SIGNAL EXTRACTION FROM THE BOND MARKET AND INFLATION FORECASTING IN NIGERIA

SIGNAL EXTRACTION FROM THE BOND MARKET AND INFLATION FORECASTING IN NIGERIA (ECONOMICS PROJECT TOPIC)

Abstract

There is the global recognition of the importance of expectations in the conduct of monetary policy, which can be attributed to the growth of financial markets, and the fact that economic fundamentals are driven, by expectations of the market agents. In an ever changing economic and financial environment, the CBN would require all the information it can get to respond to these changes in accordance with its policy objectives. Some of such information can be sourced from the bond market. The study seeks to examine the extent to which the information on private sector expectations of inflation which is contained in the yield curve that can improve inflation forecast. This would consequently increase the information set available to the CBN to forecast future inflation. The study is predicated on the premises that are enunciated in the Expectations Theory of Term Structure of Interest Rates. The theory suggests that interest rates and prices are driven by expectations.VAR model was estimated using quarterly data on security prices, inflation, MPR, and exchange rate for the period of 2006-2013. The study finds that: (i) there is information about private sector expectation embedded in the yield curves (ii) the proxy for expectation (treasury bills with 90 days maturity) has a significant effect on inflation in Nigeria (iii) the yield spread can indeed improve inflation forecast in Nigeria. The study concludes that the information embedded in the prices of securities can improve inflation forecast and monetary policy in Nigeria. From these findings, the study recommends that CBN should increase effectiveness and efficiency of monetary policy through the inclusion of the yield curve in modeling inflation in Nigeria. Furthermore, government in collaboration with the Central Bank of Nigeria should take effective measures to improve liquidity in the bond market which often disrupt the information signals found in security prices.

CHAPTER ONE

INTRODUCTION

1.1    Background to the Study

Monetary policy plays an important role in the economy of every nation. In this regard, the Central Bank of Nigeria (CBN) is conferred with the dual mandate to pursue both price stability and economic growth. Therefore, the CBN has to formulate monetary policy in such a way that is consistent with the attainment of these goals. Monetary policy over the years has been evolving in the face of changing economic realities both domestically and internationally. The CBN came up with a number of monetary policy regimes and instruments in consonance with its objectives. The introduction of Structural Adjustment Program (SAP) led to a remarkable change in monetary policy instruments given the introduction of a market based interest rate regime. By 1993, indirect instruments (market based instruments such as Open Market Operation, Liquidity Ratio and cash reserves) emerged to guide the course of monetary policy in Nigeria. In 2006, the CBN adopted the Monetary Policy Rate (MPR) which is an overnight interest rate to replace the Minimum Rediscount Rate (CBN, 2011; Dintimi et al, 2011). In recent times, the CBN recognized that achieving stable prices would require a continuous reassessment and evaluation of its monetary policy framework to enable it respond to the ever changing economic and financial environment (CBN, 2011). This is anchored on the premise that monetary policy is a tool for enhancing a stable macroeconomic environment and a sound financial system that would promote economic growth…..

SIGNAL EXTRACTION FROM THE BOND MARKET AND INFLATION FORECASTING IN NIGERIA (ECONOMICS PROJECT TOPIC)