Why policy rate hikes fail to cool inflation in Bangladesh but worked in Sri Lanka

While global central banks have effectively curbed inflation through policy rate hikes, the Bangladesh Bank's efforts over the past year have been hampered by an ineffective transmission mechanism, hindering the desired impact on money rates.

Bangladesh's central bank increased its key policy rate by 75 basis points to 7.25% at the beginning of October, the highest hike in the last decade, aiming to make money costlier to curb inflation.

However, at the end of the month, inflation rose to 9.93% from 9.63% in the previous month when food inflation reached a decade high of 12.56%, reflecting zero outcome of the policy rate hike.

This contrasts sharply with Sri Lanka's decisive action of raising its key policy rate substantially to effectively tame record-breaking inflation.

A senior executive of the central bank, on condition of anonymity, told The Business Standard that the Bangladesh Bank has increased the policy rate six times since last year but inflation remained upward due to a slow pass-through mechanism. It will take at least six months to get an outcome due to the introduction of a new formula, measured with six-month average treasury bill rates, known as the SMART rate.

The policy rate is a monetary tool that is used to make money costlier to suppress demand which will contain inflation. However, in Bangladesh, SMART is a controlled interest rate mechanism that holds back policy rates from impacting money rates immediately, he said.

Moreover, the Bangladesh Bank has been increasing policy rates on a small scale when the macroeconomic situation demands a drastic hike, he pointed out.

For instance, the lending rate increased by only 23 basis points to 10.93% in October after hiking the latest policy rate hike. The central bank increased the policy rate by 225 basis points – from 5% to 7.25% – in the last one and half years when the lending rate increased by only 80 basis points.

This slow pass-through was because of a controlled lending rate mechanism, he added.

How Sri Lanka succeeded

Inflation in Sri Lanka surged to a record high of 73.7% in the last year now cooling down due to a drastic hike in the policy rate and immediate reaction to the market.

For instance, in March last year, the central bank of Sri Lanka increased the policy rate by 700 basis points at a time to 13.5%. In one year, the country increased the policy rate by 1,000 basis points from 5.5% to 18.5%.

The lending rate increased at the same pace responding to the policy rate hike and reached a record 18.7% from 10% in one year in 2022. The rising lending rate slowly cooled down inflation to 0.8% in September this year.

Sri Lanka also moved for drastic devaluation of its currency at the same time. The dollar price increased by 160 rupees to 360 rupees in a span of just four months from February to May last year.

On the other hand, the Bangladesh Bank retained the official price per dollar at Tk111 when market demand was above Tk126 as the remittance rate surged to that rate recently.

However, the Bangladesh Bank instructed banks to buy remittance dollars at the rate of not more than Tk116 including incentives.

With all these combined measures, Sri Lanka successfully eased price pressure while Bangladesh is still struggling with soaring inflation due to delays in the outcome of policy measures.

However, the Bangladesh Bank hopes that it will see the result of the policy hike by December as money rates already started to move upward which is reflected in private sector credit growth that slowed for the tenth consecutive month, hitting a 23-month low of 9.69% in September.

The money rates started to rise slowly, mostly because of stopping new money injections through devolvement by the Bangladesh Bank, said industry insiders.

Zahid Hussain, the former lead economist of the World Bank's Dhaka office, identified three factors including measures taken late, small-scale policy rate hikes, and limited scope of transmission due to the SMART rate formula behind the failure of cooling down inflation.

He said the Bangladesh Bank moved to take measures to tame inflation in July this year which was already late. Moreover, major measures came in October with the policy rate hike. The slow transmission mechanism is also a problem.

For instance, the SMART rate increased in October on the back of the rise in the treasury bills rate because of stopping new money creation. Now, this SMART rate will transmit into money rates in six months as the lending rate formula is six months' average treasury bills plus 3.50%. As a result, there is a limited scope of transmitting the policy rate hike into the money rates which will ultimately tame inflation, he explained.

Moreover, Bangladesh's rate hikes were not adequate considering the macroeconomic situation when Sri Lanka hiked rates by 1,000 basis points, he added.

The central bank created new money of Tk80,000 crore last fiscal year to keep the treasury rate low aiming to keep the lending rate on hold which is blamed for fueling inflation. However, it had to halt money creation to finance the government's deficit amid sharp criticism from economists.

In a recent interview with The Business Standard, Syed Mahbubur Rahman, managing director and chief executive officer of Mutual Trust Bank, said interest rates for both deposit and lending started to increase as the Bangladesh Bank stopped money printing.

Now, the central bank is taking money from banks for the government's deficit financing, causing a liquidity crunch and pushing up deposit rates between 8% and 9% which was below 5% previously, he said.

He expressed hope that as money rates started to go up, it would suppress demand which would ultimately help to cool down inflation.

Bangladesh Bank data shows that call money rates touched a decade-high of 7.9% in November, which was below 6% in December last year. Treasury bills rates for two years and above are now close to 11% which was 7% to 8% in December last year.