Economic growth and state of the economy (Part-II): Inflation

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M. A. Taslim A matter of serious concern is the inflationary spiral that seems to have taken hold of the economy. Inflation has been creeping up steadily from its low level at the beginning of the millennium until the last quarter of 2008. This has been in the main due to a steady increase in domestic food prices. A large fraction of the demand for cereals, spices, sugar and edible oil is met by imports, and the country exports fish and vegetables. Consequently, their prices are closely linked to international prices. There was a world-wide increase in fuel and food prices during 2001-08: food price index increased by 2.4 times, grain by 2.8 times, fats and oils by 2.9 times and energy by 3.8 times. Such large increases in the prices quickly fed into domestic prices. There was very little that the monetary authorities could do to limit price increases from this source. Only fiscal actions, if properly designed and executed, might have had moderated the price hike. That the inflation was largely imported was underlined by the fact that it fell abruptly from around the mid-2008 due a collapse of the international commodity prices. As the international market rebounded, domestic inflation commenced its upward march from 2010 onward. However, the monetary authorities seem to have played an active part, not just accommodative, in the acceleration of price increases during the last two years. The chart below shows an unmistakable rising tendency of the money supply; the growth rate of broad money increased steadily from 17.6 per cent in FY 2007-08 to 19.2 in FY 2008-09, 22.4 per cent in 2009-10 and 21.3 per cent in FY 2010-11. Considering the fact that the inflation rate was fairly low during 2009, the large increase in money supply must have contributed to the large increase in the prices, especially that of non-food and non-traded items, by increasing the aggregate demand of the economy. The chart shows that the acceleration in monetary growth was accompanied by an increase in average Consumer Price Index (CPI) inflation. The price inflation could have been more severe but for the fact that a large part of the increased money supply found way to the share market which contributed to a very large increase in the stock prices by artificially boosting up capital market demand. The steady increase in domestic prices over a fairly long period of time (albeit with a hiatus in 2009) appears to have engendered expectations of price increases. These were further strengthened by the rapid increase in the money supply over the last two years or so. The repeated failure of Bangladesh Bank (BB) to adhere to the pre-announced monetary targets during the past several years made a mockery of its inflation-targeting policy, and helped entrench inflation expectations. It will be difficult to break the cycle without very tough measures. It is rather too well-known that a large increase in money supply will eventually lead to inflation. Why did Bangladesh Bank repeatedly increase the money supply far beyond the target set by itself? In theory the central bank controls the money supply, or has the means to control it. In practice its hands are often forced by circumstances, especially so if it is not much more than an extended arm of the Ministry of Finance. For example, the Board of the Bangladesh Bank had unequivocally said that the economy did not need any more banks at this time; but had to quickly change its stand when the Ministry insisted that the establishment of new banks was a political decision. During the calendar year 2009, the increase in money supply was largely the consequence of the substantial balance of payments surpluses. The policy decision of preventing the exchange rate from appreciating resulted in a large increase in the net foreign assets of BB. It sterilised only part of this increase by reducing its holdings of domestic assets. However, the emerging balance of payments problems meant that there was only a very small increase in the net foreign assets of BB in 2010. This was more than compensated by a very large increase in the domestic assets which maintained the high monetary growth. The growth rates of monetary reserves and broad money during the first two months of FY 2011-12 were considerably higher than that during the corresponding period last year suggesting a strong likelihood of continued high monetary growth. The large growth in the domestic asset holdings of BB was a direct consequence of the budget deficit incurred by the government and borrowing by the commercial banks from BB. The latter did not show any increase from 2005 to October 2010 remaining at about Tk 61 billion. But within the following two months it had nearly doubled and by June 2011 it had trebled. The government that had nearly halved its net credit from BB between June 2007 and December 2009 went on a borrowing spree since then. By the end of FY 2009-10, it had increased its net borrowings by two-thirds, and by the end of FY 2010-11, its borrowings had increased by another three-fifths. Thus, the government's net credit from BB had increased by 2.4 times within 18 months. Since there was no offsetting reduction in the net foreign assets of BB, the entire increase in net government credit went to raising the reserve money holdings of BB, which in turn caused a corresponding multiple increase in the money supply. If government borrowing from BB continues unabated, the money supply will continue increasing. Hence, the prospect of a substantial improvement on the inflation front in the near future seems slim. When inflation expectations become embedded, a substantial reduction in monetary growth will not have much immediate effect. It may take 12-18 months before a monetary contraction is reflected in price reductions. It would thus seem that the economy will suffer from inflation for at least a couple of years even if corrective actions are taken within a short time. The high inflation could dampen the growth momentum of the economy. (Concluded. The writer is Professor, Department of Economics, University of Dhaka. He may be reached at e-mail: m_a_taslim@yahoo.com)