter):
    - Brazil: 79* / 75* / 78*
    - Chile: 3 / 3 / 2
    - Nigeria: 3 / 88* / 87*
    - South Africa: 18 / 16 / 15
- Findings:
  - Exchange rate shocks explain a much larger share of inflation forecast error in emerging market economies than in developed economies.
  - For Brazil, exchange rate explains between 38 percent and 79 percent of inflation forecast errors depending on specification and horizon.
  - For Nigeria, when using first differences of exchange rate, the exchange rate explains around 88 percent and 87 percent of inflation forecast errors at 8- and 12-quarter horizons (significant at 5 percent).
  - Conclusion: Nigerian inflation is highly influenced by exchange rate fluctuations, with substantial pass-through and long variable lags; this complicates building credibility for price stabilization and may induce interventions (“fear of floating”).

### Commodity-Price Sensitivity
- Oil’s role in Nigeria:
  - Oil accounts for 40 percent of Nigerian GDP and 95 percent of foreign exchange earnings.
- VAR variance decomposition including first difference of log price of oil (US$) for Nigeria; first difference of log price of gold for South Africa.
- Results (not in Table 3):
  - Changes in the price of oil explain (not significantly) 13 percent, 15 percent, and 15 percent of forecast errors in Nigerian CPI inflation at 4-, 8-, and 12-quarter horizons, respectively.
  - Corresponding percentages for Nigeria’s output gap: 1 percent, 0 percent, and 2 percent.
  - Changes in the price of gold explain (significant at 12-quarter) 16 percent, 16 percent, and 22 percent of forecast errors in South African CPI inflation at 4-, 8-, and 12-quarter horizons, respectively.
  - Corresponding percentages for South Africa’s output gap: 2 percent, 8 percent, and 31 percent.
- Interpretation:
  - Nigerian CPI inflation appears not too sensitive to international oil price changes; Nigeria seems less sensitive to commodity price changes than South Africa.
  - Possible explanation: Nigeria may be more sensitive to changes in oil quantities exported (e.g., OPEC quota) rather than world oil price movements.
  - Implication: oil price fluctuations may not be a severe hindrance to central bank attempts to stabilize consumer price level.

### Fiscal Sustainability and Risk Premiums on Sovereign Debt
- EMBI+ spread (monthly averages, January 1997–December 2002) measures investor risk premium on dollar-denominated sovereign debt (J.P. Morgan EMBI+).
- Table 4: EMBI+ (average, standard deviation, coefficient of variation)
  - Brazil: Average 879.35; Standard Deviation 389.07; Coefficient of Variation 0.44
  - Colombia: Average 651.18; Standard Deviation 118.48; Coefficient of Variation 0.18
  - Mexico: Average 443.40; Standard Deviation 150.03; Coefficient of Variation 0.34
  - Nigeria: Average 1634.52; Standard Deviation 129.83; Coefficient of Variation 0.08
  - Peru: Average 601.75; Standard Deviation 120.64; Coefficient of Variation 0.20
  - Poland: Average 233.03; Standard Deviation 38.17; Coefficient of Variation 0.16
  - South Korea: Average 236.37; Standard Deviation 145.39; Coefficient of Variation 0.62
  - Notes: Exact samples vary by country; data for 1997 for Brazil and Mexico refer to EMBI, not EMBI+.
- Key points:
  - Nigeria’s EMBI+ spread is the highest in the group (1634.52 basis points), around 670 basis points higher than Brazil (the second highest).
  - Spreads are volatile; Nigeria’s spread is also volatile though its coefficient of variation is relatively low (0.08) due to high average.
  - Market perception: Nigerian government debt is seen as highly risky; fiscal stance appears extremely vulnerable.
  - Consequences for monetary policy:
    - High and volatile risk premium increases exchange rate volatility via capital flow reversals.
    - EMBI+ changes affect inflation expectations, exchange rate, and short-term policy rates.
    - Fiscal vulnerability implies central bank may be “fiscally dominated,” limiting scope for active monetary policy aimed at price stability.

### Policy Implications and Regime Choice
- Nigeria does not enjoy ideal conditions for a stable prices/free float regime focused on price stabilization under a freely floating exchange rate because:
  - Very volatile macroeconomic environment and more acute inflation-output trade-off than other emerging market economies that have abandoned exchange rate anchors.
  - High openness and exposure to external shocks due to oil-export orientation.
  - High exchange rate pass-through to consumer prices.
  - Large and volatile sovereign risk premia and fiscal vulnerability implying fiscal dominance.
- Alternative corner solution—unilateral dollarization/euroization—has drawbacks:
  - Sacrifices seigniorage revenue (important given Nigeria’s weak tax system).
  - Complicates relative price adjustments and requires domestic price deflation under external shocks, causing output losses and worsening public finances.
  - Limits policy flexibility and surrenders monetary policy to foreign authority.
  - Exposes reserves and a fixed parity to speculative attacks; implicit insurance against currency risk may induce unhedged foreign liabilities and severe contagion on forced devaluation.
- Practical recommendation:
  - Stable prices/free float remains the less dangerous, practical second-best for Nigeria.
  - Preferable long-run form: inflation targeting, ideally “full-fledged” inflation targeting with institutional commitment.
  - Justifications:
    - Can raise institutional commitment to price stability and align fiscal policy with monetary policy.
    - Consistent with Nigeria’s role in the West African Monetary Zone (WAMZ) and ECOWAS plans (e.g., reduction of inflation below 5 percent as a convergence criterion).
    - Does not rule out occasional, sterilized exchange rate interventions or a crawling band for the exchange rate while keeping inflation target priority.

