Current contractionary monetary policy: taming of the shrew?

The monetary policy of Bangladesh aims at maintaining (i) price stability and (ii) exchange rate stability, and (iii) to maximize real GDP growth with high employment. In other words, the Bangladesh Bank (BB) has three objectives in the monetary policy to accomplish. All cannot be achieved simultaneously because of an inherent conflict between price stability and promotion of real GDP growth with high employment/low unemployment, as evidenced in the Phillips Curve (1958). The Phillips Curve trade-off relationship between inflation rate and unemployment rate could be a guide for monetary policy, although its universal empirical validity is being questioned in academic research. A central bank often has to prioritize the objectives as the changes in overall macroeconomic conditions dictate. Currently, the inflation rate in Bangladesh is in the double digits. This is a matter of serious concern for the BB. The question is how to tame it effectively. Does the BB have enough control over it? Not so.

The BB could be in a unique position to tame inflation, if it had been purely a monetary phenomenon, as explained by the Fisher's Equation of Exchange (1911) assuming constancy in transaction velocity of money and real GDP. Again, this is not the case. Additionally, inflation has demand-pull and cost-push components. Any significant contraction in money supply through sectoral credit rationing may address demand-pull factor. At the same time, it will aggravate the cost-push factor by pushing interest rates too high for SMEs as well as for business and industrial loans. Again, 18%-20% depreciation of Taka against the U.S. dollar complicates the situation even further by spurring the import costs of raw materials, machineries, equipment, etc. Moreover, required financing of LCs in larger amounts will intensify pressure on banks' liquidity. Putting all in proper perspectives, anybody should guess the net effect of current monetary contraction on inflation. To be noted, cost-push factor in Bangladesh presumably dominates demand-pull factor due to disrupted supply chain mismanagement and ongoing high inflation expectation. The central focus of the monetary policy ought to stabilize inflation expectation. The extent of exchange rate pass-through into inflation also needs to be assessed carefully before blaming higher import costs alone for higher inflation. In my current academic research the extent of exchange rate pass-through to translate into higher inflation in Bangladesh is not statistically very significant.

Rising lending rates and spurring import costs of factors of production (as stated earlier) will reduce both manufacturing and agricultural outputs, accompanied by higher unemployment. Emperically imprecise Okun's Law (1962) as a rule of thumb states that 3% rise in unemployment rate accompanies 2% reduction in real GDP growth. So, is stagflation (a combination of high inflation rate and high unemployment rate) looming on the horizon as a result? If so, the so-called misery index will rise.

A stable macroeconomic environment is conducive to all economic and business activities. This requires a combination of good monetary and fiscal policies. A contractionary monetary policy alone cannot effectively tame inflation while the fiscal policy is on the loose to monetize skyrocketing budget deficits in a subsidy-dependent economy. The BB has no autonomy to say "No" emphatically to monetization of budget deficits. Eventually, it has to dance to the music of the Ministry of Finance. The BB thus becomes a whipping boy for its policy failures. Empirically evidenced that countries with less autonomous central banks experience higher inflation than a few with more autonomous central banks.

The axe of an overall credit squeeze will inevitably fall on the private sector for which adequate credit flow is the lifeblood of business. Thus, the resulting credit crunch is likely to retard the private sector activities. Net shrinkages in national output and employment will occur as consequences. Major Western destination countries of a limited number Bangladesh exports are virtually still in recession. The Eurozone remains in an economic and financial doldrum with unsettling and uncharted whirlwinds. They will ultimately take a toll on the export sector. The prospects of foreign aid and FDI inflows are uncertain causing further uncertainty for exchange rate. Potential success for obtaining $1 billion loan from the IMF for balance of payment support may temporarily improve the exchange rate. But many strings attached to it may tie up the hands of the BB to navigate the economy. The next question thus arises: Is timing perfect for drastic monetary or credit contraction? Perhaps, not. Analogously, sudden hard-braking of a speeding car may cause it to skid into a roadside ditch. So, sudden and drastic cuts in credit flows to productive sectors of the economy may risk recession that was avoided so far in the face of the current global recession. Thanks to steep rises in remittances and low-end RMG exports on record.

Thanks to money illusion of bank depositors and individual creditors. They care less for real interest rate even if it is zero or negative. In real term, they supply loanable funds to banks virtually free or at subsidy. For banks real lending rate is 5% or more at the current inflation rate. So banks as borrowers of funds are gaining and the depositors as creditors are losing. Furthermore, deposits remain unprotected in the absence of insurance coverage. In the event of a bank failure, they will end up with nothing. In a nut shell, risk is shifted to depositors from banks.

Monetary policy success depends on the credibility of the policymakers and the central bank. Their credibility is in question in the current political and fiscal environments due to a lack of autonomy and other pertinent personality factors. In concept, the recently announced five-step monetary policy stance is well-crafted. This is a step in the right direction. But it seems too late and too little to break the cycle of price-spiral and inflation psychosis. But late is better than never. The naughty economy is in a conundrum. The BB alone cannot do the job without fiscal discipline. In developing countries fiscal policy is more effective than monetary policy while the opposite applies to developed economies with matured capital markets and sophisticated banking systems. To add further, barring imports of luxury items may enhance smuggling which, in turn, will create pressure on the exchange rate in the curb market.

To be effective, the BB should adopt a comfortable and slow-moving inflation target in light of changes in overall macroeconomic conditions. For example, with 5% real GDP growth and allowing 2% monetization, the desired target inflation rate should be set at 7%. In another vein, if official unemployment rate is 5%, again, the target rate should be set at 7% allowing 2% for monetization. Both need not be the same. The lower of the two ought to be the target inflation rate for the period. Taylor Principle (1993) suggests gradual contraction in the money supply in several small doses for pre-emption once the actual inflation rate is about to cross the target rate. In contrast, when actual inflation rate slides below the target rate, there ought to be a gradual expansion in the money supply in several small doses. In either case, real interest rates should be positive with respect to both deposit and lending rates. The latter should be higher than the former within an acceptable margin to ensure profitability of the banks. This might help maintain a tenable balance between price stability and real economic growth. The balance may help stabilizethe exchange rate and improve the labor market (the mother of all markets). Milton Friedman's fixed rule of x% increase in broad money supply (M2) per year regardless of overall macroeconomic conditions to remove price uncertainty is not recommendable. Monetary discretion is essential to navigate an economy as changes in underlying fundamentals dictate.

It was easy for the BB to miss the warning signal in the absence of a comfortable and slow-moving inflation target. The recent contractionary monetary policy has to pass through several flashing yellow streetlights to avoid any red streetlight. The foregoing discussions also remind me of Shakespeare's The Taming of the Shrew — Mukhara Ramani Bashikaran.

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Matiur Rahman is the MBA Director and JP Morgan Chase Endowed Professor of finance at McNeese State University, USA.