How can we combat inflation?: Monetary tightening or boosting business

The state of the Bangladesh economy is now a classic example of stagflation, characterised by high inflation and low growth. Given this scenario, Bangladesh Bank faces an uphill task: simultaneously lowering the inflation rate and stimulating the economy. The monetary policy for the first part of the year, which will be announced in the last week of January, will be an acid test for the central bank.

Bangladesh continues to struggle with high inflation, which reached 10.89% in December. Meanwhile, private sector credit growth, which is crucial for investment, has slowed significantly, reaching a low of 7.66% in October-July.

To combat inflation, the central bank (Bangladesh Bank) has raised the policy interest rate three times by 50 basis points each in the last five months, lifting it to 10%. However, this measure has not effectively curbed inflation. Instead, it has increased borrowing costs, dampened private-sector credit demand, and raised concerns about potential long-term economic repercussions.

Economists and business leaders have expressed concerns about the effectiveness of solely relying on interest rate hikes in Bangladesh. They argue that a more balanced approach is necessary, emphasising market stabilisation and creating an environment conducive to increased investment.

While raising interest rates effectively curbs inflation in developed economies, this approach faces significant challenges in Bangladesh. In developed countries, where 90% of loans are for consumer purposes like housing and vehicles, interest rate hikes directly reduce consumer spending, as businesses have other sources of credit flow. However, 85% of loans in Bangladesh are utilised for business activities. Consequently, increasing interest rates primarily impacts businesses, hindering investment and economic growth.

Government data shows that despite record-high interest rates, inflation remains persistent. Private sector credit growth has plummeted, indicating a significant decline in investment activity. Operating businesses with 15% interest rates is nearly impossible, posing a serious threat to Bangladesh's economic progress, including its aspirations to graduate from least developed country status.

Analysts argue that increasing interest rates alone cannot control inflation in a country like Bangladesh; there must be a coordinated effort involving fiscal policy and market management. While the policy interest rate is increasing, VAT on various goods is also being raised. This reality will not only slow down growth but also fail to curb inflation. 

This creates a stagflationary economic situation characterised by high inflation, low growth, and high unemployment. Generally, it is said that a certain level of inflation is necessary for growth. However, currently, while inflation is on the rise, growth is declining.

Let's examine some selective indicators. According to the Bangladesh Bank, the growth rate of private sector credit stood at 7.66% at the end of the first four months of the fiscal year, the lowest in the last three and a half years. Also, imports of intermediate goods and capital machinery necessary for industries declined during this period.

In the first five months (November) of the 2024-25 fiscal year, letters of credit (LCs) opened for importing capital machinery decreased by 26% compared to the same period in the 2023-24 fiscal year. Similarly, the settlement of LCs for importing capital machinery decreased by approximately 22%. 

The decline in the opening and settlement of LCs for capital machinery indicates a decrease in new investment in the country. Compared to July-November 2023, the LC settlement for importing consumer goods in 2024 decreased by 13%.

The GDP growth rate has shrunk to 1.81% in the first quarter of the current fiscal year, preceded by only 3.91% in the last quarter of the 2023-24 fiscal year. Despite the statistical course correction, there is a significant slowdown. 

The impact of the movement of Hasina's ouster is felt in every sphere. Even after five months of Hasina's ouster, the storm is yet to be fully weathered, as cases of violence have become rampant, and businesses are increasingly finding it difficult to make new investments.

In a conversation with me, two medium-sized business owners shared their current business state. A medium-sized IT entrepreneur said that his businesses had shrunk by almost 40% in the second quarter of the fiscal year compared to the same period of the last fiscal year. A used car seller shared his predicament more intensely, saying his businesses have shrunk to an almost insignificant level.

We are mostly suffering from a lack of aggregate demand. So, boosting demand should be the prime concern of policymakers. This requires an adequate flow of money and other resources. As we all know, the economy is a complex web of supply and demand, along with some interconnected factors.

Policy consistency is the key, yet different government agencies have taken little action to that end: BB is hiking the policy rate, while NBR is raising value-added taxes (VAT) in a frantic effort to shore up revenue generation. So, hiking the policy rate in the market will have little impact. Monetary and fiscal policy must be synergistic, complemented by market management. Without a tripartite agreement of the three, any effort to tame inflation will simply be ineffectual.

Let us return to the big policy question at hand. Will higher interest rates increase the supply of eggs or rice in the market? Will they lower the price of food, other than by reducing incomes so much that people have to pare their diets? Of course not. On the contrary, higher interest rates make mobilising investments that could alleviate supply shortages even more difficult.

Nobel laureate economist Joseph Stiglitz said that there are many ways that higher interest rates may exacerbate inflationary pressures. Joseph Stiglitz shows that well-directed fiscal policies and other, more finely tuned measures have a better chance of taming today's inflation than blunt and potentially counterproductive monetary policies.

Addressing high inflation requires a multi-pronged approach. First, we must ensure farmers can access adequate financing for paddy cultivation and receive fair market prices for their produce. Second, food grain supply chain bottlenecks must be identified and removed. Third, given the concentration of commodity imports among a few large players, liberalising import policy to encourage greater market participation is crucial. Finally, prioritising the domestic production of essential agricultural inputs is paramount.

Last but not least, the fuel price is Bangladesh's ultimate determinant of commodity prices. Our agriculture, production, manufacturing, and transportation depend on fuel and energy prices. Any real measure to tame inflation in the country must include a fuel price cut, as we have seen how prices of essentials have skyrocketed following the hike of fuel and energy prices in the recent past. We know IMF conditions regarding the cancellation of subsidies exist, but we must find a way to circumvent that measure.

Monetary tightening ultimately strips people of cash, which is not a good idea. It interferes with people's preferred way of life and shrinks economic activity. So, let's boost the economy and find an alternative to monetary tightening.

Protik Bardhan is a senior sub-editor at the Daily Prothom Alo. 

Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions and views of The Business Standard.