Is monetary policy working?

Recently a research institute assembled a bevy of economists for a discussion on the biannual publication of Bangladesh Bank (BB), Monetary Policy Statement July-December 2014. The discussion revealed that there were sharp differences of opinions on several issues. The economists could not agree (no surprise there!) on how to describe the stance of the current monetary policy. While some participants painted the monetary policy as contractionary others thought it was expansionary. One participant even said that monetary policy cannot be categorised as contractionary or expansionary, it addressed ground realities. BB stuck to the amorphous description 'accommodative' that it has been using for several years.

The terms contractionary, expansionary or accommodative have subjective elements which give some leeway to analysts how they interpret these: what is contractionary to one is expansionary to the other. It seemed that those who regarded the current monetary policy as contractionary did so on the ground that the program credit growth rate was, in their opinion, not adequate to support a robust economic growth. Incidentally, a number of eminent people including a planning commission member, an editor and a former governor of Bangladesh Bank also hold a similar view. In contrast, those who thought it expansionary seemed to emphasise that the program credit growth rate was considerably above the actual growth rate in the immediate past, and could support any plausibly higher economic growth rate.

An official of BB argued that the program rate was a ceiling and not a target such that a lower rate is consistent with the policy. Taken literally, this of course does not make sense. A 5 percent growth, or even a -10% change, is below the ceiling. Would BB be complacent with such a rate of growth of money or credit? By program rate BB must mean that it wants the actual growth rate to be close to this rate; otherwise monetary policy numbers lose meaning.

Since the discussion was among economists, it would be pertinent to refer to what the discipline, in particular monetary economics, has to say about the matter. A few decades ago monetary aggregates such as broad money were used as proximate targets of monetary policy in most developed countries. But rapid changes in financial structure and technology, and the instability of money demand made monetary aggregates rather elusive targets. Most central banks failed in their effort as their target monetary bands were frequently breached. Western central banks gradually abandoned the use of monetary aggregates as a policy target. As a central bank governor so eloquently put: we did not abandon monetary aggregates, they abandoned us. Since then the preferred immediate target has been a short term interest rate, such as overnight call rate or money market rate, which the central banks could more easily influence or control.

It is now a common practice of monetary economics to regard monetary policy as expansionary if the interest rate declines and conversely. When the interest rate falls to near zero, central banks on occasion may be forced to use monetary aggregates as indicators of policy. However, since a reduction in the interest rate cannot be in general achieved without an expansion in money supply, monetary growth continues to be regarded as an indicator of monetary stance.

Since the objective of an expansionary monetary policy is to increase GDP, we could use the target GDP as an additional indicator of the stance of monetary policy. If the target GDP growth rate used for estimating other parameters of the monetary policy is greater than the current GDP growth rate, the monetary policy stance may be regarded expansionary.

A look at the data given in the table below will indicate the sources of possible controversies regarding the monetary stance of BB. The three short term interest rates shown in the table all rose sharply in 2010-11 with further increases in 2011-12. All interest rates eased in 2012-13 and 2013-14. There is little doubt, by the interest rate criterion, that the monetary policy was tight during 2010-11 and 2011-12, but expansionary during the following two years. However, monetary growth criterion tells a somewhat different story. Actual monetary growth decelerated with the increase in interest rates as expected, but the substantial reduction in the short term interest rates after 2011-12 did not raise the growth rate of money or credit; on the contrary these declined during the next two years. Thus, by the actual monetary growth criterion it would appear that the monetary policy was tight. The interest rate criterion and monetary growth criterion yield different conclusions regarding the monetary policy stance.

Table: Selected monetary indicators (per cent)

*Broad money, TB=treasury bill, Bank credit=advances, bills and investment, ^p BB program rates

Source: Bangladesh Bank

It could be argued that it is not the actual monetary growth, but the intended monetary growth that reflects the monetary policy stance. The intended growth is shown in the table by the program growth rate of money. The program growth rate rose from 2009-10 until 2011-12 and fell thereafter. Hence, if the intention of BB was to tighten monetary policy during the period 2009-10 to 2011-12, it set the program money growth in the wrong direction. Similarly if BB wanted to engage in an expansionary monetary policy in the following two years (2012-13 and 2013-14), its intended money growth was not consistent with that policy.

Thus, if one goes by the interest rate criterion, he would conclude that the monetary stance of BB was expansionary since 2012-13; but if he used the money growth criterion he would reach the opposite conclusion. Finally, if one uses the GDP growth rate criterion, the July-December 2014 monetary policy that targets a small increase in the growth rate will appear modestly expansionary.

It was suggested in the meeting that the low program growth rate of money does not indicate the true intention of BB. The sharp decline in domestic credit must have convinced BB that the actual monetary growth will be low. There is no point in setting a high growth target if it is in any case unattainable. The point has merit; but it is also an admission that monetary policy has ceased to be effective after 2011-12. The strong negative correlation between monetary growth and interest rate has been replaced by a positive correlation during the last two years. An expansionary monetary policy will not stimulate aggregate demand and output.

The second controversy was over foreign borrowing by domestic enterprises which has increased very rapidly. The stock of foreign loans approved till March 2014 exceeded $5.5 billion. Several participants expressed concern about the risks of foreign borrowing. Given the experience of the Asian financial crisis and financial crises endured by some Latin American countries such concern was not misplaced. BB tried to assuage the concerns of the participants by emphasising that it was very careful in selecting the prospective borrowers, and mostly reputed firms that earn foreign exchange were allowed to borrow overseas.

