Signal Extraction From The Bond Market And Inflation Forecasting In Nigeria

Project and Seminar Material for Economics

Signal Extraction From The Bond Market And Inflation Forecasting In Nigeria


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:

  1. There is information about private sector expectation embedded in the yield curves
  2. The proxy for expectation (treasury bills with 90 days maturity) has a significant effect on inflation in Nigeria
  3. 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


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.

Recent literature on the theory of monetary policy point to the fact that the success of monetary policy does not depend solely on the effective control of short-term interest rates, but also on the Central Bank’s ability to shape market expectation of how interest rates and inflation are likely to evolve overtime (Brand, Buncic and Turunen, , 2008). This was attributed to the fact that financial markets have grown globally and prices are driven by expectations of market agents. In a world governed by the rational expectation paradigm, economic agents are forward looking and form their expectations efficiently and homogeneously using all information available including precise knowledge of the economy (ECB, 2009). Such information about the functioning of the economy and the stance of monetary policy has been acknowledged as the principal drivers of interest rates and asset prices. Market expectations are shaped in part by the future course of actions of the Central Bank. Therefore monetary policy can only be effective if it is effective in coordinating market expectations (Jeffery, Stephen and Hyun, 2003). Thus, the CBN must coordinate private agents’ expectations in a way that is consistent with its inflation target. To do this, the central bank makes public its forecast and stance on monetary policy.

Inflation expectations have a great influence on actual inflation. Unsurprisingly, central banks monitor closely inflation expectations of private agents, as they provide useful signals of emerging risks to price stability (Coffinet, Mesonnier, and Lang, 2009). Therefore, knowing what such expectations are and targeting it, is an important input of monetary policy. A good forecast of inflation must capture inflation expectations because it is one of the channels through which monetary policy affects the real economy. Information on private sector expectations can be sourced from central bank surveys and financial instruments (ECB, 2011). Monitoring information regarding inflation expectations, as reflected in surveys or financial markets, for instance, has been part of the policy process at many central banks (Orphanides and John, 2003). In pursuit of its objectives, the CBN therefore cannot conduct a successful proactive monetary policy that is capable of predicting the future path of inflation and the state of the economy without gathering accurate and credible information about the economy. Much emphasis is placed on future inflation as opposed to current inflation because monetary policy affects the economy with lags. In other words, a monetary policy change takes a certain amount of time to have full effect on the real economy. For this reason, the CBN requires information some of which can be obtained from the bond market. The bonds market is the market for debts of various maturities and serves as a source of information that provides efficient estimates of inflation and the state of the economy (Nimark, 2008). Asset prices embody more accurate and up to date macroeconomic information than what is currently published or directly available to policy makers (Soderlind and Svesson, 1996).

The reason being that securities are sold on a daily basis and so reflect market participants’ expectations on day-to-day bases. On theoretical grounds, the information contained in asset prices can be tied to the fact that yields of various maturities contain a premium for risk or expected inflation. Therefore, this kind of information which is useful in the forecast of inflation can be extracted from the shape of the yield curve. This is because the yield curve embeds private sector expectations of inflation and their views on the future outlook of theeconomy. Information in the yield curve refers to the ability of its slope to predict future changes in inflation and future outlook of the economy. To get accurate results, the yield curve should be modeled alongside other economic indicators (Good friend, 1998). This is because volatility and uncertainty do exist in the bond market, and so observing the term structure or the yields on securities in such situations would be uninformative. Basically, the information embedded in asset prices cannot be ignored because it plays an important role in the transmission mechanism of monetary policy. Changes in the official rates affect asset prices and consequently inflation. A change in the official rate will alters the value of existing wealth, if such alteration is positive; it leads to an increase in demand and puts pressure on output and thus inflation. The ability of the CBN to extract information from the bonds market and its potential role in forecasting inflation and the state of the economy have a strong bearing on the performance of monetary policy/control of inflation and therefore requires an empirical investigation.

