Abstract
After a prolonged period of stable inflation, Bangladesh is experiencing a bout of persistently high inflation since the beginning of Russia’s war in Ukraine. Bringing inflation down and restoring macroeconomic stability requires a balancing act between managing inflation and growth. This analysis applies a semi-structural Quarterly Projection Model (QPM)2 to assess the drivers of the recently elevated inflation in Bangladesh and evaluate different policy options in taming inflation, as well as tradeoffs involved with these policy choices. Analysis suggests that a concerted but carefully calibrated tightening of the monetary policy stance will be needed to bring inflation down to BB’s target range. While concurrent fiscal policy consolidation could aid a faster disinflation process, it could lead to disproportionately substantial output costs as the Bangladesh economy is operating at below potential and navigating multiple external shocks. Ongoing reforms to modernize monetary policy framework could reduce the economic volatility and costs associated with navigating periods of significant exchange rate pressures and heightened inflation.
Taming Inflation: Policy Options and Trade-Offs1
After a prolonged period of stable inflation, Bangladesh is experiencing a bout of persistently high inflation since the beginning of Russia’s war in Ukraine. Bringing inflation down and restoring macroeconomic stability requires a balancing act between managing inflation and growth. This analysis applies a semi-structural Quarterly Projection Model (QPM)2 to assess the drivers of the recently elevated inflation in Bangladesh and evaluate different policy options in taming inflation, as well as tradeoffs involved with these policy choices. Analysis suggests that a concerted but carefully calibrated tightening of the monetary policy stance will be needed to bring inflation down to BB’s target range. While concurrent fiscal policy consolidation could aid a faster disinflation process, it could lead to disproportionately substantial output costs as the Bangladesh economy is operating at below potential and navigating multiple external shocks. Ongoing reforms to modernize monetary policy framework could reduce the economic volatility and costs associated with navigating periods of significant exchange rate pressures and heightened inflation.
A. Drivers of Inflation in Bangladesh
1. Bangladesh’s inflation accelerated to a decade high in FY23, triggered by cost-push factors.3 In the wake of Russia’s invasion of Ukraine, heightened global commodity prices, supply disruptions, and slowing external demand for Bangladesh’s export led to a sharp widening of the current account deficit and depreciation of the Taka, intensifying the surge in import prices. After remaining stable for a prolonged period (averaging 5.8 percent during FY15-FY22), inflation peaked first time at 9.5 percent year-on-year (y/y) in August 2022, following the government’s decision to hike domestic fuel and energy prices to stem the rapid rise in import and subsidy bills. Helped by expanded government food subsidies and bumper harvest in late 2022, inflation showed a temporary moderation. Nevertheless, inflation picked up again in the first half of 2023, as higher transportation costs stemming from fuel price hike, continued import restrictions, and further Taka depreciation significantly increased input costs for domestic producers and importers, who passed them on to consumers by raising prices. As a result, headline inflation peaked again at 9.9 percent y/y in May 2023, reaching more than a decade high.
2. Pass-through from exchange rate depreciation has contributed significantly to a surge in prices. Worsening current account and significant tightening of the global monetary conditions have put significant pressure on the Taka. To stem reserves losses and help restore external balance, the authorities have allowed the Taka to depreciate by close to 20 percent cumulatively over FY23. To estimate the pass-through of this exchange rate depreciation to inflation, this paper uses the QPM model for Bangladesh to decompose inflation into contribution of individual shocks. The exchange rate pass-through (ERPT) is then estimated as a relative contribution of uncovered interest rate parity (UIP) premia shocks (red bars on Text Figure 1) to overall inflation over the course of FY23.4 The short-run ERPT ratio is estimated at 0.25, implying that the 20 percent Taka depreciation in FY23 contributed to an increase in overall price level by about 5 percent. In other words, of the total consumer price index (CPI) increase of close to 10 percent in FY23, about half of it can be attributed (directly and indirectly) to exchange rate depreciation.
Decomposition of Inflation to Contributions of Shocks
Citation: IMF Staff Country Reports 2023, 410; 10.5089/9798400260728.002.A001
Source: IMF Staff Estimates.3. Although initially triggered by temporary cost-push factors, higher inflation has over time gotten more entrenched as second-round effects took hold. Responding preemptively to the adverse shocks, Bangladesh Bank (BB) began raising the interest rates starting May 2022. However, the gradual pace of this monetary tightening appears to not be enough in stemming second-round inflationary pressures emanating from multiple sources, including rising global commodity prices, bouts of Taka depreciation, and hikes in domestic fuel and energy prices. Widening policy rate gap with the US Fed Funds rate has further compounded the situation. As a result, real interest rates (RIRs) have remained negative (Text Figure 2). Real effective exchange rate (REER) depreciation has contributed to the effective loosening of the real monetary conditions (Text Figure 2). Moreover, increasing devolvement of the government securities to BB at below market-clearing interest rates,5 resulting in effective capping of lending rates (through maximum mark-up margins imposed on the reference lending rate, called the SMART6), as well as multiple subsidized BB credit schemes for various priority sectors, have kept the yield curve and monetary transmission subdued.
