Tight monetary policy, but is it enough?

On the surface, the monetary policy appears to be tuned to the need of the hour: bring down inflation and conserve reserves. But it comes caving down on careful reading.

"There is a question of how the central bank will actually implement this seemingly contractionary monetary policy," said Zahid Hussain, a former lead economist of the World Bank's Dhaka office.

In a break with tradition, it shifted from a quantitative-based monetary policy to an interest-based one as per the terms agreed with the International Monetary Fund for the $4.7 billion loan.

Under the quantitative-based monetary policy, a central bank increases or decreases the money supply to achieve its inflation target.

But the interest-based monetary policy focuses fully on the key interest rates -- repo, reverse repo, and special repo -- to tackle higher prices.

Accordingly, the central bank increased the rate at which cash-strapped banks take short-term loans by 50 basis points to 6.50 percent.

This is the fifth time in a year that the BB has increased this rate, known as the repo rate.

The central bank also increased the rate at which banks keep funds at the BB -- known as the reverse repo -- by 25 basis points to 4.50 percent.

Both the measures can potentially mop up the money supply and hopefully bring down inflation.

However, the BB slashed the rate at which banks secure emergency funds from the central bank -- known as special repo -- by 50 basis points to 8.50 percent.

Hussain is sceptical that the repo rate increase would have any major impact on the money supply given that the interest rate cap was withdrawn.

"The new method for setting interest rates will not bring any major change to the financial sector," he said.

Under the new method, the central bank would initially set a monthly reference rate based on the weighted average rate that would be calculated based on the interest rates of the six-month short-term treasury bill.

Another weighted average rate would be set six months later based on the monthly weighted average rates of the T-bill. The rate will be called SMART, which will be adjusted every month considering the interest rates of the treasury bill.

"The interest rate and the exchange rate will become market-based and the financial account will turn positive. But how is that possible?

— Ahsan H Mansur, executive director of the Policy Research Institute

The central bank will allow banks to add a maximum of 3 percent, which would be called the reference rate to the weighted average rate.

Currently, the interest rate of the six-month T-bill is 7.10 percent.

This means the interest rate on loans will be a maximum of 10.10 percent, up from the 9 percent ceiling that the BB has maintained since April 2020.

Hussain said that the central bank controls the interest rates of T-bills and T-bonds.

Since the central bank offers lower rates during the auctions of government securities, commercial banks do not get the opportunity to buy them.

"So, the SMART would not be determined by the market, rather it may be controlled by the central bank. This means there may be a cap on the interest rate of lending. If the cap is withdrawn, the hike in the policy rate will be worked," he said.

The central bank said that the reference rate will be 4 percent for consumer and SME loans, meaning the interest rate of such loans will stand at 11 percent.

The interest rate for consumer finance was 12 percent before. This will be lower under the new system.

This means the disbursement of consumer loans may increase further due to the lower interest rate, which may add inflationary pressure, he said.

Inflation raced to an 11-year high of 9.94 percent in May, pushing up the average to 8.95 percent this fiscal year, way above the revised target of 7.5 percent.

Many banks are now showing reluctance to disburse SME loans due to the high operational cost, but the hike in the interest rate will encourage them to disburse the loans, Hussain said.

The interest rate hike for other loans from 9 percent to 10.10 per cent may play a positive role in decreasing inflation.

"Imposing the 9 percent interest rate cap on loans was a political decision, but we have been able to manage the policymakers to remove the cap," said BB Governor Abdur Rouf Talukder.

Withdrawing the cap was also a political decision, he said.

He went on to express hope that the country's foreign exchange market will become stable riding on the monetary policy.

He hoped that foreign direct investment will increase and the gap in the financial account will come down in the next fiscal year.

From July 1, the BB will sell dollars to banks based on the interbank exchange rate. But it did not give any timeline of when the multiple exchange rate would be abandoned.

But Hussain said the central bank did not give any clear idea of how the foreign exchange market will become stable.

Ahsan H Mansur, executive director of the Policy Research Institute, echoed the same.

"The interest rate and the exchange rate will become market-based and the financial account will turn positive. But how is that possible? You cannot maintain a flexible interest rate by way of devolvement of the Treasury bill auction. We want to see if the BB would control devolvement."

It is not clear how the central bank will give loans to the government to meet the budget deficit without expanding net domestic assets, said Mansur, a former economist of the IMF.

"If the bank borrowing continues, neither the inflation nor the exchange rate will stabilise."

The BB's planned move to a single exchange rate is welcome.

"But if you manage the rate through banks or Bafeda [Bangladesh Foreign Exchange Dealers' Association], then it wouldn't really be a floating exchange rate."