Clearly, there is considerable misunderstanding of what causes inflation in a modern globalized economy and what policies are needed to fight inflation in a sustained manner. The objective of this article is to attempt to explain the underlying causes of inflation in Bangladesh and what could be done to reduce inflation without jeopardizing other economic goals.

It will be helpful to start with the basic economics of what causes inflation in a modern economy that is also inter-connected with the rest of the world through trade and capital flows. Nobel prize winning Chicago economist Milton Friedman had long ago shown conclusively that in the ultimate analysis “inflation is a monetary phenomenon”. Using the classic quantity theory framework Friedman demonstrated that over the long-term the rate of inflation is simply the difference between the rate of growth of money supply and the rate of growth of real output (GDP). So, the only viable long-term solution to the inflation problem is to align the rate of growth of money supply to the rate of growth of real GDP and the target rate of inflation. Short-term divergence between the rate of growth of money and inflation is possible, but when inflation is on a rising trend, the usual culprit is an excessive pace of monetary expansion. Accordingly, it is no surprise that Central Banks globally tend to cure inflation through monetary policy. This is true of Central Banks in advanced economies as well as in developing economies. Indeed some autonomous monetary authorities pursue monetary policy with the sole aim of inflation control.

Yet, often some Central Banks, especially in developing economies, tend to show reluctance to tighten money supply to the required extent to fight inflation. What explains this reluctance? This partly reflects the lack of autonomy in the conduct of monetary policy. For example, borrowings by the Treasury to finance fiscal deficit may dominate monetary management. But it partly reflects a belief in the “structuralist approach to inflation”. The structuralist view argues that monetary tightening could hurt economic activity through increase in the interest rate. In this view there is a trade-off between inflation and growth. So, instead of monetary tightening, structuralists argue that measures should be taken to reduce the structural bottlenecks that cause cost-push inflationary pressures. This could be a combination of investments to reduce supply shortages of key commodities as well as controls over sensitive prices such as exchange rates. Empirical evidence is unclear about the validity of this approach to inflation control. Indeed fighting inflation through control over exchange rate and other sensitive prices like energy prices could either hurt other objectives (balance of payment management) or could even be self-defeating (subsidies resulting from price controls might overwhelm public finance leading to excessive monetary expansion owing to deficit financing and fuel further inflation).

Let us now turn to the Bangladesh situation. The movements in key variables affecting the inflation rate in recent years are shown in the table below. To define money supply, I use the narrow concept of money (M1) because this more appropriately defines the transactions demand for money which is most relevant for spending purposes. However, the results are not that much affected by this choice because the pattern of broad money (M2) growth is broadly similar. The table shows that the rate of inflation has been rising noticeably since 2002-2004 with the pace creeping up by roughly one percentage point every year since then. As a result, the rate of inflation accelerated to 8.3 percent by April 2007. What has caused this increase in inflation? GDP growth has been relatively stable in this period with a slightly upward trend, rising from an average of 5.8 percent in FY02-04 to an estimated 6.5 percent in FY07. This suggests that the aggregate supply side developments in terms of growth of output have been fairly positive. Cost push pressures through world inflation have been broadly similar over the past 5 years and the rate of world inflation has been consistently and substantially lower than the Bangladesh inflation. Although exchange rate changes did contribute to cost push pressures in FY2006 relative to FY2002-04, this was not a factor in FY2007. World food prices, however, have continued to exert considerable inflationary pressure throughout the 5 year period except for a hiatus in FY2005. Looking at all the cost push factors and combining them with the rate of output growth, we get a mixed picture about the role of cost push pressures in generating and sustaining inflation. There is no evidence of a supply side shock. The only consistent factor has been the pressure exerted by world food prices. Given the large share of food in CPI and linkages with nominal wages, this is likely to have been an important determinant of inflationary pressures in Bangladesh and other South Asian countries in recent periods. The other factor that might have contributed somewhat to the cost push pressures is adjustments in petroleum prices since 2003. However, given the direct small weight of petroleum products in CPI and the relatively low energy intensity of production, it is unlikely to be a major determinant of domestic inflation.

The story on the demand pull factors is however quite telling. Along with rising income emerging from increasing GDP growth, there has been a substantial growth in money supply. Rising from an average growth of 11 percent per year during FY2002-2004, money supply growth accelerated to around 17 percent in FY 2005 and then surged to over 21 percent in FY2006 and FY2007 (April). Given the relationship between rate of growth of money supply, output and inflation, it is hardly surprising that we observe growing inflationary pressures in Bangladesh. Some of the excess money growth is likely to have also spilled over to an increase in asset prices, especially real estate. On the whole, unless the rate of monetary expansion falls significantly it is likely that inflationary pressures will continue.

The experience of other South Asian countries also provides useful light on this point. All South Asian countries have faced inflationary pressures in the past few years because of rising commodity prices including food and fuel and growing demand pressures from rising incomes. India responded quickly by tightening monetary policy in a rapid succession of policy interventions. As a result, interest rates rose, demand pressures were down and inflation fell from a peak of 6.7 percent in February 2007 to 4.3 percent in June 2007. There was little adverse effect on growth, which is estimated to stay at a healthy 8.5 percent in 2007. Pakistan responded more hesitantly with some monetary tightening, but a combination of fixed nominal exchange rate along with generally accommodating monetary policy has kept inflation at 7-8 percent while the current account of the balance of payments has widened substantially. Sri Lanka failed to tighten monetary policy while also maintaining loose fiscal policy partly in response to the financing of the ongoing civil war. The result has been a rapid growth in money supply and a surge in inflation to close to 20 percent per year.

These experiences including from Bangladesh reinforce the obvious result from standard macroeconomic theory that there is no substitute for prudent macroeconomic management. A policy of controls will not work. In particular, on a sustained basis inflation can only be cured through monetary tightening; similarly, sustained balance of payments management requires flexible management of exchange rate. What about the possible adverse effects on growth? If there is a temporary supply shock, such as crop failure from droughts, this can be accommodated through short-term fiscal and monetary accommodation. But a permanent increase in world prices of food and fuel, for example, will require that these increases be passed through to consumers. Any attempt to artificially control them through restrictive policies will not be sustainable. Neither will they allow lower inflation on a sustained basis. Such efforts will raise the budget deficit and unless taxes rise in tandem, the result will be deficit financing, monetary expansion and higher inflation. Indeed, this is a part of the story in Bangladesh where efforts to keep domestic energy prices low despite rising international prices caused a huge build up of deficits in the energy utilities that were funded through bank borrowings which have fed into monetary expansion.

The inescapable conclusion therefore is that the recent increase in inflationary pressures in Bangladesh requires monetary tightening. Interest rates will rise, which is a part of the necessary adjustment to reduce demand and lower inflation. Fortunately, the government has taken some steps to tighten money recently and the rate of expansion of M1 fell from 21 percent to 19 percent in May. The rate of inflation has also fallen somewhat from 8.3 percent to 8.1 percent. This is a welcome development but further tightening is necessary to bring down inflation to the 4-5 percent range.

The author is Sector Director Poverty Reduction, Economic Management, Finance and Private Sector, South Asia Region of the World Bank. The views expressed in this note are those of the author and do not necessarily reflect the views of the World Bank Group.