Diagnosing the monetary policy

Nahida Sultana and A Z M SalehThe monetary policy by the Bangladesh Bank is tailored to maintaining reasonable price level. It also regulates the cost and availability of domestic credits to the priority sector and at the same time it can increase investments. Monetary policy can be both expansionary and contractionary. It is contingent on the expansioncontraction of the total supply of money. In the context of high unemployment rate, expansionary policy is applied to increase production. On the other hand, contractionary monetary policy, conventionally, is applied if prices are destabilised. Recently Bangladesh Bank has declared its six-monthly Monetary Policy Statement (MPS) and adopted a contractionary monetary policy to reduce the stress of the existing liquidity pressure and contain inflationary pressure. For continuous high inflation, people need more money for consumption. Increase in domestic credit and import payment and deficit in trade balance results in rising of demand of both domestic and foreign currencies. For these reasons commercial banks are facing liquidity pressure from December 2010. So the currency outside the banks and currency inside are increasing simultaneously. To meet the objectives of the MPS, both repurchase agreement (REPO) and Reverse REPO are used. Due to the increase in the world prices of food and oil, the pressure of inflation is increasing in Bangladesh. There has been increased pressure of demand both in taka and foreign exchange markets in FY 2011. While workers' remittances are slowed down, trade deficit increases for the import growth and decline in capital account inflows creates the stress on taka and foreign exchange. In this situation, Bangladesh Bank has enhanced the REPO 50 basis points at once and Reverse REPO interest in total 255 basis points in four steps. The policy instruments enlisted such as hikes of Cash Reserve Ratio (CRR), REPO rates induce cost of capital, and thereby may dampen investment, by increasing the cost of capital as the banks borrow at higher rates. Therefore, the central bank's expectation of reduction of pressure on liquidity may not be materialised. The MPS's envisaged instruments may not rein in inflation because of the wrong diagnosis of the causes of continuous increase in prices. The inflation has occurred for two reasons: firstly, domestic prices are increasingly knotted to international prices due to the liberalisation of trade and prices being adjusted to global prices, and secondly, a reduced emphasis on public distribution system has encouraged jacking up in prices. By controlling broad money (M2), the central bank tries to control the price level. In July-May in FY 2010-11, broad money increased by Tk 662.446 billion or 18.25 per cent against the increase of Tk 557.261 billion or 18.79 per cent in FY 2009-10. But in May 2011, the supply of M2 was Tk 4,292.7580 billion whereas it was Tk 3,630.3120 billion in June 2010. Of the components of broad money, currency in circulation has increased by 16.90 per cent while demand deposits and time deposits witnessed an increase of 18.44 per cent and 9.22 per cent respectively. Domestic credits are increasing day by day due to the expansion of the credits of the private sectors. Domestic credit has increased by Tk 809.5740 billion or 23.80 per cent during July-May in FY 2010-11 whereas it was Tk 397.3580 billion in FY 2009-10. Domestic credit growth in May 2011 over May 2010 was 28.29 per cent. The Bangladesh Bank emphasises credit availability for agriculture, small and medium enterprises, renewable energy and other productive sectors. The persuasion of prescribed mechanisms to contain inflationary pressures in subsequent MPS has not given results. In FY 2008-09 inflation rate was 6.66 per cent whereas in FY 2009-10 it was 7.31 per cent and in 2010-11 8.85 per cent which is well above the targeted level of 8.00 per cent. General inflation in July 2011 was 9.1 per cent. In the urban areas food inflation was 12.03 per cent in FY 2010-11 while it was 9.85 per cent in FY 2009-10. In the rural areas general inflation was 7.3 per cent in June 2011 that was 6.83 per cent in 2010. Change in inflation rate in FY 2009-10 was 9.76 per cent whereas it was 20.25 per cent in 2010-11. Percentage of change in food inflation was 18.80 in 2009-10 but it was 32.94 in 2010-11. The government projected inflation to be 7.5 per cent in the current fiscal year but if this inflationary situation holds further, this projection will remain in the oblivion. Bangladesh Bank has taken the contractionary policy by increasing REPO and reverse REPO which increases the interest rates. The lending interest rate is 12.40 per cent and the deposit interest rate is 7.26 per cent (June 2011). For the increased food consumption in 2010-11, domestic savings as percentage of gross domestic product (GDP) falls. It was 19.59 per cent in FY 2010-11 whereas it was 20.1 per cent in 2009-10. National savings also falls as the remittance inflow decreases in this fiscal year (FY) which is 28.4 per cent of GDP. Savings rate should have increased with the rise of interest rate. But in the fiscal year this does not happen as food inflation reaches as high as 11.34 per cent. Investment is interrelated with the levels of inflation and interest rate. Increase in interest rate may pose an adverse effect on investment. The lending interest rate rose from 12.63 in 2008 to 12.83 in April, 2011. The investment trend is found to have declined but the investment ratio in GDP rises by 24.7 per cent in FY 2010-11. In 2009-10 private investment was Tk 1,346.9 billion whereas it was Tk 1,532.1 billion in 2010-11. The contractionary policy increases the interest rates in the economy. The Monetary Policy Statement of 2011 emphasises the distribution of the domestic credit to the priority sectors to reduce the inflation rates. Credit of private sectors may be squeezed by 28.25 per cent by the end of the FY 2011-12. The latest MPS stated that the government should spend more on the public sectors. Increase in the public expenditure by the government is financed by the borrowing. This public expenditure crowds out the private investment. An increase in interest rate, consequentially, is expected to have a number of effects. A rise in higher cost of capital may induce declined investment as the cost of the capital will go up, as opposed to the central bank's expectation of reduction in pressure on liquidity. Current elevated rates of inflation pose significant risks to future growth. In addition, the dampening of investment and unabated rise in the price would hurt different sections of society differently. Any failure to contain inflation is bound to increase inequality as the latter has been showing an upward trend for some time. Furthermore, the central bank has not been able to maintain its targets. Contrary to what has been prescribed in the MPS, these require harmonisation of monetary policies with fiscal measures to address this "imported" inflation, with expansion of domestic productive capacities. The apparent divergence between key targets and outcomes seems to occur with unfailing regularity raising the issue of credibility and realism in target setting. Under the business as usual scenario, it is evident that the targets set in the Monetary Policy Statement may be left far behind than the actual. (The writers are researchers at Unnayan Onneshan. Nahida can be reached at email: sultana.nahida@unnayan.org and Saleh at azmsaleh@unnayan.org)