Cenbank finally moves to make money costlier to fight inflation

The reference lending rate, also known as SMART (six-month moving average rate of Treasury bill), surged to 7.20% in September, the highest in six months, as Bangladesh has stopped money creation through devolvement for deficit financing to curb money supply amid rising inflation. 

The surge in the SMART rate indicates that money will be costlier as it is linked with the lending rates of banks. 

According to the new lending rate formula that the Bangladesh Bank (BB) introduced in the current monetary policy announced in June, banks will lend SMART plus a margin of up to 3% when the margin is up to 5% for non-bank financial institutions. 

The SMART rate was 7.10% in June which jumped to 7.14% in August and 7.20% in September as the central bank did not create money these two months amid sharp criticism from economists for printing money for deficit financing of the government. 

The Bangladesh Bank increased the policy rate to 6.5% from 6% in June when it announced its current monetary policy. 

It created new money of Tk80,000 crore last fiscal to keep the treasury rate low aiming to maintain a stable lending rate which is blamed for fueling inflation.

The Bangladesh Bank has taken a set of initiatives to contain inflation, including the reconstruction of the monetary policy committee and an increased cost of funds. 

At present, the central bank has a monetary policy committee constituted by only internal officials headed by the governor. Now it will reconstruct the committee adding two or three members from outside the Bangladesh Bank following the Indian model. The committee will be approved by the board of the Bangladesh Bank. 

India has a monetary policy committee of six members of which three are from outside the central bank. 

The Bangladesh Bank is also planning to raise policy rates as the IMF (International Monetary Fund) and other economists in informal talks suggested the central increase lending rates to contain inflation, according to central bank sources.

If the policy rate is increased, it will raise the treasury rate which is linked to the lending rate also. 

In the current fiscal, the central bank created new money of Tk9,000 crore in July only. 

In August, the central bank started to collect money from banks for the government's deficit financing by selling treasury bills. Banks are quoting high rates for treasury bills in the auction resulting in a surge of SMART rate. 

The most important policy measure to contain inflation would be to stop the financing of the budget deficit through money creation, Sadiq Ahmed, former director of the World Bank and vice chairman of the Policy Research Institute of Bangladesh (PRI) said to the Bangladesh Bank.

In a consultation meeting with the central bank held recently, he said the idea that inflation is caused and sustained by the Ukraine war was not correct. The war had an immediate inflationary impact in the March-June months of 2022. Since July 2022, global commodity prices have fallen substantially.  

The fundamental reason for the current high inflation is excess demand pressure from money creation by the BB to finance the budget deficit and interest controls that have increased demand for domestic credit, he explained.  

Therefore, the most important policy measure would be to stop financing of the budget deficit through money creation, noted Dr Ahmed. 

This must be combined with an increase in the domestic interest rate to lower the demand for credit.  He suggested that instead of targeting the interest rate, the BB should target inflation and must continue to reduce domestic credit until such time that inflation has been brought down to the desired level of 5%-6%. 

How inflation eating up reserves 

Soaring inflation is now putting pressure on foreign exchange reserves as the gap between the real effective exchange rate (REER) and the bilateral exchange rate widened to Tk5 in September indicating further devaluation pressure on the local currency. 

The gap between the two rates also resulted in a widening gap between official and unofficial exchange rates forcing the Bangladesh Bank to sell dollars from reserves which ultimately reinforced reserve erosion.

The officially announced dollar rate is Tk110.50 when the market rate is between Tk116 and Tk120. 

On the other hand, the REER-based exchange rate surged to above Tk115 in September which indicates taka is still overvalued by Tk5 in comparison to its other trading partners. 

The REER is an indicator of the competitiveness of a country's currency with respect to a basket of currencies, adjusted for inflation effects.

Despite the huge depreciation of the taka by more than 16% in one year since September 2022, it is still overvalued as inflation keeps rising in Bangladesh when it cooled down in other peer countries, said s senior executive of the central bank. 