Monetary Conditions
Citation: IMF Staff Country Reports 2023, 410; 10.5089/9798400260728.002.A001
Source: IMF Staff Estimates.1/ Real interest rate (RIR) is estimated using the QPM and is based on the quarterly average of Interbank O/N Call money rate, deflated by the model-based one-quarter-ahead inflation expectations.2/ Positive values indicate a restrictive effect and negative values an expansionary effect of the given component of real monetary conditions index (RMCI). The interest rate component is expressed as the deviation of RIR from its QPM-based neutral level estimate. The exchange rate component is expressed as the deviation of the real effective exchange rate (REER) from its QPM-based equilibrium estimate. For details on RMCI see Dennis (1997)4. Inflation expectations have remained persistently elevated. Not being firmly anchored at a clear and credible inflation target, headline inflation has become persistently elevated as second-round effects have transmitted into higher input costs and rising inflation expectations. One year ahead inflation expectations, as measured by BB, have reached their historical maximum of 10.3 percent in December 2022 (Text Figure 3). BB’s measure of core inflation,7 which is typically used to track the underlying inflation trends, has accelerated and also peaked at the end of 2022, at 9.5 percent. Although, both inflation expectations and core inflation have moderated in the second half of FY23, they remain elevated and well above the authorities’ inflation target range of 5–6 percent.
Recent Inflation Dynamics
Citation: IMF Staff Country Reports 2023, 410; 10.5089/9798400260728.002.A001
Sources: Bangladesh Bank; Bangladesh Bureau of Statistics; and Haver Analytics.B. Monetary Policy Options and Tradeoffs
5. A further tightening of the monetary policy stance is needed to bring inflation to the authorities’ target range over the medium term. In order to assess the extent of the required monetary tightening and evaluate the associated policy trade-offs, three QPM-based policy scenarios are considered:
Scenario 1. The “active policy” scenario assumes that BB actively determines its policy rate in every quarter of the forecast horizon to (i) minimize expected inflation deviation from BB’s target over the monetary policy horizon (up to 2 years), and (ii) keep the demand pressures (approximated by output gap in the model) checked, while (iii) ensuring that Call money rate remains closely aligned with the policy rate.
Scenario 2. The “hawkish policy” scenario assumes that BB decides to bring inflation down to the target range by end-FY24, before pursuing an active policy in adjusting the policy rate as in Scenario 1.
Scenario 3. The “dovish policy” scenario characterizes BB’s current monetary policy stance, keeping the stance unchanged until end of FY24, before pursuing an active policy in adjusting the policy rate as in Scenario 1.
Based on the simulations using the QPM, Text Figure 4 summarizes the policy rate responses under the three scenarios (top left chart), the projected paths for inflation (top right), as well as a cumulative percentage change in GDP and a percentage difference in the Taka exchange rate for the “hawkish” and “dovish” scenarios, compared to the “active policy” scenario.
