Monetary Policy: setting targets right

The new Governor of Bangladesh Bank (BB) has just announced the July-December 2016 Monetary Policy Statement (MPS). It declared with some satisfaction that the "available data (mostly up to May 2016) indicate attainment of almost all key objectives of the monetary program and policies for FY16". Perhaps mindful of the adage "if it ain't broke, don't fix it" the policymakers of BB have left the monetary policy more or less unchanged, with only minor revisions in its July-December version. The policy rates are to remain unchanged, while the program growth rates of credit are given a nudge upward to accommodate the unexpected increase in private credit.

These days the principal objective of the central banks around the world is to maintain the stability of the currency, i.e. to keep the inflation rate low and stable, although most central banks do wish to have reasonable economic growth. BB is no exception in this regard. It states that "the main objective of Bangladesh Bank's monetary policy is moderation and stabilization of CPI inflation alongside supporting output and employment growth." However, these two objectives are contradictory if the economy is at full employment, and in such situation the central banks are likely to focus more on the inflation objective. Bangladesh does not appear to be in that situation at present.

The CPI inflation has been declining steadily since 2013 as shown in the table below, which apparently supports the BB claim of good performance in terms of containing inflation. However, this hides a significant undercurrent. When the CPI inflation rate is split up into food and non-food inflation we see a contrasting trend (see the chart below). Non-food inflation has been increasing over the past two years, while the food inflation has been declining sharply. In other words the reduction in the CPI inflation rate was due to the decline in food prices.

Inflation in most countries including Bangladesh is affected by international fuel oil prices. Fuel prices in the international market have fallen at a sharp rate. Between 2013 and 2015 fuel price index has fallen by half. Fuel prices usually have a significant positive impact on grain, especially rice prices, which declined by about one-third. The prices of edible oil, another important food import item of Bangladesh, also decreased by more than a quarter. These reductions flowed on to domestic food prices through import prices helping to lower food inflation.

Food and fuel oil prices are widely regarded as supply determined, such that these are not directly affected by monetary policy. The non-food and non-fuel prices are the real goal of monetary policy. The inflation of the index of non-food and non-fuel prices is sometimes referred to as core inflation. BB provides a graph of core inflation in the MPS, which suggests a steep increase. Thus the prices that are susceptible to monetary policy measures rose fairly rapidly while the prices that are largely exogenous to monetary policy declined sharply. The end result was a steady decline in the headline inflation. With the world economy in a slowdown and the commodity markets slack, the target inflation rate for the next year, set at 5.45 percent, does not seem unrealistic.

The period since 2011 has been a period of falling inflation all over the world as the world economy slowed down. Just about every country grouping, such as East Asia and Pacific, LDC, Low and Middle Income Countries and OECD, has seen a large fall in the inflation rate since 2011 (World Bank data). For example, average inflation in the least developed countries (LDC) declined from 7.6 to 4 percent between 2011 and 2015 and low and middle income country average inflation fell from 6.3 to 3.1 percent. During the same period the inflation rate of Bangladesh declined from 10.7 to 6.2 percent. It thus appears that Bangladesh has lagged behind other countries in its class in terms of inflation performance.

The reduction in the inflation rate and a decline in the policy rates (REPO and reverse REPO) have brought down the nominal interest rates, in particular the lending rates of commercial banks partially meeting a long-standing demand of the business sector. It demands a further cut in the interest rate, which might eventuate if the inflation rate falls in line with the target or the spread could be reduced.

One unexpected development in the monetary sector during the last fiscal year was the large increase in the growth of private credit, which jumped from 13.2 percent in 2014-15 to 16.4 percent in 2015-16. BB regards this robust growth instrumental in raising the economic growth rate to 7.05 percent. However, real GDP growth is not determined by monetary values, but rather by real variables. The large increase in private credit is not reflected in real investment of the private sector which actually fell in 2015-16. This raises questions about both the supposed impact of private credit on GDP growth and what the real destinations of private credit were. It is not advisable to raise private sector credit target without ascertaining to what purposes it has been put to.

Some people allege that BB monetary policy has been contractionary. A superficial interpretation of the numbers in the table might support this allegation: the target growth rates of all major monetary variables have declined during the last two years or so, and inflation rate has also come down. However, expansionary or restrictive monetary policy is not indicated by the absolute values of the policy instruments, but rather by their values in relation to the market demand. It will be seen that the program values, i.e. targets, have always been much in excess of realised demand since December 2013. The actual growth rates were, therefore, not restricted by the targets. The targets themselves are flexible. When the demand exceeds the target, BB allows the growth rate to increase, as it did in the case of private credit last year. In macroeconomic parlance, BB is willing to validate increases in demand. The most reliable variable to indicate the stance of monetary policy is the interest rate. A whole slew of interest rates, including policy rates, have declined markedly during the last 2-3 years suggesting an easing of the money market. It would be a bit unfair to allege that BB was restrictive in respect of its policy measures.

The only 'restrictive' (if it can be called restrictive at all) measure that BB has stubbornly stuck to is the exchange rate. Officially on a flexible exchange rate, the taka value of the US dollar has been more stable during the last four years than the currencies of most of the countries in the world. This has required frequent intervention in the foreign exchange market to stabilize the taka-dollar exchange rate. The stability of the taka-dollar value has probably contributed to price stability, but it has not been congenial to export expansion or diversification especially in view of an appreciation of the real exchange rate.

Since the country had balance of payments surplus most of the time, intervention meant buying US dollar from the market to shore up the demand for dollar. This led to a large increase in the stock of international reserves. The balance of payments surplus was due mostly to (1) a stagnation of import demand which has declined in absolute terms during the last two fiscal years, (2) an increase in export receipts, (3) a large flow of remittances and (4) large-scale private borrowing from international financial markets. None of these except the last is determined directly by BB; and it is probably not a very healthy way for a poor nation to build up its reserves in a big way. The risks of foreign borrowing must be weighed against the benefits flowing from a reduction in the commercial bank lending rates due to increased credit market competition and a larger stock of reserves. Obviously BB has concluded that the benefits exceeded the risks.

The greatest challenge for BB, or for that matter any central bank, is to maintain discipline of the financial sector. Any malpractice or misdeed in the system may not be evident immediately and may not cause any significant damage (or may be even profitable) in the short term. But if left uncorrected, it will infect the system sufficiently over a period to cause serious harm to the entire financial architecture of the economy, which could wipe out the painstaking achievements of many years. The experience of the Asian financial crisis and the recent financial crisis in the western world amply bear this out.

An indicator of the ills afflicting the financial system of the country is the high non-performing loans (NPL) ratio. The very day the Governor was reading out the MPS, newspapers carried a news item that Tk413 billion of bad loans of the banking system had been written off. BB had earlier rescheduled a large amount of bad loans of large borrowers. These measures permit a significant understatement of the NPL statistics given out by BB, thus hiding the true magnitude of the problem. Inefficiency, unaccountability and lawlessness in the banking sector that help the piling up of NPL must be challenged strongly by BB. The unprecedented heist of central bank reserves that rattled the cyber security of the entire financial world remains largely unresolved tarnishing the image of BB. It needs to move quickly to restore discipline in the financial sector before a full-blown crisis develops.