Taka became slightly undervalued by 0.36% in July for the first time due to huge depreciation but it became overvalued again in the REER index after inflation rose to 9.92% in August, he said. 

As the Bangladesh Bank is not adjusting the exchange rate with market demand fearing further inflation, it is causing faster erosion of reserves, he added. 

Bangladesh Bank sold nearly $3 billion from the reserves in three months from July to September of the current fiscal, central bank data shows. As a result, the reserves kept falling, reaching $21.15 billion on 26 September from $31.2 billion in June. 

When inflation was 7%-8%, the Bangladesh Bank was not letting the exchange rate free float fearing inflation. Now, protecting reserves is a major challenge for the bank but it could not go for a flexible exchange rate because of skyrocketed inflation.

In this perspective, though, the central bank needs to go from massive devaluation as per the REER indicator, it is raising prices on a small scale which is ultimately not helping to protect reserves, said a senior executive of the central bank. 

Why BB failed to control inflation

When taking charge of Bangladesh Bank in July 2022, governor Abdur Rouf Talukder shared his plan with the media saying that containing soaring inflation will be his first and foremost goal among other issues.

However, inflation has kept soaring since his joining and recorded 9.92% in August from 7.48% in July last year. Moreover, food inflation hit a 12-year high of 12.54% in August making lives miserable for middle-class and poor people. 

Failure to control inflation put him in D-graded governor in the central banker ranking by New York-based Global Finance magazine.

Moreover, the devaluation of taka was another criterion that the magazine considered in grading the governor. 

The grading was based on the one-year performance of the governor.

Bangladesh experienced a faster devaluation of the taka after the governor introduced multiple exchange rates soon after his joining the central bank. This multiple exchange mechanism was blamed by multilateral lenders and global rating agencies as a major reason for forex reserve erosion. 

Global rating agencies including Moody's and Fitch downgraded ratings and both assessments highlighted heightening external vulnerability and liquidity risks amid a deterioration in foreign exchange reserves.

However, Governor Talukder at the monetary policy announcement event for the current fiscal commented that Moody's downgrading is geopolitical, not economic.  

The central bank governor was ranked below Sri Lanka which faced a severe economic crisis but finally managed to bring down its 20-month-long double-digit inflation to single digit. The new governor of Sri Lanka played the role of magic turnaround by hiking policy rates making money costlier and a $3 billion loan package from the IMF, according to the magazine. 

Sri Lanka which borrowed $200 million in loans in 2021 became able to pay back the entire amount even with an interest of $22 million recently.

Shaktikanta Das, the governor of the Reserve Bank of India was graded A+ as he successfully contained inflation with a tight money campaign delivered via six repo rate hikes.

When inflation control is the primary objective, the Bangladesh Bank failed to manage it due to little use of monetary tools and easy money supply through maintaining a cap on interest rates to serve political will. 

Moreover, the Bangladesh Bank kept its exchange rate stable artificially for a long time which contributed to surging inflation as it had to go for massive devaluation when a rate hike by the Federal Reserve Bank of the US triggered a dollar crisis.  

Amid this situation, when raising interest rates is the prime need to tame inflation making money costlier, business leaders recently met Abdur Rouf Talukder requesting him not to increase interest rate.

In response to the request, the governor assured them that loan interest is now fixed according to the smart rate, and there is no chance of the interest rate being increased at an abnormal rate, according to media reports. 

The politically pursued single-digit lending rate cap that was imposed in the year 2020 is blamed as one of the major reasons behind current inflation as imports picked up to a record high of $89 billion in FY22 due to cheap money. 

However, the Bangladesh Bank lifted the single-digit cap in its current monetary policy announced in June and introduced a new interest rate formula which is another form of fixed rate. 

This is because the new formula which is also known as the SMART rate is linked with treasury bills rates. The Bangladesh Bank kept the rate low by controlling treasury bill rates. 

This is how the Bangladesh Bank kept the money supply easy to favour business leaders when global central banks went for rapid money tightening policy by hiking policy rates for several times.