Taming Inflation: QPM Simulation Results of Monetary Policy Options
Citation: IMF Staff Country Reports 2023, 410; 10.5089/9798400260728.002.A001
Source: IMF Staff Estimates.6. Given the trade-offs involved and the monetary policy transmission lags, a concerted but carefully calibrated monetary tightening will help restore price stability. The simulation results suggest that inflation would remain elevated throughout FY24 under the “dovish” scenario and start decelerating gradually towards the target range only after monetary policy begins raising the rates. The real output gains from this policy, compared to the “active policy” scenario, are short-lived and start dissipating quickly as the monetary policy tightens in FY25 and are largely undone by the end of forecast horizon. The nominal exchange rate ends up about 3 percent weaker, compared to “active policy” scenario. On the contrary, the rapid disinflation under the “hawkish” scenario is costly, as the cumulative output loss reaches around 3 percent compared to the “active policy” scenario, but the exchange rate is stronger by about 1 percent, on the back of tighter monetary policy. The optimal policy response is therefore believed to be between these two extremes—dovish versus hawkish, and would have to carefully weigh the benefits of disinflation against the associated output costs. Given the lags in monetary transmission, the orderly disinflation process should take several quarters to two years to bring inflation to the target range, unless aided by favorable unexpected shocks.8
C. Role of Fiscal Policy in Disinflation
7. Concurrent fiscal policy consolidation could aid a faster disinflation process, but as the Bangladesh economy is operating at below potential and navigates multiple external shocks, it could lead to disproportionately high output costs. An ad hoc analysis is performed by extending the QPM framework to analyze a stylized fiscal consolidation proposed against the “active policy” scenario. As the QPM is primarily a monetary policy model and does not generally contain a separate fiscal block, a fiscal consolidation of 1 percent of GDP is assumed in FY24, which given that the economy is operating below potential and that the exchange rate remains broadly similar to the “active policy” case (see bottom left figure on Text Figure 5), translates into a fiscal impulse of about -1.5 percent of GDP, and with the fiscal multiplier of 0.39, results in 0.5 percent reduction in the output gap. Text Figure 5 summarizes the results. The end-of-period inflation in FY24 goes down by an additional 0.2 percentage point, but the permanent cumulative loss in output reaches 1 percent, compared to the “active policy” scenario. At the same time, as fiscal policy consolidates, monetary policy could adopt a mildly looser stance, with the policy rates lower by some 15 basis points compared to the “active policy” scenario.
Taming Inflation: QPM Simulation Results of Fiscal Policy Option
Citation: IMF Staff Country Reports 2023, 410; 10.5089/9798400260728.002.A001
Source: IMF Staff Estimates.D. Modernizing Monetary Policy Framework
8. A more credible and forward-looking monetary policy framework can notably reduce the economic volatility and costs associated with navigating periods of significant exchange rate pressures and heightened inflation. A more rule-based monetary policy framework, anchored at a clear medium-term inflation objective, can help in stabilizing an economy during periods of intensified economic volatility and increased uncertainty. A forward-looking approach allows a central bank to act proactively rather than reactively. By anticipating potential economic challenges and adjusting its policy tools accordingly, it can mitigate the impact of adverse shocks. At the same time, high credibility is also a policy tool, which allows central banks to better manage market expectations without resorting to excessive adjustments in other tools. (The more market participants believe that the central bank is determined to “do what it takes” to achieve price stability, the less it actually needs to “do it”.) However, a central bank’s credibility is built over time through consistent policy actions and communication. Therefore, periods of economic challenges and uncertainty present opportune moment to build credibility for active and forward-looking monetary policy.10
9. Therefore, modernizing monetary policy framework, streamlining monetary operations, and enhancing central bank transparency and communications remain key reform priorities for Bangladesh Bank (BB) under the IMF-supported program. This is especially vital as Bangladesh graduates from the Least Developed Countries (LDC) status in FY26 and becomes more closely integrated into the global financial system. Adopting a modern, more forward-looking and credible monetary policy framework, which is well understood and accountable, with clearly defined primary and secondary objectives, would allow Bangladesh to achieve a higher level of macroeconomic stability and be better equipped to deal with external shocks, which will become more frequent and intense as Bangladesh graduates from LDC. A modernization process should therefore remain a key priority for BB in the coming years, and be underpinned by a comprehensive set of reform measures, including strengthening of the central bank’s independence and governance, enhancing its analytical and forecasting capacity, streamlining operational framework, developing money markets, and improving policy communications.
References
Adrian, Tobias, and Vitor Gaspar, 2022, “How Fiscal Restraint Can Help Fight Inflation”, IMF Blog. Available at: https://www.imf.org/en/Blogs/Articles/2022/11/21/how-fiscal-restraint-can-help-fight-inflation
Berg, Andrew, P. Karam, and D. Laxton, 2006, “A Practical Model-Based Approach to Monetary Policy Analysis – Overview”, IMF Working Paper 06/80. Available at: https://www.imf.org/external/pubs/ft/wp/2006/wp0680.pdf.
