EFFECT OF FINANCIAL CONDITIONS INDEX ON MONETARY POLICY EFFECTIVENESS IN NIGERIA

Abstract

This study evaluated the impact of the Financial Conditions Index (FCI) on the effectiveness of monetary policy in Nigeria. Existing studies on Nigeria's FCI suffer from an outdated scope, exclusion of critical financial variables, and limited representation of the country's inflationary and growth dynamics. This study, therefore, aimed to construct a comprehensive FCI and assess its usefulness as a diagnostic and predictive tool for monetary policy in Nigeria. Specifically, the study examined the financial variables most suitable for constructing a robust FCI for Nigeria, analysed the dynamic response of the constructed FCI to monetary shocks and evaluated its predictive capacity for real GDP growth and inflation. A quantitative research design was employed for this study, using quarterly data from the Central Bank of Nigeria Statistical Bulletin, covering the period 2010Q1 to 2024Q4. Two FCI construction methodologies were adopted: Principal Component Analysis (PCA) and the Weighted-Sum Vector Autoregression (VAR) method. Impulse Response Functions, Pairwise Granger Causality tests, and out-of-sample Root Mean Squared Error (RMSE) evaluations were used to assess the index's responsiveness and predictive power. The findings revealed that the selected financial variables significantly contributed to FCI construction, with the first three principal components capturing about 93.05% of the total variance. Both FCIs responded significantly to monetary policy shocks primarily through the interest rate and exchange rate channels. The PCA-FCI demonstrated superior predictive power for real GDP growth, while inflation was found to Granger-cause both indices, indicating reverse causality. The study concludes that monetary policy effectiveness in Nigeria is better assessed through a composite financial conditions framework than through isolated policy rate indicators. It is therefore recommended that the Central Bank of Nigeria formally incorporate the PCA-based FCI into its policy diagnostic toolbox and place greater emphasis on price-based transmission instruments over credit volume controls.