1.2 Statement of Problem

The term structure of interest rates (yield curve) shows the relationship between yields of different maturities for different maturity loans. It has been an issue of concern both to policy makers and economic forecasters because of its predictive abilities and is often a useful indicator of the stance of monetary policy. This forecasting potentials result from the decision making process of profit seeking investors, which involves the formulation of expectations about future inflation and interest rates (Hurley, 1990). The fear for heightened inflations induces investors to demand for higher nominal yields. Such fears (inflation scare) could cause higher inflation expectations and signal a loss of confidence in the Central Bank’s commitment to low level of inflation (Goodfriend, 1998). At this point the shape of the yield curve would slope upwards indicating higher inflation expectations and disbelief in the monetary authority. The result is that credibility level of the Central Bank at this point would be very low. Economic theory suggests that if markets are efficient, it should be possible to extract the aggregates of these expectations of inflation and interest rates from observable term structure data (Hurley, 1990). However, it then follows that such expectations must be rational for the forecasting power to be effective.

And by extension, if expectations are rational, the predictive power of the term structure would also be effective. Inflation figures in the past six months of 2013 have been pegged at a single digit, while bond yields have climb to double digits (CBN, 2013). Back in may 2013, the rate of inflation stood at 9%, however the yield on a 10-year bond was 11.8% which exceeds the inflation rate by 2.8% points. Despite the decline in inflation, the rising bond yields suggest that market participants’ view this rate as unsustainable in the short-run due to unbalanced fundamentals in the economy like exchange rate and capital inflow. Accordingly, the yield curve would be more responsive to the policy direction and these economic fundamentals.

The CBN like any other central bank relies on inflation forecast and any information it can gather to make policy decisions. Nevertheless the CBN in its quest to formulate optimal policies is limited by the fact that it operates under an atmosphere of imperfect knowledge (Uncertainty). This can make it difficult for the CBN to come up with the desired interest rate that is consistent with the target level of inflation. The CBN devotes a lot of resources to forecasting and estimating the underlying state of the economy by gathering information that can shed light on this rate. The bonds market fits this profile because it contains information about participants’ expectations on inflation. So, extracting such information would be an important input for monetary policy. Influential central banks’ forecasts may lead private agents to stop forming their specific information sets and refer to the central bank’s information (Hubert, 2012).

This study seeks to empirically examine the extent to which the information on private sector expectations of inflation which is contained in the yield curve that can help forecast inflation. This is with the view of increasing the information set available to the CBN to forecast future inflation.

1.3 Research Questions

Arising from the above research problems, this study seeks to answer the following questions

  1. Is there any information in the bond market about the private sector inflation expectations?
  2. Can such information be used to improve inflation forecast?
  3. What is the implication of this information for policy?

1.4 Objective of the Study

The broad objective of the study is to examine the bond market information content and its implication for forecasting inflation in Nigeria.

The specific objectives include;

  1. To examine if such information can be used to improve the forecasting power of inflation models.
  2. To investigate the implication of this information for monetary policy.

1.5 Research Hypothesis

The research hypotheses to be tested in this study are;

H01: The bond market does not contain information on inflation expectations. H03: The bond market has no useful role to play in the policy arena.

1.6 Significance of the Study

There is the global recognition of the importance of expectations in the conduct of monetary policy. This is partly because of the recognition that expectations of inflation by the private sector form a component of actual inflation. Expected inflation is increasingly found to be a useful input in inflation forecast models. For this reason the CBN in 2009 through its statistical department began the conduct of surveys on inflation expectation using a small sample size of 1400 from the country’s total population of over 140 million (CBN, 2012). Such results results obtained may not truly reflect the expectations of Nigerians.

This also prompted the CBN (2010) in its study on inflation forecasting to call for further research that will capture the term structure of interest rate (the yield curve) and unemployment. And so this study will compliment the CBN surveys; by taking advantage of the information contained in yields of market instruments on inflation expectations.

Secondly, the study seeks to improve inflation forecast by using information obtained from asset yield and modeling it alongside other variables to obtain a more reliable inflation forecast result. As the relationship between monetary policy and asset prices is critical, obtaining reliable estimates on the likely effect of asset prices (or yields) on inflation would be a paramount step to policy decision making. It is important to note, that this study does not seek to show the superiority of the information content of the bonds market over other forecasting models and information sources, but to serve as a part of the tool kit for which the CBN can exploit in the monetary policy process.

