To continue the fight against inflation, Bangladesh Bank has adopted the tight monetary stance applicable for the last half of the current fiscal year (FY24). The announcement of the new monetary policy last week came with a moderate hike in the key policy rate, the repo rate to be precise, to 8.0 per cent from 7.75 per cent. The central bank also revised the rates of standing deposit and lending facilities to influence the commercial banks' direct borrowing from as well as parking the funds with the central bank. It is stated in the monetary policy statement that maintaining a tight monetary policy in the latter half of FY24 [January-June 2024] appears 'prudent to control inflation and anchor inflation expectations.' At the same time, 'ensuring adequate funding to the productive sectors of the economy to support desired growth' is also underscored.
The government has already revised the target of the growth rate of Gross Domestic Product (GDP) to 6.50 per cent for the current fiscal year, which was initially set at 7.50 per cent. The government also revised the targeted ceiling of the inflation rate to 7.50 per cent from the primary target of 6.0 per cent. Bangladesh Bank has aligned its monetary and credit policy targets accordingly, where inflation takes priority.
The idea behind the tight monetary stance is to reduce the amount of liquid money from the open market and transfer the money to the banks' vaults. So, interest rates on deposit and credit have to be increased. In the first case, it is theoretically presumed that people will be attracted to park their cash in the bank vaults in exchange for higher returns or interests. In the second case, banks will disburse less credit as the borrowers will find it costly due to the increased rate of interest. Thus, the overall liquidity will drop, and demand for consumption will subsequently come down. The ultimate result will be a decline in the price level or inflation.
To achieve the optimal result, the role of the central bank is critical as it applies its monetary instruments and policy rates along with relevant rates, driving the banks in the desired direction. If the central bank increases the policy rates it gives the signal that banks should follow the path. By hiking policy rates, the central bank makes lending to commercial banks costly. Commercial banks generally borrow from the central bank in case of liquidity shortfall. If it becomes expensive, banks will take more caution to manage their liquidity situation and increase both the deposit and lending rates. The process will ultimately reduce the supply of money in the market. As less money will now chase fewer goods in the market, the prices will also come down at one stage, and the economy will see a moderation in inflation.
The real world is, however, more challenging than described in economic theories. Nevertheless, empirical evidence strongly substantiates the theory, especially in the advanced economies where informal activity is limited. Developing countries like Bangladesh have a strong presence of informal economic activities where cash-based transactions are prevalent. Though the country's estimated cash-GDP ratio is below 10 per cent, there is still a tendency to hold cash for some valid reasons. Thus, a modest increase in deposit rates is unlikely to attract many people to put their money in banks.
Over the years, distortion in the financial market by imposing fixed lending and deposit rates has discouraged many from keeping their excess funds in the banks. The weak governance and higher default loans in the banking sector, mainly due to politically backed unwanted intervention, have also shaken the trust in banks. In view of finding better alternative for making safe deposit, most people choose banks, however. So, they withdraw funds whenever they find an alternative, no matter how risky that is. The lower growth of bank deposits from people and the sharp rise in currency outside banks in the last two fiscal years reflect that situation. Bangladesh Bank statistics showed that currency outside banks increased by around 13 per cent in FY22, which jumped further to 23.45 per cent in FY23.
Nevertheless, a persistent rise in interest is bound to reduce cash in hand to a certain level. As the central bank also maintained a contractionary monetary stance in the first half of the current fiscal year by gradually hiking the policy rate from 6.0 per cent to 7.75 per cent, it paid off to some extent. Currency outside banks increased by around 5 per cent only in the first five months of FY24 against 14 per cent growth in the same period of FY23, reflecting the outcome.
The trend is expected to continue in the last half of the current fiscal year. In that case, inflation is also likely to slow down, although the causal link between the inflation rate and the growth rate of currency outside banks is not well corroborated.
Moreover, the status of the money supply is critical to understanding the impact of a rate hike. Bangladesh Bank statistics showed that the annual growth of broad money (M2) declined to 8.80 per cent at the end of December last from 10.50 per cent at the end of June 2023. The monthly inflation rate also decreased to 9.41 per cent in December, up from 9.74 per cent in June. Any concrete conclusion, however, will be premature as the lag effect of the rate hike is also subject to review. Generally, after making an interest rate move, there is a delay of uncertain length before it affects inflation. One must wait at least a couple of months or so to see the effectiveness of the just announced contractionary monetary policy.
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