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The management of oil revenues is the past, present and future of macroeconomic policy in Nigeria. As Paul Collier’s paper in this workshop describes (Collier, 2006), the long history of fiscal mismanagement of oil booms in Nigeria severely proscribed the Central Bank of Nigeria’s ability to pursue a coherent monetary policy. Without the support of a disciplined and broadly predictable fiscal stance, the central bank was unable to make credible commitments to an inflation target or, indeed, to any other intermediate target such as the monetary supply or the exchange rate. Monetary policy could not reliably anchor inflation expectations. Since the turn of the century, however, the landscape has started to change. Harnessed to a stronger political commitment, the successful consolidation in the financial sector concluded at the end of 2005 and the de facto unification of the foreign exchange markets in early 2006, measures such as the Fiscal Responsibility Bill, currently working its way through the legislature, are laying the foundations for improved fiscal management of oil revenues. As a result, and for possibly the first time in its history, the prospects now exist for genuinely ‘independent’ central banking in Nigeria. It now makes sense to consider monetary policy playing a more central role in the short-run management of oil revenues. This paper is concerned with one specific aspect of this management problem, namely how a more autonomous central bank should seek to set its limited monetary policy instruments so as to efficiently manage the short-run volatility in oil revenues. We start from the premise that the central bank sees its core remit as pursuing low and stable inflation, even though it does not at present explicitly see itself as an ‘inflation targeter’. However we also assume that other concerns compete for the central bank’s attention. First, there may be an anxiety about the level and volatility of the nominal and real exchange rates. Fears of adverse ‘Dutch Disease’ effects accompanying oil surges may draw the authorities into attempts to prevent the temporary (or persistent) appreciation of the real exchange rate in order to forestall perceived losses in competitiveness. But concerns about exchange rate volatility may centre less on the question of competitiveness than on the political costs of temporary exchange rate appreciations which first confer big income gains on net consumers of imported goods before reversing them. The central bank may also be concerned about interest rate volatility. Attempts to address nominal (and real) exchange rate volatility through exchange rate intervention - a fear of floating - are often accompanied by a belief that some form of domestic liquidity sterilization is necessary to deliver on an inflation target. Sterilization, in turn, raises concerns over interest rate volatility, the effects on private investment, and the quasi-fiscal burden of increased domestic borrowing. Finally, the central bank may also seek to avoid excessive volatility in output, particularly in the non-tradable sector where prices are more likely to adjust sluggishly to demand shocks. The challenge facing the central bank is to identify operational monetary rules that navigate these competing concerns without losing their anchor on inflation, or, more precisely, inflation expectations. This challenge can be distilled into three specific questions. First, to what extent should the monetary authorities seek to manage the path of the nominal exchange rate, if at all? Second, what is the role for using official foreign reserves as a buffer to smooth the spending and absorption of the oil windfall? Finally, should windfall-related liquidity growth be sterilized through bond sales? This paper contributes to the making of monetary policy in Nigeria by examining the performance of a small set of alternative monetary policy rules in the face of volatile oil prices, holding other sources of volatility constant. Two key messages emerge from our analysis. The first is that when the fiscal response to oil surges significantly alters the path of domestic deficit financing needs, strategies involving significant foreign exchange intervention to offset the incipient nominal exchange rate appreciation deliver less volatile outcomes than those which allow the exchange rate to float freely. This intervention can be achieved by simple rules that match foreign exchange intervention directly to the saving out of the windfall (what we refer to as a buffer-plus-float) or through an explicit exchange rate crawl aimed at keeping the rate of nominal exchange rate depreciation close to the long-run inflation target. Both rules are much more effective at reducing short run real and nominal volatility than a pure float. Second, judged solely against the narrow criteria of minimizing short-run price, exchange rate and output volatility, the crawl outperforms the buffer-plus-float. However, if in addition to targeting macroeconomic volatility, the authorities are also concerned to develop the structural performance of domestic finance markets by promoting greater market-based exchange rate determination, the balance tips in favour of the buffer-plus-float. The second main message is that in the face of an oil price surge, the conventional case for domestic bond sterilization is not well made, even when the authorities’ foreign exchange rate intervention leads to a growth in domestic liquidity. The combination of income growth and a reduction in expected inflation arising from fiscal consolidation serve to increase the demand for domestic money thereby warranting the growth in liquidity arising from the authorities’ accumulation of official net international reserves. Indeed, there may be a stronger case for ‘reverse sterilization’ where part of the oil windfall is used to buy-back domestic debt. This may serve two purposes. First, a debt buy-back serves to crowd-in private investment by temporarily lowering the real interest rate. At the same time, a debt buyback at the beginning of an oil surge creates ‘space’ for the monetary authorities to more effectively manage the end of an oil price surge, especially in circumstances where the fiscal authorities cannot credibly commit to adjust expenditure immediately as windfall revenue disappears. Three important caveats apply, however. First, the strength of the case for foreign exchange intervention, and against bond sterilization, in the face of oil surges depends intimately on the sensitivity of the private sector’s demand for money to changes in expected inflation, and how heavily it discounts the future. In contemporary Nigeria, especially as reforms in the financial sector begin to take root, portfolio effects appear to be relatively strong. However, if the inflation elasticity is low and horizons are short, portfolio effects on the demand for money weaken, the distinction between alternative exchange rate rules is less stark, and the case for a debt buy-back less powerful. Second, the analysis reported below is based on a model which de-emphasises the role of the banking system in the transmission of monetary policy and hence the results do not do justice to the full range of policy instruments available to the central bank. Finally, we must reiterate a self-evident truth about monetary policy in Nigeria. With oil revenues constituting such a dominant share of total fiscal receipts, it will always be the case that monetary policy is conducted in the shadow of the fiscal management of oil revenues. Whilst it may be possible for the central bank to lean against weak fiscal management in the short run - for example by relying heavily on quantitative controls such as reserve requirements and central bank liabilities to mop up excess domestic liquidity - no long-run inflation target can succeed without a supportive fiscal policy. Other papers in this volume address issues of fiscal management directly; given the objectives of this paper, we assume the existence of a broadly coherent fiscal stance.
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