Monetary policy instruments and inflation in Nigeria: a revisit of FAVAR

This paper revisits the potency of the Factor Augment Vector Autoregression (FAVAR) model in tracking the impact of monetary policy instruments on inflation in Nigeria. Having identified the latent information from the unobserved variables using the factor analysis approach, we retained the variables with higher communality and eliminate those with higher uniqueness. Our results show no immediate evidence of “price and liquidity puzzles”, contrary to Mordi et al. (A factor-augmented vector autoregression (favar) model for monetary policy analysis in Nigeria, Research Department, Abuja, 2014) and other notable authors. The estimated factors did not only improve the inflation forecast for Nigeria but further show that there exists a high impact of monetary policy rate on Inflation. The persistent increase in the unobserved information of short-term interest rates and monetary aggregates serves as an effective monetary channel or transmission mechanism of the Nigerian monetary system. Moreover, we find that inflation is mostly driven by food consumer price indices and an acceptable FAVAR estimation should not only be restricted to the selection of favorable factors but rather include the scientific process of eliminating variables whose variance contributes least to the variances shared by the common factor. Consequently, for Monetary Policy Rate, Treasury Bill Rate, and Cash Reserve Ratio to be an effective policy instrument, they need to be anchored on efficient operating and monetary targets.