### Operationalizing Price Stability: Targets and Instruments
- Recommended long-run inflation target:
  - International practice: long-run inflation goals slightly above zero, midpoints of long-run target ranges lying between 1 and 3 percent.
  - For Nigeria: a similar long-run target between 1 percent and 4 percent would be appropriate; given current double-digit inflation, interim targets would be needed.
- Rationale and caveats:
  - Zero percent target debated; arguments for positive low target include avoiding downward nominal wage rigidity and deflation risk.
  - Targets above 3–4 percent generally discouraged due to adverse effects on growth, credibility, and inflation volatility.
  - Interim targets should be calibrated to central bank credibility and Nigeria’s inflation-output trade-off.
- Institutional prerequisites for full-fledged inflation targeting (per Mishkin (2000)):
  - (i) Public announcement of medium-term numerical targets for inflation.
  - (ii) Institutional commitment to price stability as primary objective.
  - (iii) Information-inclusive strategy (many variables used for decisions).
  - (iv) Increased transparency and communication with public and markets.
  - (v) Increased accountability of the central bank for attaining objectives.
- Operational tools:
  - A simple rule (e.g., Taylor rule) can serve as a benchmark for setting short-term nominal interest rates while pursuing the inflation target.
  - Inflation forecasting plays a critical role; policy should focus on stabilizing expected inflation.

### Taylor Rule Application and Historical Findings for Nigeria
- Taylor rule specification (pseudo-formula):
  - Nominal interest rate = a + b × (actual inflation – inflation target) + c × (percentage difference between real and potential output)
  - a is the nominal equilibrium interest rate (long-run real equilibrium interest rate plus steady-state inflation); b and c are positive parameters.
- Principles for emerging market adaptation:
  - b (response to inflation) may need to be larger due to lower credibility and weaker term-structure transmission.
  - Expected inflation (not lagged inflation) should be used in constructing the nominal equilibrium interest rate; absent data, current inflation can be used.
  - Equilibrium real interest rate must align with expected potential growth (typical range 2 percent to 6 percent).
  - De-emphasize or eliminate feedback on output gap (set c = 0) due to measurement problems in GDP and potential output.
  - Consider augmenting the rule with exchange rate feedback given strong exchange rate channel.
  - In some cases, consider money-based rules rather than interest-rate-based ones if investment/export shocks dominate or interest rate measurement is unreliable.
- Historical Taylor-rule-implied analysis (Figure 5 and discussion):
  - Parameter permutations used: a (real equilibrium interest rate 2–5 percent), b (0–1), c (0–1); inflation target choices included implicit subperiod midpoints and a hypothetical 4 percent long-run target after 1996.
  - Two main findings:
    - 1991–1996: actual Minimum Rediscount Rate (MRR) was “exceptionally loose” relative to Taylor-implied rates; deviations up to 9000 basis points (90 percentage points). Monetary policy was constrained by fiscal financing (monetary financing of deficits averaged 5.6 percent of GDP annually).
    - Post-1996 to about end-1999: monetary policy aligns more closely with Taylor-rule prescriptions under stationary 4 percent inflation goal; monetary policy tightened in 1998 H2–1999 H2. More recently (post-1999/early 2000s), monetary conditions again appear “too loose” relative to rule, reflecting fiscal largesse and administratively-set interest rate ceilings.
  - Corollary: Greater institutional CBN autonomy and fiscal prudence would be necessary to maintain or achieve sustainable one-digit inflation rates.
- Cross-country Taylor rule comparisons (Brazil, Chile, South Africa):
  - Figures 6–8 show interest rates diverged more from Taylor-implied rates before adoption of inflation targets than after, suggesting inflation targeting can discipline policy.
  - Brazil and South Africa had periods with interest rates below rule-implied paths (violating the Taylor principle), potentially explaining deviations from targets.

### Concluding Remarks and Policy Recommendations
- Overall assessment:
  - A stable prices/free float regime focused on inflation targeting, ideally full-fledged, is the recommended long-run option for Nigeria despite imperfect initial conditions.
  - Neither stable prices/free float nor unilateral dollarization/euroization is an obvious panacea; each has significant drawbacks in Nigeria’s context.
- Recommended policy package:
  - Adopt inflation targeting with a long-run numerical target between 1 percent and 4 percent, with interim targets to transition from current double-digit inflation.
  - Institutional reforms to clarify CBN mandate, enhance operational independence (instrument independence), transparency, accountability, and communication.
  - Fiscal consolidation to reduce fiscal dominance: reduce fiscal deficits, strengthen tax system, build financial buffers against oil price shocks.
  - Use a modified Taylor-rule-like plan as a benchmark for short-term policy setting, adapted for emerging market characteristics (stronger inflation response, cautious use of output gap, consideration of exchange rate channel).
  - Allow limited, sterilized exchange rate interventions (e.g., crawling band) while keeping inflation target priority.
- Final policy implication:
  - Had Nigeria followed a rule-consistent, independent monetary policy in past decades, monetary conditions might have been tighter and inflation lower and less volatile; achieving sustainable low inflation now requires combining institutional commitment, credible policy rules, and fiscal discipline.

*Source: Author’s calculations and analysis based on IMF IFS data and J.P. Morgan EMBI+ data as presented in the source document.*

### References

### References

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### D–G
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### I–M
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### N–S
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### T–Z
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*Source: _wp0497 - References*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2004/_wp0497.pdf_