Monetary policy stance and recent movements in monetary aggregates
Friday, 6 May 2011
Mustafa K Mujeri in the first of his two-part article
The Bangladesh Bank's (BB) latest bi-annual Monetary Policy Statement (January 30, 2011) adopts a monetary policy stance that claims to support "the government's goals of faster inclusive economic growth and poverty reduction, besides maintaining monetary and price stability". In the backdrop of 5.8 per cent Gross Domestic Product (GDP) growth and 7.3 per cent average Consumer Price Index (CPI) inflation in FY10, the annual monetary programme of BB for FY11 was set assuming real GDP growth of 6.7 per cent and average inflation of around 7.0 per cent during the current fiscal year. It may be mentioned that BB's monetary policy uses repo, reverse repo, and BB bill rates as policy instruments for influencing financial and real sector prices toward the targeted path of inflation. The annual monetary programme adopts reserve money (RM) as the operating target while broad money (M2) is used as the intermediate target. The underlying assumption is that the growth of monetary aggregates (such as M2) has a direct impact on the domestic price level. Therefore, by controlling the growth of monetary aggregates, BB aims to achieve price stability. In practice, BB sets a growth rate of RM that is deemed consistent with the targeted inflation rate, with the idea that this RM growth will in turn lead to a growth rate of M2 that is consistent with the inflation target and adequate liquidity in the economy. However, if the link between RM and M2 weakens as the financial sector develops and a more diverse array of financial assets becomes available, a new approach to monetary policy would be warranted. This write-up examines recent movements in RM vis-à-vis BB's monetary programme for FY11 and brings out possible policy implications and management options as mismatch between monetary aggregates and the desired inflation path becomes evident. Inflation and M2 growth As mentioned earlier, M2 is one of the key aggregates of BB's monetary programme. The relationship between the growth rate of M2 and inflation is relatively weak in Bangladesh (the correlation coefficient is estimated at 0.33 over FY00 and FY 08). In general, there does not exist any credible evidence of a clear, stable relationship between the growth of M2 and inflationary dynamics in the country especially in recent times. Empirical evidence does not show any strong relationship even after taking into account the lagged impact of M2 growth on inflation. This shows that even if BB is able to influence the monetary aggregates using the policy tools, the tools are losing effectiveness in controlling inflation in view of the increasingly complex nature of price dynamics in the country. One important implication of the above development is that, in such situations, contractionary monetary policy may not be very effective in maintaining low inflation. One reason for this weak relationship lies in the underlying sources of inflationary pressure. Recent inflationary pressures have originated largely from supply shocks affecting several key prices such as food, fuel and other essential products. It is important to recognize that monetary aggregates influence the domestic price level through demand side effects on purchasing power. If, however, inflationary pressures originate from supply side shocks, changes in M2 growth will have a limited impact on inflation dynamics. In such situations, undue reduction of M2 growth may become counterproductive through worsening the negative impact of inflationary supply side shocks on economic growth by reducing liquidity and raising interest rates. Movement in Reserve Money In absolute terms, RM has experienced a secular rise over the years reaching Tk. 805.1 billion in FY10 from Tk. 170.6 billion in FY00. This has been contributed by increases in both net domestic assets (NDA) and net foreign assets (NFA), although there has been some change in their relative contribution with NFA gaining importance over time (Table 1). Moreover, wide fluctuation can be observed in the yearly growth rate of RM since FY00; varying within a range of 3.3 per cent in FY03 and 31.5 per cent in FY09. The growth rate was 16.0 per cent in FY10. On the other hand, growth rates of NDA and NFA showed more violent changes. Over the FY00-FY08 period, the coefficient of variation of NDA is estimated at 19.7 whereas similar value for NFA is high at 63.2. The growth rate of NDA was 31.0 per cent in FY09 and (-) 26.2 per cent in FY10 while the corresponding values were 31.7 per cent and 41.5 per cent for NFA. One important characteristic of changes in NDA and NFA is that, in most years, their growth rates moved in opposing directions thereby reducing the volatility of RM growth. The monthly movements in the level and growth of RM, NDA and NFA indicate that, although fluctuations in the levels are mostly irregular, monthly growth rates reveal some seasonal patterns with distinct peaks and troughs. Thus, the movements in NDA and NFA are such that their growth should not be seen in isolation in order to assess the potential impact on monetary expansion. Moreover, it is important to take into account the seasonal patterns of movements in NDA and NFA in