CBN JAS Article: Asymmetric Impact of Oil Price on In?ation in Nigeria

CBN Journal of Applied Statistics Vol. 11 No. 2 (December 2020)

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Asymmetric Impact of Oil Price on Inflation in Nigeria

Sani Bawa, Ismaila S. Abdullahi, Danlami Tukur, Sani I. Barda, and Yusuf J. Adams1

This study examines the impact of oil price shocks on inflation in Nigeria. A NonLinear Autoregressive Distributed Lag (NARDL) approach was applied on quarterly data spanning 1999Q1 to 2018Q4. Results showed that oil price increases led to increase in headline, core and food measures of inflation in Nigeria. However, a decline in oil price resulted in a decline in the marginal cost of production and culminated in moderation of domestic inflation. Furthermore, negative oil price shocks led to higher inflation in Nigeria when exchange rate is dropped from the models, indicating that exchange rate absorbed the impact of oil price declines earlier, as lower oil prices culminated in lower external reserve, depreciation of the naira and ultimately higher inflationary pressures. Also, core inflation tends to respond more to oil price increases than food inflation. These results were robust to changes in econometric specifications and sample period. The study recommends that monetary policy actions of the Central Bank of Nigeria should focus on taming core inflation in periods of substantial oil price increases while strengthening its efforts at ensuring domestic sustainability in food production through its agricultural intervention programmes to further minimize the impact of international oil prices on food inflation. Similarly, the fiscal authorities should ensure that the fiscal stance is not excessively procyclical in periods of rising oil prices .

Keywords: Asymmetry, inflation, nonlinear autoregressive distributed lag, oil price shocks

JEL Classification: E31, Q43

DOI: 10.33429/Cjas.11220.4/8

1. Introduction

Crude oil remains the world's most important source of energy in the last seven decades, with its products serving as sources of energy for industries, homes, vehicles and airplanes2. Con- sequently, sudden disruptions in oil supplies and sharp increases in its prices are among the most important shocks hitting world economies. Oil has remained an important commodity that drives economic activities globally, and thus, oil price movements are a major determinant of macroeconomic outcome across countries.

• Authors are staff of the Central Bank of Nigeria.
  The views/opinions expressed in this paper are those of the authors and do not in any way represent the views of the Central Bank of Nigeria.

2UK Oil and Gas https://www.ukogplc.com/page.php?pID=74

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Nigeria is endowed with abundant oil and gas resources, which production accounted for an average of one-fourth of its GDP from 1981 to 2018. Similarly, oil exports constituted about

95.7 percent of total exports, while oil revenues accounted for an average of 73.3 percent of government collected revenues during the same period. Consequently, the country's macroe- conomic performance has been strongly associated with the oil sector.

Although Nigeria remains Africa's largest oil producer, the country has inadequate refining capacity and imports refined petroleum products to satisfy domestic demand. Thus, government subsidises petroleum products to maintain a regulated price irrespective of changes in international crude oil prices and the exchange rate. While this has severely constrained the government's fiscal space overtime, it has ensured that rising oil prices do not spill over to domestic prices of refined oil products, thereby minimizing its impact on consumer prices.

Nigeria's economy has largely been insulated from the direct impact of oil price changes through the fuel subsidies, though it has the tendency to suffer from inflationary pressures resulting from increases in the cost of producing imported goods when oil price increases in the international market. Available data on international trade statistics3 indicated that the country imported most of its consumer and capital goods worth about US$44.0 billion (10.4 percent of GDP) in 2018.

Symmetric shocks are disturbances that generate uniform effects on a set of macroeconomic variables, that is, positive or negative shocks tend to cause movements in the variables in the same direction. However, disturbances due to asymmetric shocks induce macroeconomic variables to move in different directions. Consequently, a symmetric association between oil prices and inflation would imply that the same oil price/inflation elasticity applies to both increases and reductions in oil prices. Asymmetric relations between the two variables indicate that rise in oil prices could have a different impact on inflation from decline in oil prices.

Positive oil price shocks have the tendency to increase money supply in oil producing countries (Oyeyemi, 2013; Omolade, Ngalawa & Kutu, 2019) with profound implications on consumer prices. Also, falling oil prices weaken the foreign earnings of oil producing countries resulting in currency depreciation and rising inflation (Bala & Chin, 2018). Thus, oil

• Compiled by the External Sector Statistics Division of the Central Bank of Nigeria

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price shocks, whether positive or negative, have profound implications on consumer prices in oil producing countries including Nigeria.

Previous empirical studies such as Olusegun (2008) and Odionye, Ukeje and Odo (2019) focussed on the impact of oil price shocks on inflation at the aggregate level utilizing symmetric approaches. These approaches assume that changes in oil prices at the international market affect inflation in the same direction, without distinguishing the impact of an increase or a decrease in oil prices on inflation. However, the empirical association between oil prices and economic activity may not be symmetrical as positive and negative oil price shocks may have distinct impacts on economic activity (Mory, 1993). Consequently, it would be inappropriate to presume that the behaviour of inflation in response to oil price shocks is symmetric (Omo- lade et al. 2019). Empirical works including Kelikume (2017), Bala and Chin (2018) and Omolade et al. (2019) address this problem by adopting asymmetric approaches to examine the impact of oil price shocks on aggregate inflation in Africa's oil producing countries including Nigeria. In this study, we also examine the impact of oil price shocks on consumer price inflation in Nigeria. However, oil price increases could have a larger impact on core than food measure of inflation because most of the food consumed is produced locally and thus, its prices are largely immune from oil price induced inflation. Given this, we decompose inflation into the headline, core and food components to examine how oil price shocks influ- ence each of the inflation categories. The paper contributes to the debate on which measure of inflation should be relevant for monetary policy response in periods of oil price shocks. We adopt a Nonlinear Autoregressive Distributed Lag (NARDL) model advanced by Shin, Yu and Greenwood-Nimmo (2014) as it allows for the evaluation of the potential long-run and short-run asymmetries in the relationship between oil prices and the three components of inflation.

