Making interest rate corridor work

The International Monetary Fund (IMF) has been recommending a flexible interest rate targeting to modernise monetary policy for the past half decade. The Bangladesh Bank has agreed to move to such a framework by 2026 as part of the $4.7 billion IMF program now in place. Hopefully, this time intentions will translate into actions leading ultimately to an exit from the prevailing quantitative targeting framework and interest rate repression. There is hardly any reason why BB cannot do it if it really wants to sooner than planned.

Awaiting action for a while

IMF's Article IV report in 2017 envisaged:

"A price-based framework – interest rate targeting and a more market-based exchange rate – would allow a more agile response to changing domestic and external circumstances…." Five years later, their 2022 report emphasised the development of a Forecasting and Policy Analysis System at the BB to allow an "informed decision-making process on the appropriate level of the policy interest rate, and monetary policy stance more generally, given the prevailing macro-economic and financial conditions and outlook."

The IMF's latest Program Document 2023 reports a rather protracted timeline. The "authorities are building their capacity to modernize monetary policy formulation and move away from reserve money to interest rate as an operational target by the end of the program period." This means a complete switching cannot be expected before mid-2026. The program stipulates transition to an interest rate corridor system with automatic standing lending and deposit facilities by end-July 2023 as a first step.

Many central banks around the world use interest rate targeting as a monetary policy tool to manage inflation and support growth. Interest rates are the time-tested instrument of choice in their playbook. The interest-based policy regime has two prerequisites – a central bank able to conduct monetary policy with some degree of independence and the willingness and ability of the monetary authorities not to fall into the trap of multiple, inconsistent targets.

No central bank can be entirely independent of government influence, but it must be free to choose the policy rate consistent with the inflation target. Forex market interventions derail the conduct of domestic monetary policy operations. These have to be subordinate to the management of the short-term interest rate as a general rule.

Getting started

The incremental approach recommended by the Fund begins with the more active use of the existing operating framework. Absence of a market determined yield curve relating interest rates with the maturities of various government and corporate debt limits the choice of operating interest rate targets.

The secondary market for government debt securities in Bangladesh is largely missing in action. There are about 270 treasury bonds worth more than Tk4,600 billion with tenures ranging from 91 days to 20 years. BB publishes a yield curve of government securities of different tenors based on auction data. These do not reflect market conditions. The securities could not be traded like shares and mutual funds until recently.

Trading of treasury bonds began on the Dhaka Stock Exchange on 9 October 2022, on a trial basis. The results so far are not worth writing home. Getting it into full swing to generate a competitively determined yield curve still looks like a pie in the sky. Transactions have just not taken off. General investors have little interest in participating in an inactive market. Banks and financial institutions hold almost all of them to satisfy Statutory Liquidity Requirements and manage their treasury operations. The circuit breaker – maximum of 2% price variation in a day--the securities regulator has imposed on the price in market trading severely limit the tradability of the listed T-bonds.

An interest rate targeting framework is feasible despite shallow financial markets, volatile exchange rates, supply shocks and lack of data. The end point of the move toward interest-rate based frameworks is a policy rate that anchors interest rates in the financial system. Targeting interest rate achieves greater certainty that allows businesses and consumers to make spending plans with more confidence. However, targeting may constrain how interest rates respond to shocks, thus magnifying its effects, in the absence of a high frequency adjustment mechanism to account for changing macroeconomic conditions. The framework needs to be flexible with built in learning mechanisms.

The nuts and bolts

The BB can target the call money rate. This is the average market-determined interest rate at which banks lend funds to each other on an overnight basis. The BB will need standing facilities to steer the call money rate toward the chosen target without dictating it. The combination of an unlimited access lending facility putting a ceiling on rates and a standing deposit facility setting a floor can do the trick.

The target rate is typically positioned in the middle of the corridor formed by the standing facilities. BB's open market operations will have to ensure the call money market rate is as close as possible to the target. The rate going beyond the ceiling or floor will respectively trigger BB lending and deposit taking. The presence of an active inter-bank money market makes such liquidity operations feasible.

The BB could enhance its' signalling powers and the transmission of policy changes by using more rigorously the repo/reverse-repo interest rate corridor. It could target the interbank repo market rate where banks sell some of their securities to other banks, including BB, with a short duration future contract to buy the securities back at a slightly higher price. BB's repo rate, the rate at which Banks do repurchase contracts with BB, in theory, provides an upper bound (ceiling) for the market repo rate. Its reverse repo rate, the rate at which the BB does the same with banks, creates a lower bound (floor). The targeting can graduate to the call money market as automatic standing facilities are put in place.

Central banks globally have much more experience with corridor-type systems. Setting the target and the bounds necessarily involves "guesstimation". A wide corridor may encourage banks to hoard liquidity while a narrow corridor may discourage interbank trading. To start with, the corridor could be relatively wide (400-500 basis points) because of uncertainty about the relationship between reserve money and interest rates, narrowing over time as the focus shifts from money aggregates to interest rates. The target rate is often (not always) set in the middle of the corridor. Leaky ceiling and soggy floor come with the territory for a variety of reasons. There is some unavoidable playing by the ear involved on the part of the policy plumbers.

Transmission is never smooth

There are long and variable lags between changes to monetary policy and its effect on interest rates, credit, exchange rate, economic activity, and inflation. There are "inside" lags in policy formulation and "outside" lags in policy implementation. Central banks, businesses and households take time to adjust their behaviour.

The capacity to produce coherent medium-term forecasts and analysis consistent with current and expected state of the economy is a manageable requirement. BB has staff with the ability to develop quantitative frameworks for monetary policy analysis and liquidity forecasting. All they need is meaningful encouragement to do so. Progress in these areas can be self-reinforcing with demand creating supply.

The challenge for an efficient operating procedure is to minimise the transmission lag from changes in the policy rate to a variable (such as bank lending rates) that directly transmit the monetary policy actions. An underdeveloped financial market impedes transmission. However, it is the choice of an appropriate monetary regime that experience suggests is more important in determining the strength of monetary transmission.

Do the full course

Interest rate targeting presumes passthrough from policy rates to lending rates. Changes in the monetary tools influence the targeted short-term rate which in turn must be able to influence deposit and lending rates for households and businesses. The existing lending rate cap blocks the latter because of the current tiny and shrinking range for the movement between money and credit market interest rates.

Transformative progress toward the liberalisation and deepening of financial markets since the 1990s have been succeeded by reversion in the scope for independent monetary policy in Bangladesh in the past decade. Flexible interest rates have served Bangladesh well historically. This is evident from data on financial deepening since liberalisation in the early 1990s. BB has relaxed the lending interest rate cap on consumer loans and committed to remove other caps over the 42-month IMF program period.

Minimising volatility in the operating target is important for clarity in policy signals. Implementing half measures towards interest rate targeting without contemporaneously strengthening monetary policy formulation, unblocking the interest rate transmission channel, and improving policy communications could lead to a lot of song and dance with no improvement in outcomes compared to the existing regime.

Switching regimes is like antibiotics. You have to complete the course without losing continuity.

Zahid Hussain is the former lead economist of The World Bank, Dhaka office