evaluating their potential impact. The movement in NDA is governed by two of its important constituents-net credit to the government and to DMBs. For NFA, the single most important determinant is the foreign exchange reserves. Monetary programme of FY11 and recent trends The monetary programme of BB sets RM growth at 13.0 per cent and M2 growth at 15.2 per cent for FY11 compared with actual growth of 18.1 per cent and 22.4 per cent respectively in FY10. It is presumed that the growth of private sector credit would be 16.0 per cent and, as indicated in FY11 budget, net credit to the government would not exceed Tk 156.8 billion in FY11. In addition, it is assumed that net non-bank borrowing by the government would be Tk 80 billion. Recent changes in selected monetary aggregates are given in Table 2. During July-February FY11, RM recorded a growth of 9.7 per cent compared with 5.4 per cent during the same period of the previous fiscal year. The increase of RM during this period resulted from increase in NDA by 44.7 per cent while NFA decreased by 1.4 per cent. Domestic credit has expanded significantly during July-February FY11. Overall, domestic credit grew by 15.9 per cent, and the growth rate was 26.4 per cent (year-on-year basis) in February 2011. The growth rate of private sector credit was 17.6 per cent during the period which was 28.3 per cent in February 2011 on a year-on-year basis. The monthly growth of private sector credit shows sustained increase during the period. The growth of M2 was 21.7 per cent (year-on-year) in February 2011. On the external front, there has been a significant increase in trade deficit to more than US$ 4.85 billion during July-February FY11 (compared with $3.32 billion during the same period of the previous fiscal). The current account balance (CAB) showed a surplus of only $602 million during July-February FY11 (which was $2.55 billion during July-February FY10) due mainly to slow growth of remittances. During the period, overall balance was recorded at (-) $490 million whereas similar balance was $2.39 billion during the same period of FY10. Despite high export growth by 40.4 per cent during the first eight months of FY11, import payments also rose by nearly 42 per cent. The foreign exchange reserves slightly declined to $10.73 billion at the end of March 2011 from $10.75 billion in June 2011. In general, recent developments indicate that the country's external sector is under pressure and the pressure is likely to increase further due to rising food and oil prices in the world market and increased uncertainties surrounding remittance inflows from the Middle East. Dr. Mustafa K Mujeri is the Director General of Bangladesh Institute of Development Studies
The Bangladesh Bank's (BB) latest bi-annual Monetary Policy Statement (January 30, 2011) adopts a monetary policy stance that claims to support "the government's goals of faster inclusive economic growth and poverty reduction, besides maintaining monetary and price stability". In the backdrop of 5.8 per cent Gross Domestic Product (GDP) growth and 7.3 per cent average Consumer Price Index (CPI) inflation in FY10, the annual monetary programme of BB for FY11 was set assuming real GDP growth of 6.7 per cent and average inflation of around 7.0 per cent during the current fiscal year. It may be mentioned that BB's monetary policy uses repo, reverse repo, and BB bill rates as policy instruments for influencing financial and real sector prices toward the targeted path of inflation. The annual monetary programme adopts reserve money (RM) as the operating target while broad money (M2) is used as the intermediate target. The underlying assumption is that the growth of monetary aggregates (such as M2) has a direct impact on the domestic price level. Therefore, by controlling the growth of monetary aggregates, BB aims to achieve price stability. In practice, BB sets a growth rate of RM that is deemed consistent with the targeted inflation rate, with the idea that this RM growth will in turn lead to a growth rate of M2 that is consistent with the inflation target and adequate liquidity in the economy. However, if the link between RM and M2 weakens as the financial sector develops and a more diverse array of financial assets becomes available, a new approach to monetary policy would be warranted. This write-up examines recent movements in RM vis-à-vis BB's monetary programme for FY11 and brings out possible policy implications and management options as mismatch between monetary aggregates and the desired inflation path becomes evident. Inflation and M2 growth As mentioned earlier, M2 is one of the key aggregates of BB's monetary programme. The relationship between the growth rate of M2 and inflation is relatively weak in Bangladesh (the correlation coefficient is estimated at 0.33 over FY00 and FY 08). In general, there does not exist any credible evidence of a clear, stable relationship between the growth of M2 and inflationary dynamics in the country especially in recent times. Empirical evidence does not show any strong relationship even after taking into account the lagged impact of M2 growth on inflation. This shows that even if BB is able to influence the monetary aggregates using the policy tools, the tools are losing effectiveness in controlling inflation