The rest of the paper is structured as follows: Section 2 reviews the literature and Section 3 contain the data and methodology, while Section 4 discusses the empirical results. Section 5 concludes the study and presents policy recommendations.

2. Literature Review

2.1 Theoretical Literature

Higher oil prices impact the economy in a number of ways: transfer of income from oil importing economies to oil exporters; rise in the cost of production of goods and services

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in an economy emanating from an upsurge in the relative price of energy inputs; it impacts on the price level; decline in economy's productive capacity as producers respond to higher oil prices by reducing their utilization of both oil and capital; and uncertainty in investment decisions by households and firms owing to uncertain oil prices in the future. Others include direct and indirect impacts on financial markets and the incentive for providers of energy to increase production and investment (Fried & Schultze, 1975; Marquez, 1986; Blanchard & Gali, 2007; DePratto et al., 2009; Bataa, 2010; Alvarez et al., 2011; Trang et al., 2017; Bala

• Chin, 2018). The magnitude and direction of its impact, however, differ between industrial and developing countries as well as between oil producing and consuming economies (IMF, 2000).

Oil price shocks affect domestic inflation in countries through both direct and indirect chan- nels: directly through increases in prices of refined oil products, which spill over to the Consumer Price Index (CPI), and indirectly through price changes in goods and services, which utilize oil or oil products as inputs in the production process (Zivkov, Duraskovic & Manic, 2019). The direct impact would depend, among others, on the expenditure share of households on refined oil products over total expenditure. Alvarez et al. (2011) have shown that the direct impacts tend to exhibit higher pass-through to inflation than the indirect impacts. Meanwhile, inflationary pressures emanating from rising oil prices through these channels (first round effects) may trigger behavioural responses from firms and workers, leading to revision of inflation expectations, increase in nominal wages, transferring the marginal increase in cost of production to consumers and further changes in the price level through the second round effects.

Corroborating this, Conflitti and Luciani, (2017) states that oil price hikes may have an in- flationary effect in four ways - increase in production costs, higher inflation expectations, demand for higher wages by workers to compensate for the increase in energy prices and an adverse supply shock if real wages do not decrease sufficiently, thus triggering an adjustment in employment. However, it can have a deflationary effect through a demand shock as higher oil prices tend to reduce net disposable income, hence consumption and investment.

2.2 Empirical Literature

Several empirical studies have investigated the relationship between oil price fluctuations and economic activity. Earlier attempts include Hamilton (1983, 1996, 2005), which pro-

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vide evidence on a robust relationship between oil price increases and subsequent economic downturns in the United States (US) particularly after the Second World War. In Nigeria, Aliyu (2009) establishes an asymmetric impact of oil price shocks on real GDP, with positive changes having larger impact on real GDP than negative changes. Alhassan and Kilishi (2016) have also shown that oil price shocks led to macroeconomic fluctuations in Nigeria. Narrowing down to inflation, Hooker (2002) finds evidence that fluctuations in oil prices contributed to the increase in US core inflation before 1981 and reduced afterward. Since then, several studies have investigated the relationship between oil prices and inflation in both advanced and developing economies utilizing different methodologies.

Studies such as Brown, Oppedahl and Yucel (1995); Dias (2013); Lu, Liu and Tseng (2013); Zhao et al. (2016); Conflitti and Luciani (2017); and Zivkov, Duraskovic and Manic (2019) reported significant positive impact of oil prices on inflation in advanced countries. Utilizing a vector autoregression (VAR) model and US data, Brown et al. (1995) have shown that oil price shocks influence output and the price level, though, the country's monetary policy was able to accommodate the inflationary pressure from the shocks. Similarly, Dias (2013) estimates the effects of oil price shocks on economic variables including GDP, employment and inflation using a structural VAR model for the Portuguese economy during the 1984 - 2012 period. Results from impulse response functions (IRFs) indicated, among others, that an increase in oil prices of approximately 13 per cent, translated into higher inflation by 0.25 and 0.05 percentage points in the first and second period, respectively. However, the impact reduces slowly from the third period, with virtually no long-term effect on the price level.

Lu et al. (2013) examined the effect of oil price shocks on inflation in Taiwan utilizing a bivariate GARCH approach and data covering the 1986 - 2008 period. They reported that oil prices strongly Granger-caused inflation in Taiwan and revealed a persistent volatility spill- over from oil price to inflation during the period. Zhao et al. (2016) built an open-economy dynamic stochastic general equilibrium (DSGE) model for the Chinese economy to assess the impact of oil price shocks on output and inflation. The study categorized four types of oil price shocks to include supply shocks driven by political events in OPEC countries, other oil supply shocks, aggregate shocks to the demand for industrial commodities, and demand shocks that are specific to the crude oil market. They revealed that the first shock mainly accounts for short-term changes to output and inflation in China, while the other three shocks

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