Should monetary policy maintain its course?

We are again close to that time of the year when the central bank will announce a new monetary policy. We all know that the Bangladesh Bank (BB) has termed its monetary policy in recent times as 'accommodative' and 'growth-supportive' but various stakeholders have alleged that it is highly 'conservative'. A reputed think-tank recently suggested reducing central bank policy rates (known as repo and reverse repo rates) to improve investment momentum and trigger a depreciation of the exchange rate to support exporters. Certainly this view is not without merit, given the urgent need to expedite private sector investment and boost exports to realise Bangladesh's dream of achieving 7-8 per cent GDP growth. In this context, this note discusses possible path for monetary policy given BB's objective of supporting private sector investment, growth and employment while curbing inflation.
There are various channels of monetary policy transmission to real economic activity: we willrefer tothree specific channels which appear relevant for Bangladesh. First, lower policy rate increases private sector investment and output as real interest rate falls (interest rate channel). This mechanism works through a reduction in short-term rates translating to lower long-term rates (such as bank deposit and lending rates). Assuming price levels remain unchanged or 'sticky' in the short-run, reduction in long-term rates lower real interest rate and increase demand. Second, output is also expected to rise as the supply of loanable funds increase (bank lending channel). Third, expansionary policy triggers exchange rate depreciation, improving the country's net trade and remittance inflows (exchange rate channel). This is especially relevant for Bangladesh given persisting appreciation pressure which has compelled BB to relentlessly intervene in the foreign exchange market to maintain exchange rate stability. The associated sterilisation operations have amplified quasi-fiscal costs as the interest paid on sterilisation operation greatly exceeds that received on foreign exchange reserve holdings. These potential benefits on economic activity notwithstanding, lowering policy rates require further consideration in the context of Bangladesh given banking sector challenges and price-stability related constraints.
In the absence of a strong domestic bond market, the interest rate transmission of monetary policy depends almost entirely on the banking sector. But banks may not necessarily respond efficiently to policy rate reduction of 25-50 basis points. With inflation of around 6.1 per cent, lowering deposit rate by another 50 basis points from current level of around 6.5 per cent will offer savers negative real rate of return. This will only serve to expedite shift of funds from banks to financial instruments like national savings schemes (offering around 11 per cent return) where interest rates are not market-determined. This obvious threat might discourage banks from lowering deposit rates by the amount that policy rates are reduced, undermining efficiency of interest rate transmission.
What's about the bank lending channel? This mechanism works through an increase in bank reserves following monetary easing. Increase in reserves raises the quantity of bank loans available. Given banks' special role as lenders to borrowers who do not have access to other sources of capital, increase in available loans will cause investment spending to rise (Frederic Mishkin, 1995). It is worth mentioning that empirical studies in the context of Bangladesh have not found strong evidence of the existence of bank lending channel of monetary policy. Chart 1 supports this stance - bank credit growth did not really pickup in the months following the last time BB reduced policy rates (January 2013). In fact, total bank credit decreased slightly. So increase in loanable funds did not translate to higher investment and consumer spending. Various factors can be used to explain why credit growth did not pickup - but it does not mask the fact that issues like energy supply and land constraints can again hinder transmission from higher loanable funds to greater investment and output. This leaves only the exchange rate channel to facilitate higher output from expansionary policy. The overall implication is that transmission of policy rate reduction to the real economy is not strong, raising concerns related to its usefulness in Bangladesh's context.

Reducing policy rates in an environment of high excess liquidity in banking sector is also an issue worth exploring. Press reports state that excess liquidity has climbed well above BDT 1 trillion amid low credit demand from the private sector. It should be pointed out that there are disagreements regarding this amount, but it is definitely true that there is high volume of involuntary excess funds in the sector. Banks have had little option but to rush towards BB's reverse repo facility to stash their excess funds. On the other hand, massive amounts of reverse repo operations had escalated financial costs for BB, compelling the central bank to switch to lower-yielding BB bills - implying further reduction in banks' profitability.
Recently banks have been reducing lending rates to attract private sector entrepreneurs and this has translated (after a substantial lag) to a moderate increase in private sector credit growth in the last 2-3 months. While this is certainly encouraging, a sustained pickup in credit demand to levels necessary for 7 percent GDP growth requires improvements in infrastructural issues mentioned above (along with continued political stability). Until government tackles these well-known challenges, the banking sector may remain awash with excess liquidity. As long as banks are constrained by surplus funds, there is little justification of injecting more liquidity into the economy. Greater liquidity in the absence of sustained credit demand from the real sector will only serve to reduce banks' profitability. The other possibility is money flowing into unproductive sectors, creating inflationary pressures.
Risk of an increase in inflation is arguably the most pressing concern while pursuing an expansionary policy. What does economic theory have to say about inflation targeting through monetary policy? It is generally accepted that monetary policy should target only those prices over which it has leverage, namely core prices, and accommodate movements in non-core (food) inflation, at least up to the point that non-core inflation feeds through onto core inflation. By this definition, non-core prices are determined by supply-side factors or world market conditions (Adam et. al, 2012). So the central bank's main influence is on core inflation, or non-food inflation in Bangladesh's case.
Data on general inflation numbers in Bangladesh show gradual reduction from 6.87 percent in January, 2015 to 6.10 percent in December, 2015. A closer look at inflation components (food and non-food) tells a substantially different story (See Chart 2). While food inflation has generally fallen, non-food or 'core' inflation has risen from around 6.10 per cent to 7.05 per cent in December, 2015. Upward adjustment of electricity and gas prices has largely contributed to the increase in core inflation. Despite pursuing a relatively cautious monetary policy, BB's capacity to reduce inflation remains constrained when significant components of core prices are administratively increased by the government (not adjusting oil prices to international markets is worth mentioning as well). Core prices need to be brought down much further if Bangladesh wants to realize general inflation levels of around 5 per cent. Otherwise the country's real effective exchange rate will continue to remain appreciated due to high inflation-differential between Bangladesh and its major trading partners. We all know the consequences to export competitiveness due to real exchange rate appreciation. With price stability a primary mandate, the uptrend in core inflation suggests policy rate needs to remain where it is.

Proponents of policy rate reduction may argue that the gains to trade and remittance, through exchange rate depreciation, justifies monetary easing. We believe these benefits should be balanced against any costs imposed upon the economy in order to assess the net benefit of the policy action. For instance, if policy rate reduction accelerates inflation, Bangladesh will experience even wider price-differential with its major trading partners. This will exert appreciation pressures on the real effective exchange rate, further eroding trade competitiveness. Based on this argument, depreciation should be triggered by an increase in productive imports - which would slowdown rapid foreign currency inflow - giving the central bank a more realistic opportunity to intervene and devalue the currency.  
Even without policy rate reduction, banks are already bringing down lending rates given massive volume of excess liquidity and increasing pressure from the business community. Recent trend suggests domestic interest rates will continue falling gradually, especially to remain competitive against growing presence of foreign lenders. In the meantime, the central bank should make a strong plea to the government to expedite progress in energy supply issues, land constraints and oil price adjustment. Only when core inflation starts falling steadily and excess liquidity in banks starts declining, the central bank should ease policy rates. Now is not the time.
(To be continued)
The writer currently works as a Macroeconomic Analyst for an organisation in Washington D.C. He is a Fellow for the Asian Centre for Development in Dhaka.  
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