Should the central bank follow the market or lead it?

Bangladesh Bank announced its Monetary Policy Statement (MPS) for the second half of the current fiscal year (January-June 2016) on  January 07. The objective of the present paper is to undertake an illustrative analysis of the limitations of monetary policy in Bangladesh by making use of the current policy as a reference material.
To set the stage for the analysis, two quotations from two outstanding Nobel-laureate economists are cited below. The first one is from Milton Friedman who is known to be a staunch monetarist. In an article published in 1955 he wrote:
"There seems little doubt that a large change in the money supply within a relatively short period will force a change in the same direction in income and prices…..But when the money changes are moderate the other factors come into their own….there are thus definite limits to the possibility of any fine control of the general level of prices by a fine adjustment of monetary change…"
The second quotation is from Paul Samuelson who wrote in a 1967 article:
"In the debate what should a central banker watch, should he watch the money stock or should he watch the interest rate structure…..I think when the Good Lord gave us two eyes, He had a purpose in that. He didn't want us to watch just one thing, He wanted us to watch both of these things".
The messages that come out from these quotations are:
I. It requires large changes in money supply within a short period to have an effect on income and price level. The effect of small changes in money supply is likely to be swamped by other factors.
II. Monetary policy should exert control over both stock of money and interest rate. It is generally held that the transmission channel is from money supply to interest rate and then to flow of credit to and investment by the private sector. Higher money supply leads to lower interest and thereby promotes growth.
The first limitation of the present Monetary Policy of Bangladesh is that the proposed change in broad money is small. The target envisages an increase of 15 per cent compared to the previous one of 15.6 per cent. Therefore, the effect on growth is bound to be small in light of Friedman's observation.
It goes to the credit of the Bangladesh Bank that due recognition is given to both broad money and interest rates as intermediate targets with a view to ensuring sustainable growth and moderate inflation. This is consistent with Samuelson's prescription, but raises two questions:
(a) To what extent can Bangladesh Bank exercise control over broad money? (b) How does broad money affect interest rate?
With regard to the first question, a large chunk of broad money (about 40 per cent) comprising net foreign asset and credit to the public sector remains outside the control of Bangladesh Bank (Table 1). Net foreign asset is determined by exports, remittances and inflow of foreign capital-none of these elements can be effectively controlled by Bangladesh Bank. Similarly, the central bank cannot exercise any control over government borrowing and little, if at all, borrowing by other public sector entities some of which receive government guarantee. The incapacity explained above is the second limitation of monetary policy in Bangladesh.
The third limitation arises from tenuous link between broad money growth and interest rate. A comparison of broad money growth and interest rate on advances shows that during the FY 11 through FY 14, high interest rates on advances persisted despite high growth of broad money; in FY 15 interest rate fall in spite of a large fall in growth of broad money (Table 2). The most likely explanation lies in interest rate fixing through collusion among banks, particularly private banks.
The fourth limitation has to do with the maintenance of excess liquidity in the banking system which surged from TK 408.81 billion (40,881 crores) at the end of July 2012 to TK 1,206.79 billion (1,20,679 crores) at the end of December 2015. In this scenario Bangladesh Bank's policy instruments such as open market operations (through repo and reverse repo) and variations in reserve requirements exert practically no impact on broad money.
The final point to note is that the present Monetary Policy is reactive, rather than proactive. It is reflected in the statement "the need to realign the rates with the markets made a case for easing of policy interest rates" and this was cited as justification for the lowering of repo and reverse repo rates by 50 basis points to 6.75 per cent and 4.75 per cent respectively. Should the central bank follow the market or lead it?
Dr. Mirza Azizul Islam, a former Advisor to the Caretaker Government, Ministries of Finance and Planning, is a Visiting
Professor in BRAC University.