Dennis, Richard, 1997, “A measure of monetary conditions”, Reserve Bank of New Zealand, Discussion Paper, (G97/1). Available at: https://www.rbnz.govt.nz/-/media/07e2dc6194ef42d69046ce237f3ecc09.ashx?sc_lang=en
International Monetary Fund, 2014, “Fiscal Multipliers: Size, Determinants, and Use in Macroeconomic Projections”, IMF Technical Note; September 2014. Available at: https://www.imf.org/en/Publications/TNM/Issues/2016/12/31/Fiscal-Multipliers-Size-Determinants-and-Use-in-Macroeconomic-Projections-41784
International Monetary Fund, 2015, “Evolving Monetary Policy Frameworks in Low-Income and Other Developing Countries”, IMF Policy Paper; October 23, 2015. Available at: https://www.imf.org/external/np/pp/eng/2015/102315.pdf
International Monetary Fund, 2022, “Modernizing the Monetary Policy Framework in Bangladesh – Model-Based Insights”, Bangladesh: Selected Issues paper, IMF Country Report No. 22/72. Available at: https://www.imf.org/en/Publications/CR/Issues/2022/03/07/Bangladesh-Selected-Issues-514021
International Monetary Fund, 2023, “Fiscal Monitor: On the Path to Policy Normalization. Chapter 2: Inflation and Disinflation: What Role for Fiscal Policy?”, Washington, DC: IMF, April 2023. Available at: https://www.imf.org/en/Publications/FM/Issues/2023/04/03/fiscal-monitor-april-2023
Ha, Jongrim, M. Ayhan Kose, and F. Ohnsorge, 2019, “Inflation in Emerging and Developing Economies: Evolution, Drivers, and Policies—Chapter 5. Inflation and Exchange Rate Pass-Through”, Washington, DC: World Bank. Available at: https://www.worldbank.org/en/research/publication/inflation-in-emerging-and-developing-economies
Prepared by Yaroslav Hul (ICD).
The QPM model for Bangladesh had been developed by the IMF staff and reflects selected stylized features of the Bangladeshi economy and key characteristics of the BB’s monetary policy framework. For more detailed discussion on the unique features of the QPM for Bangladesh see Bangladesh: Selected Issues paper “Modernizing the Monetary Policy Framework in Bangladesh – Model-Based Insights” IMF Country Report No. 22/72, (https://www.imf.org/en/Publications/CR/Issues/2022/03/07/Bangladesh-Selected-Issues-514021). For details about a canonical QPM model, see Berg et al. (2006)
Fiscal year in Bangladesh starts in July and ends in June.
Extent of exchange rate pass-through (ERPT) to prices depends critically on the nature of the underlying shocks hitting the economy—some shocks affect both exchange rate and inflation in the same direction (e.g., monetary policy tightening typically works to bring down inflation and strengthens the domestic currency), some can affect in different directions (e.g., a foreign deflation leads to lower import prices, but puts pressure on the exchange rate to depreciate to restore the trade competitiveness). Therefore, there is no single notion of an ERPT to prices, and each episode should be analyzed on its own, depending on the underlying nature of the shocks driving the episode. A (semi-)structural model, such as a QPM, is particularly useful in this regard, as it helps in identifying different sources of shocks during different economic episodes. For discussion on ERPT see Ha et al. (2019).
Although government securities are mostly oversubscribed in auctions, the cut-off yields have been systematically set below market-clearing yields. In FY23, devolvement on BB represented 44 percent of the total issued amount, and in some auctions accounted for 70–80 percent of the entire issuance.
Under the new SMART (six month moving average rate of T-bills) system, maximum lending rates across different categories of borrowers are indexed to the average of the 182-day T-bill rates issued in the last six months and updated monthly. Even though 182-day T-bill are presently not devolved to BB, devolvement of government securities of other maturities has kept SMART rate subdued.
BB’s measure of core inflation excludes food and fuel items, which are typically most volatile and affected by cost-push shocks. Interestingly, in Bangladesh core inflation has historically been more volatile than headline inflation. This could be explained by the fact that core items constitute residual spending in the consumer basket (the weight of core items is relatively low at close to [30] percent). Therefore, for example, whenever food prices rise, the share of disposable income spent on food items increases and demand for core items goes down along with prices.
Central banks generally operate with a medium-term perspective when implementing monetary policy to achieve their goals and are considered most effective on a horizon from 1 to 2 years. Many factors can impact the effectiveness of monetary policy, including the specific economic conditions, the credibility of the central bank’s commitment to its policy goals, and the responsiveness of households and businesses to changes in interest rates and other monetary policy tools. For Emerging Markets and Developing Economies (EMDEs), this is particularly relevant for a disinflation process, when a central bank has to tighten to bring inflation down to a target (range).
In line with other low-income countries; see IMF (2014).
This qualitative assessment is further supported for Bangladesh by a counter-factual QPM-based analysis in IMF (2022). There, an episode from recent Bangladesh economic history is analyzed, when a build-up of exchange rate pressures led to significant depreciation of the Taka in FY12, with subsequent spike in inflation and increased macroeconomic volatility. The counter-factual simulations show that having a forward-looking monetary policy regime with a clear and credible inflation anchor would have allowed BB to navigate the mentioned period in a much smoother and controlled fashion, with faster and less disruptive disinflation and lower output cost.
