How an interest rate corridor will affect macroeconomic reality in Bangladesh

The interest rate corridor is one of the important monetary policy tools used by the central banks to stabilise money supply and demand. It helps maintain a balance between supply and demand in the money market, and thus promotes stability in the banking and financial sector. In this regard, adjusting the money supply is often essential to achieve targeted rates of output and inflation. 

Ensuring more flexibility in rate adjustment is believed to be a part of Bangladesh Bank's monetary policy modernisation framework, especially given the IMF conditionalities. It will be one of the first initiatives taken by the central bank. Instead of providing fixed policy rates, it will now provide lower and upper rates, allowing both the central bank and commercial banks to strike a balance, depending on their need for the supply and demand of money.

Providing a range of acceptable upper and lower interest rates can help financial stability, by limiting the potential for sudden increases or drops in interest rates that cause instability and financial market disruption. Several countries are using this tool to adjust short-term interest rates.

Bangladesh Bank will probably follow the model of India. The interest rate corridor in India is the area between the Reverse Repo rate (the rate at which the central bank borrows money from the commercial banks) and the MSF rate (Marginal Standing Facility or MSF is the rate at which the central bank loans to the scheduled commercials banks when they face liquidity crisis). 

Here, the reverse repo rate is the lowest policy rate and the MSF rate is the highest policy rate (higher than repo). The corridor is the area where the weighted average call money rate will travel. If the call money rate (the rate at which short-term funds are borrowed and lent in the money market) stays within the corridor, there will be less liquidity disturbance in the system.

Once the corridor is applied, the short-term interest rates will not go above or below a certain limit, and so there will be no detrimental impact on the depositor and investor. 

In India, the reverse repo rate is 6.25% while the MSF is 6.75% and the repo rate is 6.50%. The difference among the rates is 0.50 basis points in India. On the contrary, the gap is wider in Bangladesh, as the reverse repo is 4.50%, repo is 6% and special repo is 9%. Here, the difference between the rates is 4.50 basis points.

Policy rate adjustment within the corridor influences interbank rates, commercial lending rates, and retail lending rates. Presently, there is a cap on interest rate at 9%; the rate may not be changed at the moment to avoid a shocking impact on the economy. The question has already arisen that when the repo rate is 6% and reverse repo is at 4.5%, special repo is at 9.0%, how much spread remains in their hands to fix interest rates? 

As per Bangladesh Bank information, point-to-point inflation reached 9.24 % in April 2023, which is a bit less than that of the inflation in March at 9.33%. LC for import declined by 26.80% during July-April FY23, and LC settlement declined by 8.15% in the same period. The industrial long-term loan outstanding during Oct-December in FY23 increased by 26.54% (year-on-year). 

While inflation is high, output growth is not at an expected level either. So the central bank may raise the upper bound of the interest rate corridor to increase interest rates to control the money supply and tighten credit conditions in the economy. 

On the other hand, because of the cap on the interest rate, flexibility in the hands of the financial market is limited; they would need to do their business and manage their clients within this fixed rate. The margin rate has also been increased, the practical scenario is that businesses are not in a position to open L/Cs as per the required level, thus business and output have not been growing. 

The effectiveness of an interest rate corridor in addressing inflation depends on various factors such as the state of the economy, the level of inflation expectations, the credibility and independence of the central bank and the confidence of businesses about a business-enabling environment.

The impact of an interest rate corridor on inflation is not immediate. Monetary policy actions typically take time to filter through the economy and influence inflationary pressures. Therefore, central banks need to carefully assess the state of the economy and make informed decisions regarding interest rates and other policy measures to achieve their inflation targets.

The Federal Reserve uses an interest rate corridor, with the discount rate (lending rate) and interest on excess reserves (deposit rate) forming the boundaries.  The European Central Bank (ECB) also uses a corridor system, with the deposit facility rate and the marginal lending facility rate serving as the upper and lower boundaries. 

The People's Bank of China (PBOC) uses a corridor system with the standing lending facility rate and deposit facility rate serving as the upper and lower boundaries, respectively, and the one-year medium-term lending facility rate serving as the midpoint.

One of the main benefits of an interest rate corridor is that it allows central banks to signal their policy intentions to financial markets more effectively. By setting a target rate within the corridor, the central bank can communicate its desired level of interest rates to investors and borrowers, which can help to shape expectations and influence market behaviour.

The spread should be based on the Bangladesh Bank's assessment of the level of risk in the banking system and the amount of interest rate differential that it is willing to tolerate. The interest rate corridor is to influence short-term interest rates and achieve its policy objectives. Bangladesh Bank needs to promote economic stability and growth in Bangladesh.

As per bankers, because of several innovations in the money markets, demand for money is not stable, creating evolving factors and attracting new policy options for the central banks to play their role in the money market. 

Commercial  banks need to take a balanced approach to their profitability, address their cost of borrowing issues, and encourage savings by fixing competitive deposits; all these issues are dependent on the role of the central bank. Over and above, a conducive regulatory environment can work to bring discipline in the money markets, the upcoming MPS is expected to respond to these issues.

Ferdaus Ara Begum is the CEO of BUILD-a Public Private Dialogue Platform works for private sector development

Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions and views of The Business Standard.