in view of the increasingly complex nature of price dynamics in the country. One important implication of the above development is that, in such situations, contractionary monetary policy may not be very effective in maintaining low inflation. One reason for this weak relationship lies in the underlying sources of inflationary pressure. Recent inflationary pressures have originated largely from supply shocks affecting several key prices such as food, fuel and other essential products. It is important to recognize that monetary aggregates influence the domestic price level through demand side effects on purchasing power. If, however, inflationary pressures originate from supply side shocks, changes in M2 growth will have a limited impact on inflation dynamics. In such situations, undue reduction of M2 growth may become counterproductive through worsening the negative impact of inflationary supply side shocks on economic growth by reducing liquidity and raising interest rates. Movement in Reserve Money In absolute terms, RM has experienced a secular rise over the years reaching Tk. 805.1 billion in FY10 from Tk. 170.6 billion in FY00. This has been contributed by increases in both net domestic assets (NDA) and net foreign assets (NFA), although there has been some change in their relative contribution with NFA gaining importance over time (Table 1). Moreover, wide fluctuation can be observed in the yearly growth rate of RM since FY00; varying within a range of 3.3 per cent in FY03 and 31.5 per cent in FY09. The growth rate was 16.0 per cent in FY10. On the other hand, growth rates of NDA and NFA showed more violent changes. Over the FY00-FY08 period, the coefficient of variation of NDA is estimated at 19.7 whereas similar value for NFA is high at 63.2. The growth rate of NDA was 31.0 per cent in FY09 and (-) 26.2 per cent in FY10 while the corresponding values were 31.7 per cent and 41.5 per cent for NFA. One important characteristic of changes in NDA and NFA is that, in most years, their growth rates moved in opposing directions thereby reducing the volatility of RM growth. The monthly movements in the level and growth of RM, NDA and NFA indicate that, although fluctuations in the levels are mostly irregular, monthly growth rates reveal some seasonal patterns with distinct peaks and troughs. Thus, the movements in NDA and NFA are such that their growth should not be seen in isolation in order to assess the potential impact on monetary expansion. Moreover, it is important to take into account the seasonal patterns of movements in NDA and NFA in evaluating their potential impact. The movement in NDA is governed by two of its important constituents-net credit to the government and to DMBs. For NFA, the single most important determinant is the foreign exchange reserves. Monetary programme of FY11 and recent trends The monetary programme of BB sets RM growth at 13.0 per cent and M2 growth at 15.2 per cent for FY11 compared with actual growth of 18.1 per cent and 22.4 per cent respectively in FY10. It is presumed that the growth of private sector credit would be 16.0 per cent and, as indicated in FY11 budget, net credit to the government would not exceed Tk 156.8 billion in FY11. In addition, it is assumed that net non-bank borrowing by the government would be Tk 80 billion. Recent changes in selected monetary aggregates are given in Table 2. During July-February FY11, RM recorded a growth of 9.7 per cent compared with 5.4 per cent during the same period of the previous fiscal year. The increase of RM during this period resulted from increase in NDA by 44.7 per cent while NFA decreased by 1.4 per cent. Domestic credit has expanded significantly during July-February FY11. Overall, domestic credit grew by 15.9 per cent, and the growth rate was 26.4 per cent (year-on-year basis) in February 2011. The growth rate of private sector credit was 17.6 per cent during the period which was 28.3 per cent in February 2011 on a year-on-year basis. The monthly growth of private sector credit shows sustained increase during the period. The growth of M2 was 21.7 per cent (year-on-year) in February 2011. On the external front, there has been a significant increase in trade deficit to more than US$ 4.85 billion during July-February FY11 (compared with $3.32 billion during the same period of the previous fiscal). The current account balance (CAB) showed a surplus of only $602 million during July-February FY11 (which was $2.55 billion during July-February FY10) due mainly to slow growth of remittances. During the period, overall balance was recorded at (-) $490 million whereas similar balance was $2.39 billion during the same period of FY10. Despite high export growth by 40.4 per cent during the first eight months of FY11, import payments also rose by nearly 42 per cent. The foreign exchange reserves slightly declined to $10.73 billion at the end of March 2011 from $10.75 billion in June 2011. In general, recent developments indicate that the country's external sector is under pressure and the pressure is likely to increase further due to rising food and oil prices in the world market and increased uncertainties surrounding remittance inflows from the Middle East. Dr. Mustafa K Mujeri is the Director General of Bangladesh Institute of Development Studies