BOTH in developed and developing economics, monetary policy seeks to maintain price stability accompanied by sustained stable output growth in the face of internal and external shocks that are faced from time to time. For developing economies like Bangladesh with significant underemployment/ under-exploitation of production factors, stimulating higher growth is imperative for rapid reduction and eventual elimination of endemic poverty, and is therefore an overriding priority. The stimulus provided by monetary policy in accommodating the growth aspirations must not however jeopardise macroeconomic stability and future growth; and the pursuit of monetary policy comprises of various supportive measures to attain the highest sustainable output growth while adjusting smoothly to internal and external shocks that the economy encounters from time to time.
History and objectives of Bangladesh monetary policy: Objectives of the monetary policy of the Bangladesh Bank as outlined in the Bangladesh Bank Order, 1972 comprise of attaining and maintaining of price stability, high levels of production, employment and economic growth.
In the decades of seventies and eighties, monetary policy in Bangladesh was conducted with full direct control on interest rates and exchange rates, as also on the volumes and directions of credit flows.
The situation began changing in the nineties with the abolition of directed lending and gradual liberalisation of interest rates; the change process culminating in transition to market based exchange rate of Taka from May 31, 2003. From then on, interest rate and exchange rate are both market driven, exchange rate is no longer in the role of nominal anchor for prices.
The policy targets: Monetary policy in Bangladesh is formulated around inflation and output growth rates as the basic policy targets. Levels and growth paths of relevant monetary aggregates such as reserve money, broad money and domestic credit are also projected and monitored as intermediate targets in conducting monetary policy.
Inflation target: Consumer Price Index (CPI) inflation, expressed as the rate of change of CPI is used in Bangladesh for measuring price stability in conducting monetary policy. Some central banks opt for suitably defined 'core inflation' excluding from consumption basket items with typically high seasonal price volatility, viewed as better representing the actual underlying inflation trend.
The target level of CPI inflation is chosen taking into account the country's past long run inflation performance, and the domestic and external factors driving the current trend of domestic inflation.
Apart from a brief spell of relatively high instability of prices in the mid seventies, inflation in Bangladesh has always been contained at moderate levels. From the early nineties, annual average CPI inflation has consistently been at single digit levels, reaching a low of 1.94 per cent in fiscal year (FY) 01 and edging upwards thereafter, in line with the bottoming out and subsequent upswing of global inflation. Other than the administered energy prices, consumer prices in Bangladesh are market driven, and as mentioned earlier, trends of domestic prices of tradable in the open economy are increasingly mirroring global price trends, the divergence between domestic and global inflation arising largely from the price trends of the nontradables.
Growth target: GDP growth projections of the Medium Term Macroeconomics Framework (MTMF) in the government's 'Unlocking the Potential: National Strategy for Accelerated Poverty Reduction', modified appropriately in the light of unfolding actual developments, are used as output growth targets for the purpose of monetary policy. The MTMF projected 6.5 per cent and 6.8 per cent real GDP growth for FY06 and FY07 respectively. In view of the good post flood recovery of agricultural output and the better than expected holding up of apparels export demand after Multi-Fibre Arrangement (MFA) expiry, real GDP growth targets for the purpose of monetary policy have been taken as 6.8 per cent and 7.0 per cent respectively for FY06 and FY07.
Conducting monetary policy: The near term inflation objective of monetary policy will be to contain the annual average CPI inflation, on an upswing phase since 2001, at around the current level of under 7.0 per cent. Monetary policy is therefore on tightened stance until inflation levels off and enters its downswing phase.
l Interest rate: In tightening the monetary policy stance, key policy rates (treasury bill/bond auction yields, repo and reverse repo interest rates of Bangladesh Bank) have been raised and maintained on uptrend, for these in turn to raise the rates of other financial costs and returns, restraining demand growth in the real sector.
l Revision of the statutory ratios for scheduled banks: The markets are yet to gain sufficient depth to respond with the changes in policy interest rates. To compensate for this inadequate interest rate responsiveness of markets, policy interest rate interventions in Bangladesh are at times supplemented by changes in the Cash Reserve Requirement (CRR) and Statutory Liquidity Ratio (SLR) for scheduled banks, thus influencing the volumes as well as costs of funds available for credit growth. In October 2005, the CRR and SLR were revised upward from 4.5 per cent and 16.0 per cent respectively to 5.0 per cent and 18.0 per cent of time and demand liabilities of scheduled banks, with a view to slowing down overall domestic credit growth as well as the growth of credit to the private sector.
