Why Bangladesh Bank is prioritising FX Reserves over inflation in its rate decisions

In a typical macroeconomic environment, central banks adjust policy interest rates primarily in response to inflation deviations from target levels. While this is a simplification, it captures the core framework behind most monetary policy decisions.

However, Bangladesh currently finds itself operating under far from normal circumstances. At the end of May 2025, the inflation rate stood at 9.05%, while the policy interest rate was 10.00% and the 91-day treasury bill yield was as high as 12.02%. This implies a real interest rate of approximately 2.97% on the 91-day bill, a notably tight monetary stance.

Why maintain such high real rates?

High real interest rates come at a cost, chiefly, slower economic growth. Businesses face more expensive borrowing conditions, consumer spending tightens, and investment incentives weaken. So, the natural question arises: Why is Bangladesh Bank maintaining such a restrictive policy stance in the face of these trade-offs?

The answer lies not in inflation targeting but in concerns surrounding the external sector, specifically, foreign exchange (FX) reserves.

Between 2021 and 2023, Bangladesh experienced a sharp drop in FX reserves. While reserves have since stabilised, they remain at suboptimal levels. The situation was further complicated by a $3 billion backlog in overdue external payments and a financial account that has yet to show significant positive inflows to bolster reserves.

Despite improvements in the current account balance, these structural weaknesses in the capital and financial accounts have limited the central bank's ability to build reserves through traditional means.

The IMf and exchange rate volatility

Recent negotiations with the IMF brought out the central bank's hesitation to adopt a fully floating exchange rate regime. There's a clear concern that any abrupt depreciation could trigger import-driven inflation, undermining economic stability.

Hence, the central bank's current strategy seems aimed at rebuilding FX reserves first, to create a buffer against future volatility. Only once reserves are deemed adequate will Bangladesh Bank likely feel confident enough to allow more flexibility in the exchange rate and, subsequently, to cut policy rates.

FX reserves trump inflation for now

In the current policy framework, FX reserve adequacy is taking precedence over inflation metrics. While inflation remains elevated, the more pressing concern for policymakers is ensuring exchange rate stability and external payment capacity. Until Bangladesh Bank is satisfied with the strength of its reserves, any meaningful monetary easing is likely to remain on hold.

On an optimistic note, Bangladesh Bank expects a significant rise in FX Reserves in the near term, likely driven by multilateral inflows. A $3-5 billion boost to reserves should lead to comfort for the central bank and pave the way for an interest rate cut. 

Asif Khan is the President of CFA Society Bangladesh.

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.