The Bangladesh Bank (BB) stated that the first half of the FY 2023-24 monetary policy will be on 18 June 2023. The policy statement for each fiscal year has unique attributes and characteristics. The monetary policy for this year is different and perhaps more challenging than the previous ones since it concentrates on constraining inflation while meeting the IMF conditions. 

Conforming to the contractionary monetary policy approach, for the current fiscal year, Bangladesh Bank has chosen to raise its policy rates, also known as the repo rate, by  50 basis points to 8.5 percent. The aim is to raise the cost of borrowing and make money more expensive to achieve the ultimate target of minimizing inflation infuriated by global market price increases due to COVID-19, the Russia-Ukraine war, and the depreciation of the taka against the dollar. 

However, BB is far behind in creating impactful policy rates compared to the rest of the world. The Monetary Policy Committee set the goal of reducing inflation to 8% by December 2023 and 6% by June 2024. Although December has passed, we are nowhere near the destination. The current inflation rate in Bangladesh has increased slightly to 9.67% (as of May) way above the targeted 6% inflation for the current fiscal year, and therefore, the purchasing power of currency needs to escalate fast.  

Let us try to define a policy rate first. It is the rate at which commercial banks can borrow money from the central bank. The definition varies per country. For instance, in the US, the policy rate known as the discount rate is the interest rate the Federal Reserve charges commercial banks for loans. In Europe, the marginal lending rate is known as the policy rate, simply the rate at which banks can refinance themselves with the help of the central bank-provided guarantees. An increase in policy rates cools economic activity by reducing the money injection supply, while lowering policy rates escalates economic growth.

Policy rate hikes around the world

All across the globe, a policy rate hike is acknowledged as a convenient monetary tool. It is specifically significant in the case of taming inflation. The Federal Reserve of the USA has raised interest rates to the highest level in 22 years to restrain the money supply in the economy. The Fed has raised the policy rate 11 times in the previous year, and as an outcome, the inflation rate reduced to 3.1% in November 2023 from 3.20% in October 2023, far lower than the 9.1% inflation in June 2022. Policy rate hikes worked perfectly in the context of the North American economy. Nevertheless, the initiatives of the Federal Reserve to tone down inflation have historically brought them in the front door of recession. Therefore, as a precaution, the Fed tries to set rates high enough to lower inflation but not so much that the economy falls drastically.

Like the Federal Reserve, the European Central Bank has also raised policy rates intending to discourage people from spending, thereby rebalancing the economy from an unhealthy expansion. The euro area inflation contracted from 10.6% to 5.3% within a year. In 2022, India applied the 250 basis points to control inflation. Sri Lanka’s determination to raise the key policy rate to scale down its high inflation has worked well and effectively. High interest rates have helped these countries to raise the cost of borrowing and thus achieve their monetary policy goals. These economies have learned to trust in high policy rates as they observe fruitful consequences.

Why did it work for the USA but not for us?

BB increased the repo rate last year as inflation rose following a sharp increase in commodity prices. However, unlike other countries and economic zones, BB could not produce the expected results in battling inflation. The Fed has raised the policy rate 11 times in the previous year, and yet the Inflation rose to 9.81%  in March from 9.67 percent in February of 2024. Meanwhile, food inflation reached 12.56%. Moreover, taka has depreciated against the US dollar by about 28% in the past 18 months. The significance of the policy rate has proven to be very inefficient from our economic perspective, and there are many reasons behind it. 

It was already too late when BB took the initiative to scale down inflation. The current market system is also faulty and fragile. Lack of good governance and a biased management system where only a few groups control the pricing is why many monetary policies have stumbled in this economy.  

BB has been raising policy rates insufficiently when the economic condition requires more powerful tools. The central bank increased the policy rate by 225 basis points – from 5% to 7.25%. In contrast, Sri Lanka has increased the policy rate by 1,000 basis points from 5.5% to 18.5% in just one year and successfully dominated inflation, which peaked at 73.7% the previous year. 

The special repo rate (Standing Lending Facility, or SLF), which is the ceiling of the interest rate corridor, rate has been increased by 50 basis points to 10 percent to refine liquidity management. Meanwhile, the reverse repo rate (Standing Deposit Facility, or SDF) has been raised by 50 basis points as well to 7 percent.   

In June last year, BB introduced a new interest rate regime, removing the lending rate cap to achieve the conditions of the IMF’s loan. With higher inflation already existing in the economy, bringing the lending rate was a risky decision. In October, after the latest rise in the policy rate, BB increased the lending rate by 23 basis points to 10.93%. However, the rising lending rate in Sri Lanka successfully cooled down inflation to 0.8% in September 2023.

The policy rate hike influences private sector expenses and importation costs. The policy rate hike did not appear to be considerably impactful as a decrease in the opening of letters of credit (LCs) for import loans has lowered the public sector growth. The slow increase in the policy rate will eventually raise the lending rate, reducing the loans demanded. 

