Information Content of Interest Rates Spreads in Nigeria

Abstract

This paper extends the largely OECD-based research on the predictive content of the yield curve for future economic activity to the Nigerian context. Measured simply as the difference between the 14-year Federal Government Development stock rate and the 3-month Treasury bill rate, the slope is used to predict future growth in both total and disaggregated measures of real output and real expenditure. We find that the term-structure spread does predict real activity in Nigeria quite well. The in-sample predictive power of the spread is comparable to that found for OECD economies. The spread contains strong and reliable information on real economic activity growth from three to eight quarters ahead. It outperforms other available predictors over this horizon, but has little or no predictive power beyond two years. The spread contains relatively more information on future demand growth than on future output growth in Nigeria. The demand side sub-aggregate for which the spread has the highest information content is gross domestic investment. In fact the slope is quite weak in explaining private consumption or government consumption in the in-sample tests. The spread however contains considerable exclusive information only on consumer spending in Nigeria. Interestingly, out-of-sample forecast results also suggested that the information content of the spread is confined to consumption growth. Further tests for the transmission mechanism confirm that the explanatory power of the spread for future real activity stem entirely from the demand side of the economy. The information contained in the slope for future real output growth is still high in absolute terms, being only relatively lower than demand side. Manufacturing activity is the supply-side aggregate for which the spread has the highest information content. Since both investment demand and manufacturing output are more closely associated with the business sector in Nigeria, the information contained in the slope probably reflects business sectors' (investors') expectations of future activity or 'business confidence'. The spread however has absolutely no predictive content for real activity in the period before 1985. Its information content appears confined to the post liberalization/structural adjustment period when interest rates reflected relative scarcity of funds, exchange rate and goods prices were fully liberalized, and the macro-economy entered a turbulent phase. Finally, we note a number of reasons why the practical usefulness of the slope of the yield curve for policy purposes will vary over time. The slope of the yield curve will be of practical value to the central bank only when it is used in combination with information available on other key variables in the economy at any given point in time. It is only in this way that the slope can be a very strong indicator of the best courses of action, even when the slope itself cannot be used as a policy instrument or an intermediate target.