If BB could stick to such a policy, there would not be much concern. If a 100% exporting firm borrows funds from overseas to finance its, say, working or fixed capital needs, it cannot run into difficulties due to exchange risks that arises because of unanticipated depreciation of the local currency. Indeed, depreciation actually raises the local currency profit of the firm. The firm could suffer some problems in case of appreciation, but appreciation can be more easily dealt with by the central bank. However, the government or BB must not underwrite foreign loans ¾ these must be strictly private sector undertakings where both borrowers and lenders bear the risks. Cautious firms could hedge against exchange risks by transacting in the forward exchange market. When the international reserve level runs low, suspension or curtailment of overseas borrowing facilities may be contemplated. If a borrower conducts business injudiciously or runs into a bad patch, and incurs losses, the consequences must be borne by him and his lenders.

However, if borrowing overseas becomes commonplace, BB is unlikely to be able to restrict non-exporting firms from the facility, especially when the interest spread is large. If BB yields to pressure, we shall indeed have many firms facing exchange risks. BB could minimise the risks by requiring such firms to take out forward contracts, but it is doubtful if this could be enforced.

A suggestion was made that BB might consider enriching its monetary policy statements with some analytical material. Another suggestion was that BB should indicate the transmission mechanisms of monetary policy. A BB official replied that there was a page on monetary transmission in the statement. The referred page actually contains a description of what BB is doing to improve the efficiency of the financial sector. A well-functioning financial sector is of course essential for an effective transmission of monetary policy. Such transmission is achieved through various channels or mechanisms. The same channel is not equally effective in all countries or at all times. A good knowledge of the principal transmission mechanisms is essential for successfully conducting monetary policy. In the words of an Executive Vice President of Federal Reserve Bank of New York: "Monetary policy is a powerful tool, but one that sometimes has unexpected or unwanted consequences. To be successful in conducting monetary policy, the monetary authorities must have an accurate assessment of the timing and effect of their policies on the economy, thus requiring an understanding of the mechanisms through which monetary policy affects the economy." (F.S. Mishkin 1995).

The importance of understanding the transmission mechanisms is not diminished by an improvement of the functioning the financial sector, if at all the importance is enhanced since monetary policy assumes a greater role and importance as the functioning of financial sector improves with economic development.

This importance can be illustrated with the following example. A study done by the Research Department of BB found that the exchange rate and bank loans were conduits of monetary policy in Bangladesh (this is not an official position of BB). If this is taken to be true, then this has important implications for the effectiveness of monetary policy.

The exchange rate policy of BB during the last 16 months has been to maintain the value of US dollar at about Tk. 77.7. There were very little variations about this value (standard deviation of 0.1). A large amount of foreign exchange was purchased by BB to prevent an appreciation of the taka. The near constancy of the exchange rate however implies that it could not have performed its role as a transmission mechanism of monetary policy. BB's current exchange rate policy is at variance with effective transmission of its monetary policy.

Many authors believe the bank lending or credit channel to be the most important transmission mechanism of monetary policy, especially in developing countries. An easing of monetary policy, indicated by a reduction in the interest rate, leads to a greater volume of lending by banks which encourages a higher rate of investment. This raises aggregate demand and consequently output.

However, during the last couple of years, substantial reduction in the short term policy rates failed to reduce the lending rate significantly. The mechanism that transmits the changes in short term rates to longer term rates was weak. More worryingly, the rate of expansion of bank lending (credit) plummeted since 2011-12. A sharply falling volume of bank lending could not have stimulated aggregate spending. The bank lending channel was not effective during the last two years as it could not transmit monetary policy impulse to the real economy.

Monetary policy affects monetary variables such as nominal interest rate and price, but the real economy is affected by real variables. A reduction in the nominal interest rate may be achieved by an expansion of the money supply, but it does not guarantee that the real interest rate will decline too. During the last two years, the short term rates declined markedly, but so did the inflation rate. As mentioned earlier, the reduction in the short term rates were not transmitted to the long term rates, in particular the bank loan rate. The result was a more than doubling of the real interest rate. Since real private investment depends on the real loan rate, it is no wonder that it decreased during the last two years. Monetary policy was not effective because of the weakness of the credit channel and BB's inflation targeting policy.

Although BB could not keep the inflation rate below the target rate, it was not exorbitant. These days BB seems to be overly mindful of the inflation rate, sometimes at the expense of output growth. The large reduction in the inflation rate in 2012-13 was achieved at the expense of a sizeable reduction in the GDP growth. The economy slid down the short term Phillips curve. It remains to be seen whether the curve itself will shift down. It is of course possible to argue that the reduction in inflation was a consequence of the prolonged slowdown of the economy caused by such factors as financial mismanagement and political uncertainty that did not have much to do with monetary policy.

BB has been publishing monetary policy statements at six month intervals regularly for several years. It is well known that monetary policy has a long gestation lag often exceeding 12 months. Hence, whether a monetary policy measure has been effective, or whether a change is necessary, will not be known until after at least a year. If so, it may be pertinent to re-examine the utility of bringing out a new monetary policy statement every six months. Given the pressure to be seen proactive and the long adjustment lags of monetary policy, the probability of incorrectly adjusting a correct policy rises with the frequency of adjustments.

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M. A. Taslim is Professor and Chairman of the Department of Economics, University of Dhaka.