Inflation and monetary policy: Which way?
Price reversals are rare. Structural rigidities – like fixed input costs, entrenched markups, and behavioural inertia – act like glue in the system.
Headline inflation in Bangladesh has been easing since November 2024, hinting at a possible turning point. But the 7 basis point uptick in September has reopened a familiar question: is this moderation durable, or merely a pause in a longer upward climb?
Some of the easing can be traced to base effects and softer global prices. Yet the spotlight is increasingly falling on Bangladesh Bank's exchange rate management – specifically, whether its foreign exchange interventions align with a genuinely tight monetary stance. This matters because the exchange rate isn't just a background variable; it's a key driver of domestic inflation.
Before going further, a brief detour may help clarify what inflation actually measures. Inflation tracks the speed at which prices rise – not their absolute level. Think of prices as a hill and inflation as your climbing pace. A slower pace means you're still ascending, just more gradually. Since November, the climb has continued, with occasional spurts – like the September spike in food and non-food inflation. True price declines (deflation) are rare; what we usually see is either upward creep or disinflation, where the climb slows but doesn't reverse.
Evidence on inflation drivers
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The evolution of monthly (year-on-year) headline inflation in Bangladesh from July 2019 to September 2025 indicates a shift in its pattern. Initially, inflation fluctuated moderately within a 5-7% range, but after 2021, it surged, exceeding 12% on several occasions. The trend line demonstrates a persistent upward movement (chart), highlighting that inflation is becoming structurally entrenched.
The dominant narrative often blames rising inflation on global and domestic supply shocks. The World Bank's October 2025 Bangladesh Development Update highlights disruptions like hoarding, cartel-driven bottlenecks, and extortion – alongside exchange rate depreciation, energy price hikes, and flawed policy responses. Supply shocks are like sudden storms: intense, disruptive, yet transitory. Their impact tends to taper off over time. In contrast, macroeconomic forces – such as the flow of taka, foreign exchange liquidity, and the exchange rate – are more like the climate itself. They shape the inflation landscape continuously, conditioning how prices evolve long after the storm has passed. Whether those price pressures fade or persist depends heavily on these underlying fundamentals.
Monthly data from July 2019 to June 2025 shows that inflation in Bangladesh behaves much like a river – its flow shaped by upstream forces. A 1% depreciation of the Taka causes a 0.42% rise in consumer prices downstream. Each percentage point increase in domestic credit growth adds about 0.28% to the inflation current, while a 1% drop in net foreign assets (NFA) stirs a 0.31% rise in price levels. Inflation doesn't just respond to fresh shocks – it carries echoes from the past. Lagged effects suggest that expectations and inertia act like sediment in the riverbed, reinforcing the momentum and making the inflation stream harder to redirect.
Inflation doesn't fall as fast as it rises
Inflation in Bangladesh doesn't respond to shocks in a balanced way. It tilts heavily toward upward pressure. When the exchange rate depreciates, credit expands, or foreign reserves shrink, prices tend to rise swiftly. But when the reverse happens – currency appreciation, credit contraction, or reserve buildup – the disinflationary response is far more muted. It's like climbing a steep hill and descending a gentle slope: inflation accelerates quickly but slows down reluctantly.
Currency depreciation packs a stronger punch than appreciation when it comes to price levels. Likewise, inflation reacts more sharply to liquidity injections than to tightening. Even the accumulation of net foreign assets (NFA) offers only modest relief, while NFA depletion stirs significant inflationary heat. Once these pressures take hold, they are hard to unwind – especially in non-food sectors, where pricing tends to be stickier.
Price reversals are rare. Structural rigidities – like fixed input costs, entrenched markups, and behavioural inertia – act like glue in the system. Traders and retailers often resist lowering prices, even when conditions soften, due to strategic habits and embedded expectations. As a result, even during periods of moderation, the overall price level remains stubbornly high.
BB's recent tilt toward reserve accumulation – evident in its aggressive dollar purchases – may be reinforcing this asymmetry. By prioritising nominal exchange rate competitiveness over domestic disinflation, it risks keeping inflation elevated, potentially well above the 6.5% target by June 2026.
Monetary policy options
Balancing external competitiveness with internal price stability is like walking a tightrope – every step involves trade-offs. The current stance – Plan A – leans toward limiting nominal appreciation and stockpiling reserves as insurance. There could be an alternative path – Plan B – that calls for a wider band around the peg (200-300 basis points), accepting some currency appreciation risk in exchange for stronger disinflation.
Given that headline inflation has eased by only 52 basis points over the past 12 months (on a 12 monthly moving average basis), this alternative deserves serious consideration. Bangladesh's disinflation is among the slowest in the region, contrasting sharply with the rapid post-crisis price corrections seen in peers like Sri Lanka and India.
Concerns about export and remittance fallout are valid, but perhaps overstated. Exporters do gain from a weaker currency, yet they also grapple with high input costs, regulatory burdens, and expensive external financing. The government and the BB have recently rolled out measures to reduce regulatory hassles. Remittance flows are sensitive to exchange rate signals – but only when formal channels are trusted, accessible, backed by a stable foreign exchange regime and constrained illicit outflows.
Trying to stabilise everything at once – the exchange rate, inflation, and business sentiment – is like juggling fire, water, and wind. A soft peg, liquidity expansion, and monetary tightening cannot coexist without contradiction. BB has kept the policy rate unchanged at 10% – a level considered high. At the same time, it's buying dollars without offsetting (called sterilisation) the taka liquidity injection, effectively printing money to stabilise the exchange rate.
This creates a contradiction: the double-digit policy rate signals tightening, while the unsterilised dollar purchase signals quantitative easing. The mixed signals – one foot on the brake, one on the accelerator – confuses the market and undermines the credibility of both objectives.
There is no risk-free path
Our monetary stance currently is akin to crossing a river on stepping stones – every step demands balance, and none guarantees dry feet. Any form of exchange rate pegging ties the hands of monetary policy, subordinating inflation control to the currency objective.
The current 10% policy rate sits in an uncomfortable middle ground. It's high enough to frustrate borrowers, but not high enough to signal a decisive anti-inflation stance. Exporters and businesses generally have voiced concern that credit is too costly, and investment pipelines are drying up. Yet from a monetary credibility standpoint, the rate lacks bite – it hasn't yet curbed inflation decisively.
The recent revival of generous loan rescheduling is a quiet form of monetary easing. They lower the effective cost of borrowing without touching policy rates. While politically convenient, this wave of rescheduling risks blurring further the signals BB is trying to send on interest rates and foreign exchange. It's like trying to steer a ship while the rudder is jammed – intentions are clear, but direction is compromised.
Inflation in Bangladesh remains higher than in our trading partners, making our goods more expensive abroad even as the nominal exchange rate stays put. This quiet real appreciation erodes the competitiveness of both exports and domestic import substitutes. BB's dollar purchases help rebuild reserves – but maybe only temporarily. As foreign goods become relatively cheaper, imports rise; as our goods become relatively costlier, exports fall. Together, these forces risk draining the very reserves being rebuilt. The policy may look steady, right up to the point when it isn't.
A more convincing monetary approach would allow the exchange rate to adjust with greater flexibility, intervening only when necessary – and neutralising those interventions to avoid excess liquidity. Establishing a transparent interest rate framework would help align policy rates, money supply, and currency dynamics. At present, the stance feels too cautious to build confidence in its ability to tame inflation, and too muddled to signal clear intent.
Zahid Hussain is a former lead economist of the World Bank, Dhaka Office