Monitoring mechanism: Annual monetary programmes based on the inflation and GDP growth targets of monetary policy provide a convenient framework for interventions in monetary developments, and for monitoring the outcome of the monetary policy stance pursued. Based on the assumption that inflation rises and falls with increase and decrease in the rate of growth of money stock, the annual monetary programme targets a growth path for broad money consistent with the inflation and real GDP growth targets of monetary policy, allowing for the likely change in income velocity of money.
Levels of another monetary aggregate, Reserve Money (currency in circulation plus balances of banks with the Bangladesh Bank, also termed 'high powered money') is regulated with open market operations (periodical auctions of treasury bills/bonds) and daily repo, reverse repo auctions; towards maintaining broad money on the growth path targeted in the monetary programme.
The monetary programme is nevertheless very useful as framework for gauging the growth supportiveness and the inflation stabilisation effectiveness of the monetary policy stance pursued. The broad money growth target of the monetary programme has further been desegregated into sub-targets on the asset and liability side.
On the asset side, the net foreign asset and net domestic asset growth outcome relative to the targets and to each other indicate the relative performance in the domestic and external sectors of the economy; the outcome in growth of credit to the public and the private sectors relative to programme targets indicate whether the available credit volumes were short of or in excess of what was needed for the targeted GDP growth. On the liability side, the growth rates of currency in circulation and demand deposits indicate the extent of inflationary bias. In FY05, growth rates of credit to public and private sectors both exceeded programme levels, showing excess demand and inflationary bias, which also showed up on the liability side in the high growth rates of currency in circulation and demand deposits. These evidences of excess demand and inflationary pressure prompted the tightening of monetary policy stance for FY06.
While contractionary monetary policy continued beyond FY 05 to mop-up monetary overhang, GDP growth rate for FY 06 is estimated at much higher rate of 6.5 per cent mainly reflecting better performance of agriculture sector supported by growing industrial and services sectors. The growth rate would even be higher depending on final outrun of the boro crop. The tight money depressed import growth to 10 per cent during the first nine months of the fiscal year. Nevertheless, imports for capital machinery rose by 25 per cent ensuring continued investments. Despite difficulties in the garment sector following MFA-phase out, 31 per cent growth in knitwear contributed to about 19 per cent increase in exports. A growth rate of 23 percent in inward remittances provided a cushion for the external sector.
Despite improvement in the external sector, exchange rate, which is now market determined under floating exchange rate regime, faced some volatility. After remaining stable for a long time, the taka-dollar rate depreciated by 8.8 per cent during the last fiscal year up to April 06. Considering the tight liquidity position and noting that the real interest rate has fallen very low as the inflation rate has risen, banks are now compelled to offer higher nominal interest rate, or in other words, positive real rates to attract their deposits, without which credit expansion and rise in investment would not be possible. The banks would hopefully lower the nominal rates as soon as their liquidity position improves. Similarly the central bank will allow exchange rate to move with market fundamentals without volatility.
Our present challenge is to stabilise inflation rate. One caveat the pro-poor growth momentum is facing -- is the rise in inflation rate -- not only caused by the aftermath of the flood in 2005 and rapid credit expansion but also due to rise in fuel and commodity prices around the globe; which is beyond our control. Inflation rate that stood at 7.35 per cent in June 05 rose to 7.95 per cent in November 05. With a brief down swing during early months of 2006, it again started moving up to 6.17 per cent in March 06. We hope the monetary stance and prospective growth along with optimistic global economic scenario would bring down the price level within a short period.
Conclusion: As mentioned earlier, attaining and maintaining the highest sustainable output growth for rapid reduction of pervasive poverty is the overriding priority for monetary and other macroeconomic policy in Bangladesh. Monetary and fiscal policies have significant mutual impact, and are therefore formulated and conducted in a mutually consistent and co-ordinated way with reference to the Medium Term Macroeconomic Framework of the National Strategy for Accelerated Poverty Reduction (NSAPR) in attaining the growth, price stability and poverty reduction objectives.
The tightened monetary stance now being pursued is intended not to slowdown output growth but to curb excess demand arising from inflationary expectations, thereby supporting sustained stable output growth over the near and medium term. The monetary stance is subject to continuous review in the light of evolving situation, may shift to a neutral stance, and may even move further to an accommodative stance as values of key macroeconomics variables change over time.
This is an edited version of a presentation made by the writer who is the Governor of Bangladesh Bank to the participants in a training programme