An Econometric Analysis of the Monetary Policy Reaction Function in Nigeria

In the past decade, models have been developed to explain the monetary policy formulation behaviour of central banks. As expected, propositions for rules abound, among which the Taylor rule has almost come to be accepted as a benchmark, because of its simplicity, efficiency and insight into tracking historical monetary policy in many countries. However, it is accepted in the literature that some of the peculiarities of developing countries make a rigid application of the rule improper. For developing countries, therefore, the specific policy reaction function in each economy needs to be tracked. This paper specifies two simple models of monetary policy reaction functions for Nigeria: The first, a tracking model based on the revealed processes at the Central Bank of Nigeria (CBN), and an alternate model which closely follows the Taylor rule. The results confirm the primacy of inflation and credit to the private sector in the CBN’s monetary policy reaction function, which is consistent with the literature. Apart from these, however, none of the key macroeconomic variables that CBN indicates in its policy documents actually seem to have been considered in setting the interest rate policy. Empirical estimates could also not confirm interest rate smoothing, or the relevance of fiscal dominance in the reaction function. However, inflation and credit to the private sector do matter to the bank – although the first only retroactively. It is therefore apt to infer that the CBN acts consistent with its price stability and private sector-led growth objectives, but accommodates discrepancies in its goals and outcomes and, possibly without intending to do so, follows the Taylor rule