The dearth of congruence between the monetary and fiscal policy has made the policy hike deficient in controlling inflation. Private sector growth is already draining as investors follow a stiff business pattern interrupted by economic stress and political imbalance. The central bank tightened the money supply while the overall interest rate increased. In July last year, the weighted average interest rate on deposits stood at 4.46%, and the weighted average rate on loans was 7.75%. 

Besides small portioned policy rate hikes, some economists blame the SMART rate formula for the failure to cool down inflation. As per the new monetary policy, the Six-Month Moving Average Rate of the Treasury Bill, abbreviated as the SMART rate, cannot be changed within six months. This means that even if the interest rate increases, banks must keep it the same for existing customers. Banks can apply a 3% margin on the Six-Month Moving Average Rate of Treasury Bill (SMART) loan, whereas non-banking financial institutions can apply up to 5%. The SMART rate stands at 7.43%, and the maximum lending rate of banks will be 11.18%. 

However, BB hopes to see the result of the policy hike soon. As we have seen, inflation has started to decline. Although very slowly, the inflation rate decreased from 9.86% in January to  9.67% in February of 2024. If implicated Properly, hopefully, we will see a thoughtful impact on the economy. 

Implementation in Bangladesh

Whether raising the policy rate is a good idea is an issue amongst economists worldwide. Bangladesh is in desperate economic distress and needs a way out from falling. With IMF loans on top of our heads and the ever-rising price hike, Bangladesh has taken the risk of increasing the policy rate to reduce money from the economy. Despite slow improvement, policy rate hikes can help reduce inflation in Bangladesh. 

61 scheduled banks in Bangladesh operate under BB’s full control and supervision. Commercial banks and financial institutions borrow money from the central bank at the repo rate. When BB increases the repo rate, commercial banks increase the interest rate on deposits and loans. Consequently, there will be a tendency among people to reduce consumption and increase savings as the returns on bank deposits have increased. The benefit of having more deposits will reduce people’s interest in buying land, buying gold, or other expensive assets.

With reduced consumption, the demand for goods and services will fall. A decrease in demand will cause supply to fall, and production will face a scale-down, leading to a rise in unemployment. Thus, cutting off consumption dampens economic growth, which is done intentionally to counterbalance inflation. 

The prices of a few products are already decreasing, indicating that the supply is increasing while demand is comparatively lower. Prices declined 0.95% in November from the previous month’s increase. Food & non-alcoholic beverages prices reduced by 10.76% in November compared to 12.56% in October. Household equipment eased to 14.11% and miscellaneous goods & services by 6.15% in November. Transportation prices reduced to 6.12% in November while it was 7.33% in October. Health expenses declined further to -3.83%. 

As interest rates increase, loans become more expensive for the business owners. High interest rates make loans less attractive to investors. Therefore, demand for dollars will decrease as there will be fewer LCs to open. 

An increase in the policy rate will also increase the interest rate for interbank lending. The interbank rate is the rate of interest charged on loans taken from one bank by another. Thus, interbank borrowing will become costlier. This will reduce the demand among banks to borrow money. 

Whispers of a rise or fall in interest rates can affect the stock market almost immediately. Higher interest rates reflect the large discount rate used for future cash flow. Thus, rising interest rates can depreciate stock prices in stock exchanges in Bangladesh. 

Can policy rate be an alternative to price control?

Economists who are uncomfortable with price control propose measures like price controls. A policy rate hike is one of the most widely discussed and controversial solutions for inflation. In the case of price control, the government imposes a measure that prohibits sellers from selling particular goods and services above a certain price. Unfortunately, the government’s control over markets and price regulation often does not work well. Price control decisions such as keeping a steady gas price, maintaining a fixed house rent, or controlling food prices such as rice, oil, and sugar may work well for a few days, and then the prices start to rise again. This is why the government lets the market make the pricing decisions for most products, except for a few specific ones.

With inflation raging out of control all across the globe, it is becoming common to utilize policy rate hikes to reduce the money supply from the economy instead of imposing price control on specific products. The rising interest rate may hurt the economy, and despite everything, implementing policy rate hikes will help keep the inflation rate steady. 

While BB plans to continue raising rates, the dilemma remains as to whether to continue raising rates or not to raise rates and keep things as they are. Raising interest rates to combat high inflation can cause an economic slowdown and a potential recession. Undoubtedly, this is a tough decision for BB to take. There are pros and cons to making any monetary policy decisions, and with inflation control as our ultimate target, it is the best time to take risks and imply a policy hike. 

It is challenging to control inflation in a country like ours only by implementing price control. However, with the current condition, economists seek alternatives to stabilize the price level, such as policy rate hikes. Perhaps it is the perfect time for an implication policy rate hike, and we should be more welcoming. 

If rules and regulations regarding price inflation are correctly implemented, the result of the policy rate hike can be as good as that of Sri Lanka. By coordinating with powerful organizations, BB can break record inflation, slow the high commodity prices, and appreciate the value of the taka. 

Zanjabil Mashkura is an Economics graduate from Dhaka University and a regular writer on national finance and economics. Reach her here: z.mashkura@gmail.com