Can new monetary policy crush inflation?
The Bangladesh Bank may today raise its key interest rates to tame inflationary pressure but the attempt might go in vain since the monetary authority may not withdraw the interest rate cap on loans in a true sense.
Usually, central banks hike interest rates to curb inflation and ensure price stability. For example, the European Central Bank hiked its key rate on Thursday, the eighth straight increase since July 2022 for the 20 countries that use the euro currency.
The BB also increased its key interest rates, or the repo rates, several times to squeeze the money supply in a bid to rein in inflation. Still, inflation has not come under control.
The policy rate, which is termed the repurchase agreement (repo), is a pivotal benchmark interest rate that commercial banks follow in fixing the interest rates on both loans and deposits. Quoting the rate, cash-strapped banks also take short-term loans from the central bank and disburse them among borrowers.
The central bank of Bangladesh started to increase the repo rate in May last year as inflation went up following a sharp increase in the commodity prices driven by the crisis brought on by the Russia-Ukraine war.
It hiked the rate to 5 per cent from 4.75 per cent. The rate has been revised upwards four times since then and now stands at 6 per cent.
"However, the transmission of monetary policy was impaired as a result of an ongoing interest rate cap of 9 per cent for the industrial sector lending," said the World Bank in April.
Today, the BB will unveil its monetary policy for the upcoming fiscal year of 2023-24 and it comes at a time when the economy is facing mounting challenges, stemming from a higher inflation and a declining foreign exchange reserve.
Inflation raced to an 11-year high of 9.94 per cent in May, pushing up the average to 8.95 per cent this fiscal year, way above the revised target of 7.5 per cent.
According to Ahsan H Mansur, executive director of the Policy Research Institute of Bangladesh, the central bank has recently said that it will introduce an interest rate-based monetary policy and roll out a system called SMART to determine interest rates on loans.
"But the initiatives may not restore stability in the economy as they will not bring about fundamental changes to the policies the central bank is following now."
Under the existing monetary policy, the central bank now increases or decreases the money supply to achieve its inflation target. But it will focus fully on the key interest rates – repo, reverse repo, and special repo – to tackle higher prices.
The reverse repo, now 4.25 per cent, is a rate at which commercial banks keep funds at the central bank. Banks secure emergency funds from the central bank through the special repo, the rate of which is 9 per cent now.
But the upcoming changes may not impact the money supply in the market substantially as the new system called SMART – Short-term Moving Average Rate – will not remove the existing central bank policy of fixed interest rate cap on lending.
As per plans, the central bank will initially set a monthly reference rate based on the weighted average rate, which is calculated on the basis of the interest rates of the six-month short-term treasury bill.
The BB will also set another weighted average rate for every six months based on the monthly weighted average rates of the T-bill. The rate will be called SMART, which will be adjusted every month considering the interest rates of the treasury.
The central bank will allow banks to add a maximum of 3 per cent to the weighted average rate.
Currently, the interest rate of the six-month T-bill is 7.10 per cent, meaning that the interest rate on loans may be a maximum of 10.10 per cent, up from the 9 per cent ceiling that the BB has maintained since April 2020.
Mansur says that the central bank controls the interest rates of T-bills and T-bonds.
Since the central bank offers lower rates during the auctions of government securities, commercial banks don't get the opportunity to buy them.
"The central bank should stop purchasing T-bills and bonds if it wants to introduce a market-based interest rate in a true sense," said Mansur, also a former official of the International Monetary Fund.
The central bank's stance has given a clear indication that the interest rate on loans may go up to a little over 10 per cent.
In January, the BB increased the lending rate cap for consumer credit to 12 per cent and removed caps on credit card loans. However, these categories represent only about 20 per cent of overall private sector credit, according to the World Bank.
Mansur says that the central bank has been injecting dollars into the market on a regular basis, meaning commercial banks are purchasing them in exchange for taka.
The BB has injected more than $12 billion into the market this fiscal year to help banks settle import bills.
But mopping up the taka has not created any major impact in the market since the government itself is borrowing heavily from the central bank to meet its budget deficit.
For instance, it has so far borrowed Tk 92,289 crore from the banking system this fiscal year. Of the sum, Tk 71,610 crore came from the BB.
"But taking loans from the central bank means injection of high-powered money into the market. This ultimately fuels inflation," Mansur said.
"So, keeping the government borrowing at a particular level is important to contain inflation. And the new monetary policy should put emphasis on that."
Analysts will also expect measures from the monetary policy that would stabilise the foreign exchange market, which has been facing stress for nearly a year owing to a 30 per cent drop in reserves.
"We have been urging the central bank for long to allow the market to set the exchange rate. But the central bank has not paid any heed," said Mansur.
Amid the sharp depletion of the reserves, the value of the local currency has fallen by about 25 per cent against the US dollar in the past one year.
Zahid Hussain, a former lead economist of the World Bank's Dhaka office, says the new monetary policy might not be too much different from the current one.
"If the interest rate on loans increases by only 1 percentage point, it will have little impact on the financial sector."
The Federation of Bangladesh Chambers of Commerce and Industry, the apex trade body, has opposed removal of the lending rate cap, saying if the ceiling is withdrawn and left to be decided by the open market, inflow of investments will be affected.
But Sadiq Ahmed, vice-chairman of the PRI, said recently evidence shows that countries that adopted demand reduction policies through hikes in interest rates have all succeeded in reducing inflation substantially.
As compared with these successful outcomes of inflation reduction, Bangladesh did not achieve any success with inflation control, he said, urging the central bank to abandon the 9 per cent interest rate policy and use interest rate flexibly.