1.7 Scope of the Study

This study will cover the period of 2006-2013. The choice of this period is derived from the fact that monetary authority introduced a new framework for monetary policy through its introduction of the monetary policy rate (MPR). The ultimate goal of this framework was to achieve a stable value of the domestic currency through stability in short-term interest rates around an operating target (MPR). More so, this study adds new depth to the understanding of how assets of different maturity affect the level of inflation, since it explicitly reflects market participants’ expectations.

1.8 Organization of the Study

This study is organized into five chapters.

  1. Chapter one contains the general introduction which includes; the background to the study, statement of problem, research questions, and objectives of the study, research hypothesis, and significance of the study, scope and limitation of the study.
  2. Chapter two contains with the review of literature; this consists of conceptual literature, theoretical literature, empirical and other relevant literature that could help the study.
  3. Chapter three is on the methodology and it contains; the theoretical and analytical framework, estimation method, model specification and source of data.
  4. Chapter four presents and analyses the empirical results as well draws implications from the findings.
  5. Finally, chapter five presents the summary, conclusion and recommendations of the study. References and appendices form the finishing part of this study.

Chapter Five

Discussion of Findings, Conclusion and Recommendation

From table 1 to 3, the results present the conditions of our findings and the position of the independent variables on the dependent variable. The normality results further present that all the variables and findings of the study are normally distributed. Two hypotheses form the basis of the study with interest rate and market bond being control components; the ADF unit root test showed that all the variables are stationary and good for analytical procedures. The ARDL result which was necessitated by the presence of different levels of stationarity showed that the four variables facilitated both negative and positive insignificant impact on economic development and the result also showed absence of significant long run relationship in the study. Signifying that all the bond market variables and the control components except interest rate combined were unable to facilitate significant change on the inflation rate of Nigeria. The study further showed the long run bound test which further confirm the position of no long run relationship in the study. The short run dynamics prove that only govt bond among the entire variables can facilitate positive increase on inflation rate, however the relational impact is insignificant and showed that government bond in the market development can improve inflation rate expectation(forcasting) but this improvement is insignificant for the period reviewed in the study. Other variables prove to have negative implication affirming that CORP bond, interest rate necessitate decrease on the inflation forcasting in Nigeria.

However, the overall adjusted r-squared prove that a large proportion change manifest on economic development by virtue of an increase in the variables to the tune of 93% approximately in Nigeria. The Durbin Watson statistics of 2.17 further approved the acceptability and reliability of the result of the study for policy decision on the Nigerian economy. The results inclusively showed that bond market however have not facilitate necessary change on economic development which is confirmed in the insignificant relationship of the study both at the short run and long run thus hindering the achievement of the full potential of economic development in Nigeria.

The findings thus imply that Bond market does not enhances inflation rate in Nigeria within the period under review. This is contradicted by the findings of Onaolapo and Oluwafemi (2010) whose study reveals a considerable link between bond market and economic growth and a more robust support of our findings is Ewah et al (2009) views in their work that the capital market in Nigeria has the potential to induce growth in line with observations of our study, but it has not contributed meaningfully to the economic growth of Nigeria because of low market capitalization, low absorptive capacity, illiquidity, misappropriation of funds among others.

For the corporate bond market, the result showed a negatively insignificant relationship with economic development both in the long run and short run in Nigeria. This confirms the inability of government bond and corporate bond to facilitate economic development in Nigeria. Hence, the study conclude that bond market has not facilitate required improve economic development of Nigeria.

The study therefore recommends improved presence of corporate bonds in the market to achieve activities that enhance human development index in the economy. This is achievable via reduced public quotation cost, less stringent requirement for listing, improved communication and information cost. There is need for government to increase its budgetary allocation on education, health and youth empowerment schemes which will improve human development and Human Capital Development in Nigeria. Finally, the provision of dependency by state and local governments on monthly allocation should be totally prohibited and eliminated to fasten capacity to utilization of the bond market for developmental purposes.

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