A sharp rise in policy rate. What it means for you

The Bangladesh Bank has increased its key policy rate by 75 basis points to 7.25%, the highest hike in the last one decade, aiming to make money costlier to curb inflation.

This is the second hike in three months and sixth since May last year when inflation just shot over 8% from below 6% in January 2022.

Around the same period, the US Federal Reserve hiked rate for nearly a dozen times since March last year and neighbouring India went for a massive 250 basis points at one go in May last year to cool surging prices. Both economies have now chosen to keep their rates unchanged at high levels after significantly containing inflation that roared to their peaks in decades for most Western economies.

Of late, Bangladesh's central bank opted for the most-used policy tool as its weapon with the massive one-time hike to fight inflation, which remains stubbornly high at over 9% for months, after its meeting with the IMF's loan review mission.

The International Monetary Fund (IMF) has said the Bangladesh Bank's monetary policy has failed to control inflation, pointing to the central bank's failure to fix the exchange rate based on the actual market situation and to set a sufficiently high lending rate to reduce money supply.

"IMF officials said the dollar and lending rates were not raised by the amount they were supposed to, which in turn failed to control inflation," a senior central banker said after their meeting on Wednesday with the IMF team that examined the progress in monetary policy stance before the second tranche of the $4.7 billion budget support.

The latest hike in the policy rate, also known as the repo rate, will increase borrowing costs for commercial banks from the central bank which will eventually push the lending rate up. When the lending rate goes up, it will make money costlier for consumers reducing credit demand which will ultimately ease price pressure.

When banks borrow at 7.25% from the central bank, they will quote a higher rate for treasury bills which is linked with the lending rate. The rise in the policy rate will surge the deposit rate also.

An IMF study that examined how policy rate change impacts inflation in some central Asian economies suggests 1 percentage point increase in the policy rate results in 0.5 percentage point in inflation and 1 percentage point exchange rate appreciation results in a 0.3 percentage point decrease in inflation in the first year.

But Bangladesh Bank has so far been slow in hiking policy rates considering its impact on private sector investment and cost of import.

The latest hike in policy rate came at a time when private sector credit growth fell to a 22-month low to 9.7% in August, far below the rate needed to achieve 7.5% GDP growth. Bankers apprehended that the rate hike would create further liquidity pressure in the banking system.

Earlier on 1 July, the Bangladesh Bank increased the policy rate from 6% to 6.5% but it did not help much to ease credit demand as lending rate was kept low through supplying money printing. Since May last year, the policy rate was hiked by 225 basis points in six revisions.

Zahid Hussain, the former lead economist at the World Bank's Dhaka office, told The Business Standard the central bank adjusts the policy rate to keep inflation under control.

"Hiking the repo rate may not tame inflation because the lending rate at the customer level is determined according to the SMART rate, which is somewhat fixed," he said.

Zahid Hussain said the policy rate has been increased several times so far but it has not played an effective role in controlling inflation. "I think, by hiking the repo rate, only the profit of the Bangladesh Bank will increase."

He said that the central bank should leave the rate of treasury bills and bonds to the market to control inflation. The market demand for interest rate on Treasury Bills is 9-10% but this rate is now slightly above 7%.

The central bank should keep another 7% ceiling over the SMART, which is now only 3%. Banks could then offer different rates on loans at the customer level which would further increase lending rates which would control inflation.

In a meeting with the governor Abdur Rouf Talukder on Wednesday, the IMF team blamed the fixed exchange rate mechanism and new lending rate formula that kept lending rate managed for failure in containing inflation, according to meeting sources.

The SMART rate was 7.10% in June which jumped to 7.14% in August and 7.20% in September as the central bank did not create money these two months amid sharp criticism from economists for printing money for deficit financing of the government.

Bangladesh Bank created new money of Tk80,000 crore in the last fiscal year and Tk9,000 crore in July alone in the current fiscal year to keep the treasury rate low aiming to maintain a stable lending rate which is blamed for fueling inflation.

Syed Mahbubur Rahman, managing director & CEO of Mutual Trust Bank, told TBS, "Money will become dearer due to the hike in the repo rate. As a result, banks will reduce credit flow."

"On one hand, the central bank rate is increasing and on the other, the government is borrowing thousands of crores of taka from the banks to meet the budget deficit, which will further dry up the market," he said adding that If the liquidity crisis of the banks increases they will have to collect high-interest deposits from the customers.

"The problem of the banks is that the deposit rate is constantly increasing but the lending rate is not increasing. Because the lending rate can be adjusted once every six months, he said.

"If the treasury rate increases, the lending rate increases. However, the treasury rate should be hiked according to the market. Only then it would be helpful in controlling inflation," he said, adding that the repo rate hike by the central bank now should have been hiked in 2022.

In August, the central bank started to collect money from banks for the government's deficit financing by selling treasury bills. Banks are quoting high rates for treasury bills in the auction resulting in a surge of SMART rate.

In a meeting with the Bangladesh Bank last week, Sadiq Ahmed, former director of the World Bank and vice chairman of the Policy Research Institute of Bangladesh (PRI), suggested stopping the financing of the budget deficit through money creation to control inflation.

Though the Bangladesh Bank has set an inflation target of 6% for the current fiscal year, it stood at 9.63%, slightly lower than the previous month.

The central bank of Sri Lanka which faced a severe economic crisis but finally managed to bring down its 20-month-long double-digit inflation to single-digit by hiking policy rates making money costlier.

Shaktikanta Das, the governor of the Reserve Bank of India, successfully contained inflation with a tight money campaign delivered via six repo rate hikes.

Inflation in the US and Europe also cooled down in recent months as a result of policy rate hikes

Rate hike has several implications for the economy

Cost of borrowing: One of the most immediate effects is an increase in the cost of borrowing for individuals, businesses, and the government. Banks typically pass on the higher policy rate to borrowers, leading to higher interest rates on loans, including mortgages, car loans, and business loans.

Consumers may reduce their spending: When borrowing becomes more expensive, consumers may reduce their spending on big-ticket items like homes and cars.

Demand may fall: Falling consumption may dampen economic growth.

Investment: Higher interest rates can also deter private investment. Companies may delay or scale back capital expenditures, which may cut jobs.

Stock markets: Rising interest rates can lead to lower stock prices.

Government finances: Governments may face higher interest payments, which may hike public expenditure and widen the budget deficit.

Housing market: Higher interest rates can make housing less affordable.

Positive impacts

Exchange rates: An increase in the policy rate can attract foreign capital seeking higher returns.

Savings and investments: Higher rates may benefit savers.