Where is Bangladesh Bank in The Inflation Debate?

Published in Daily Star (June 2007)

For chart see:

http://www.thedailystar.net/2007/06/14/d706141501124.htm

Where is Bangladesh Bank in the inflation debate?
Faisal Salahuddin

Why is inflation at a 9-year high and increasing? Policymakers and citizens need to get the answer right as effective policy responses can come only after appropriate diagnosis.

This article argues that higher money supply has contributed to rising inflation and that a sustained decline in inflation would therefore need monetary policy action by the Bangladesh Bank.

Inflation debate

Debates on inflation in Bangladesh have mostly been populist. Our policymakers and analysts have identified two sets of villains. The first set includes structural factors: (i) hoarders and syndicates; (ii) middle-men in the supply chain; and (iii) poor business confidence.

The second set includes supply shocks -- both international (rising global food and oil prices) and domestic (higher transportation costs and energy prices). Temptation is strong to explain inflation with only supply shocks -- implying that as the supply bottlenecks improve, inflation will go away.

Not surprisingly, policy measures so far have also been either populist: "four whole-sale markets in the four corners of the city" and "dal-bhat program for the poor" or too long-term to be immediately meaningful: "research to improve agricultural productivity" (budget speech, 2007-08). These measures -- while useful to limit the impact on the poor households -- will not succeed in containing inflation and may eventually risk bringing down the popularity of any government instead of inflation.

Inflation ultimately is a monetary phenomenon -- when higher level of money chases few goods. Any meaningful debate cannot exclude the role of money in inflation.

Surprisingly, missing from our national inflation debate has been the role of monetary policy and how the Bangladesh Bank (BB) should/could be made responsible and held accountable for controlling inflation.

Unfortunately, even the BB has chimed in with the populist debate and frequently pointed more emphatically to the structural and supply factors -- almost never to its own monetary policy.

Show me the money

Popular argument is that recent inflation has primarily been driven by structural villains --implying money supply has little to do with it. Of course, some of the structural and supply-side factors may have raised prices. But is it the real or major part of the story? Let's look at the big picture.

Inflation steadily went up from 2.8 percent in 2002, to 4.4 percent in 2003, to 5.8 percent in 2004, and to 6.5 percent in 2005. It exceeded 7 percent in 2006. Clearly prices -- of both food and non-food -- have been rising for a while.

Recent temporary factors alone, either structural or supply shocks, cannot explain this rising trend. Definitely, forces other than structural or temporary supply shocks are at play. What happened to money supply -- the ultimate inflation generator?

Money supply for some years now has been rising at a rapid rate (over 50 percent in total during last 3 years) due to both external (higher exports and increasing remittance) and domestic (government borrowing from the central banks and strong private sector credit growth) factors. Real interest rates (bank rate or 28-day T-bill rate minus inflation) have recently turned negative, suggesting loose monetary policy.

Compared to nominal output, money supply has clearly grown faster. In other words, the amount of money chasing a unit of output has been on the rise year after year. As theory suggests, so have the prices. And hence inflation.

It is puzzling that not many commentators are talking about monetary policy or money supply yet.

Some may retort that money supply can grow fast without creating inflation due to financial deepening -- people's higher willingness to hold more money. This argument lazily bypasses the responsibility of monetary policy in controlling inflation and the costs of not doing so.

In fact, contrary to this popular belief, money supply (M2) growth and inflation in Bangladesh have been closely related in recent years (see graph): the higher the money supply, the higher the inflation.

Ignoring monetary causes of inflation can be very costly. Many Latin American countries with populist policies learned it the hard way: once high inflation expectation gets entrenched, controlling it becomes exponentially difficult. People then ask higher salaries which in turn raise prices again -- creating a vicious cycle.

Zimbabwe -- with inflation at over 1,000 percent in 2006 -- is now feeling the pain of earlier monetary policy inaction and populist polices. The US in the 1970s tried wage-price controls to reduce inflation and predictably failed. Inflation came down only when the Federal Reserve Bank under Paul Volcker in the 1980s tightened monetary policy.

Timely AND appropriate response is of essence -- un/mistreated cold may lead to pneumonia.

Asleep at the wheel?

Unfortunately, the BB, despite its past achievements like banking sector reform, has not provided the policy leadership on inflation expected from modern and independent central banks.

The BB should take the central stage in this debate by providing proper analysis and actions needed for containing inflation. People should know that inflation ultimately is a monetary phenomenon and that it takes some time (12-18 months depending on monetary transmission) and may involve hard choices (higher interest rate/lower government deficit and borrowing) to reduce inflation. Forward-looking monetary policy, like a large oil tanker which takes time to turn, needs to target inflation 12-18 months ahead, based on forward-looking indicators, to deliver it.

Like a financial shepherd, the BB should guide the country to anchor inflation expectation by publicly announcing its inflation target and needed monetary policy instruments.

Fortunately, the BB does not need to start from scratch; it can learn from others' experience.
After a decade of over 10 percent inflation, New Zealand successfully reduced inflation by making its target (now under 2 percent) explicit in 1988 and acting accordingly. New Zealand then, somewhat similar to Bangladesh today, lacked sophisticated financial system, a good inflation forecasting ability, or even a robust measure of inflation.

In our own neighbourhood, India and Pakistan are also moving in that direction. The Reserve Bank of India in May 2007 just reduced it medium-term inflation limit to 4.0-4.5 percent to anchor inflation expectation. The State Bank of Pakistan (SBP) is increasingly embracing the role of monetary policy to reach its targeted inflation. Let's not fall behind.

Wanted

The current BB mandate (1972 and 2003 BB Order) is too broad -- covering price, exchange rate, economic growth, and high employment. If the BB tries to achieve so many objectives and promises to deliver everythinghigh growth, low inflation, strong but competitive currency by targeting all of them -- it will surely end up delivering none.

The BB needs to: (i) prioritise its mandate of price stability; (ii) ask for independence with regard to management of monetary policy; and (iii) build its credibility. To be effective, it needs to act independently from the government (or politicians running the government) so that interest rate and exchange rate decisions are depoliticised. It should ask for operational independence for inflation targeting and start acting as the primary champion to target inflation.

It is high time that the BB properly diagnose the causes of our national fever (inflation) and be ready to firmly apply its medicine (monetary policy). The sooner it acts, the less bitter its medicine would taste. Wishing like an ostrich that inflation would simply vanish as supply shocks dissipate or that supply response through structural measures will bring it down may only worsen inflation expectation down the road.

It's time for the Bangladesh Bank to take charge and redefine the inflation debate. We are waiting.

Faisal Salahuddin is an actuary and economist.