Can a contractionary monetary policy cause issues in the long run?

The Bangladesh Bank (BB) recently announced its decision to keep the policy rate unchanged at 10% for the January–June period of 2025, signalling a continued focus on curbing inflation.

The central bank's decision to maintain the status quo follows a prolonged period of monetary tightening, during which the policy rate—the interest at which the BB lends to commercial banks—has been raised consistently since May 2022. While the unchanged rate reflects a softer stance compared to the aggressive hikes of the past two and a half years, it raises important questions about the long-term implications of contractionary monetary policy on the economy.

Where are we?

Inflation, which peaked at over 11% in July 2024, has shown signs of easing, declining to 9.94% in January 2025. Food prices, a major driver of inflation, have also followed a downward trend, falling from 12.92% in December 2024 to 10.72% in January 2025, partly due to the seasonal availability of winter vegetables. However, non-food inflation edged up slightly, rising to 9.32% in January from 9.26% in December, indicating continued price pressures in other sectors.

Fahmida Khatun, executive director of the Centre for Policy Dialogue, told The Business Standard that the lack of changes in the policy rate suggests the central bank expects inflation to decrease further in the next six months. However, she noted that the economy is likely to remain in a low-level equilibrium during this period.

"The central bank's decision to raise the policy rate has had some effect, as inflation slightly decreased in January," she said.

Despite inflation easing in recent months, consumers in Bangladesh have faced ongoing price pressures for the past two years, with inflation consistently exceeding 9% since March 2023.

"The BB cannot afford to take such a risk while inflation remains unacceptably high. Non-food prices have risen every month for the past three months, mirroring the trend from the previous year. This suggests inflation has become endemic," said Dr Zahid Hussain, former lead economist at the World Bank's Dhaka office.

How effective is monetary policy?

Experts agree that the economy is gradually stabilising, but they emphasise that monetary policy alone cannot control inflation—other factors must also be considered. Inflation has also eased due to an increased supply of food items from domestic sources. However, they warn that when the supply of vegetables declines, prices will rise. Additionally, Bangladesh will need to import two million tonnes of rice, which will require foreign exchange. The diversion of foreign exchange to these imports could lead to further depreciation of the local currency, the taka.

According to Dr Zahid Hussain, "Streamlining inefficient business regulations and untangling supply chains from exploitative practices would boost productivity sooner rather than later. These reforms are difficult to implement—until they are done."

The biggest critics of contractionary monetary policy are businesses, which argue that reducing the money supply in the private sector negatively impacts trade and industry, particularly as almost all raw materials used in production are imported.

"Bangladesh Bank's decision to maintain a contractionary monetary policy in the second half of FY 2024-25, keeping the policy rate at 10%, is concerning for businesses. This rigid stance hampers private sector credit growth and economic expansion," said Taskeen Ahmed, president of the Dhaka Chamber of Commerce and Industry (DCCI).

"The private sector relies heavily on banks for investment, and high interest rates increase production costs, ultimately fuelling inflation," he added.

However, economists challenge this perspective, arguing that there is little evidence to suggest that high policy rates are responsible for low growth.

"Technically, the policy rate has been increasing for around two years now, but in reality, it has only started affecting the market since last September. Before that, interest rates were lower, and in fact, the real interest rate was negative for almost two years after Covid-19," Dr Hussain explained.

While inflation increases sellers' revenues, it also raises their costs. Negative real interest rates mean sellers' revenues are outpacing the cost effects of inflation.

"So why did we see no impact on investment when the real interest rate was negative? Investment has remained stagnant as a percentage of GDP, with only 4.2% growth last year," Dr Hussain added.

Critics argue that this approach has been ineffective in Bangladesh, claiming it also hampers employment by constraining production and investment. They highlight the rising costs of doing business but often overlook the effects of high inflation on business revenues.

Economists argue that Bangladesh's experiment with a cheap-money policy during FY 22–24 resulted in higher inflation and lower growth. This period serves as evidence that deviating from orthodox economic policies can lead to significant regrets. The costly outcomes of the FY 22–24 policy regime highlight the risks of disregarding established economic principles.

Long-term impacts

Monetary policy is generally regarded as a short-term tool, and contractionary monetary policy, in particular, is often described as a "firefighting" measure—used to extinguish inflation. However, firefighting cannot cease until the blaze is fully controlled.

Yet, prolonged application of this approach can have complex consequences for economies like Bangladesh, which rely heavily on informal sectors and export-driven industries such as textiles and garments.

"Even if inflation does not fall to 8% by this June and to 6% by the following June, there is no scope to reduce the policy rate," said Dr Zahid Hussain.

"If, in that case, interest rates can no longer be blamed for inflation, another factor will be driving the pressure—perhaps foreign exchange constraints, export disruptions, food production challenges due to energy or fertiliser shortages, etc. Lowering the policy rate would only further fuel inflation," he explained.

Sustained high interest rates increase borrowing costs, discouraging consumer spending and business investment. This curtails economic activity, heightening the risk of slower growth and higher unemployment. In the 1980s, the US experienced job losses as industries retrenched under rising financing costs. While Bangladesh's economic structure differs, stringent policies could similarly strain employment and growth.

"Other countries have successfully controlled inflation using policy rates, so we must examine why it has not worked in Bangladesh. As long as inflation remains high, the policy rate cannot be reduced, as doing so would further fuel inflation," said Ferdaus Ara Begum, Chief Executive Officer at BUILD, a Public-Private Dialogue Platform.

She further pointed out a misalignment between fiscal and monetary policies. "An assessment of monetary policy's role in inflation is necessary. In December, private sector credit growth stood at 7%, while public sector credit growth was 19%. This indicates a lack of coordination between fiscal and monetary policies. Why is the public sector borrowing so high despite a contractionary fiscal policy?"

Persistent tightening also restricts access to credit. As banks impose stricter lending criteria, small and medium-sized enterprises (SMEs)—vital to Bangladesh's economy—may struggle to secure funds for expansion.

Raghuram Rajan, in Fault Lines: How Hidden Fractures Still Threaten the World Economy (2010), highlights the challenge for emerging markets: "Monetary policy is not a silver bullet; while essential for taming inflation, prolonged tightness can stifle credit for entrepreneurial activity—particularly in emerging markets." For Bangladesh, balancing inflation control with economic growth requires meticulous attention.

"It has become clear that inflation in Bangladesh cannot be resolved through monetary and fiscal policy alone. Market distortions must also be addressed through stronger law enforcement," said Ferdaus Ara.

Rising borrowing costs also increase debt-servicing burdens for both the public and private sectors. Higher interest rates may force governments and businesses to divert budgets from productive investments to debt repayments, further stifling expansion.

Experts argue that while large businesses may navigate high interest rates, SMEs are hit the hardest, often lacking the resources to withstand economic pressures. A wave of SME closures could place a further strain on the economy.

"The high interest rate is putting serious pressure on businesses. Not all businesses can pass on these higher costs to consumers. We need to recalibrate the standing deposit facility (SDF) rate and the repo rate," explained Ferdaus Ara Begum.