Policy interest rate reduced amid high inflation; will inflation rise further?

The Bangladesh Bank (BB) recently reduced its policy interest rate in the midst of high inflation. According to conventional economic principles, this should cause the rate of inflation to climb further. This is because a lower policy interest rate increases the flow of money within society, placing more spendable cash into the hands of the public.

One does not need to be an economics scholar to grasp this reality. Anyone with even an elementary understanding of the subject can foresee the consequences of this decision. However, the Bangladesh Bank likely had little choice.

The economic slowdown—driven by political instability and other factors over the past few years—presents a difficult challenge for the new government.

In May last year, inflation reached a 16-month high at 9.42 per cent. In June, it eased slightly to 9.16 per cent. However, recent flooding has disrupted agricultural production and supply chains, raising fears of fresh inflationary pressure in July. This comes despite the government's target in the current budget to bring inflation down to 7.5 per cent.

The reality is that the country's economy is currently suffering from multiple inflationary pressures. Some are policy-driven, some related to the financial sector, and others stem from supply-side bottlenecks. Although the central bank had maintained a contractionary monetary policy for some time, this recent reduction in the policy interest rate effectively breaks that streak.

Recently, the Bangladesh Bank reduced the policy interest rate from 10 per cent to 9.5 per cent. At the same time, the Standing Lending Facility (SLF) rate was lowered from 11.5 per cent to 11 per cent.

Furthermore, the government announced a target to narrow the bank lending interest rate spread to 4 per cent, whereas the actual average spread remains above 5.5 per cent—and in most cases, significantly higher. How, over what timeframe, and through which policy framework this target will be achieved remains unclear.

Due to a lack of confidence in the banking sector, the public's tendency to hold cash has increased, weakening bank deposit growth. However, the mere presence of cash in people's hands does not automatically trigger higher inflation. If, at the same time, the central bank creates new reserve money that is subsequently used to expand credit, it could create additional pressure on broad money and future inflation.

In the meantime, the government has announced a Tk 600 billion stimulus package to resume closed industrial factories, of which approximately Tk 190 to 200 billion will be supplied by the central bank. If these funds enter the economy as new reserve money and are disbursed as loans through the banking system, the impact will be far-reaching. However, the true extent will depend on credit distribution and actual demand.

Meanwhile, both reserve money and broad money (reserve money being the foundational currency issued by the central bank upon which banks generate loans and deposits, ultimately forming broad money) are on the rise.

According to Bangladesh Bank data, reserve money grew by 21.74 per cent in May this year compared to May 2025. During the same period, broad money growth stood at 12.45 per cent. When the central bank increases reserve money, any subsequent rise in banking-sector credit transforms into broad money. Consequently, an excess of reserve money carries the risk of expanding the money supply and driving up future inflation, all else being equal.

Another area of concern is the real interest rate on deposits. When adjusted for inflation, the real interest rate on deposits is negative. In other words, even if people keep their money in the bank, their actual purchasing power diminishes. Under such conditions, the public loses the incentive to save.

On another front, government borrowing from the banking sector exceeded the limit set in the 2025–26 fiscal year budget. The government surpassed not only the original target but also the revised, higher borrowing limit introduced later. By the end of the fiscal year, net government borrowing from banks reached Tk 131,129 crore—the highest single-year figure in the country’s history.

Conversely, private sector credit growth fell to 4.47 per cent in June—an all-time low. This follows growth rates of 4.98 per cent in May and 4.75 per cent in April. Even during the peak of the COVID-19 pandemic in 2020, private sector credit growth remained above 7.5 per cent.

It can be said that a "crowding-out effect" is taking place, as excessive government borrowing starves the private sector of credit and investment. Under these circumstances, lowering lending interest rates is unlikely to boost credit flow to the private sector on its own. This is because growth momentum has slowed, and government revenue collection remains low. Moreover, various tax concessions risk eroding government earnings further.

In a modern financial system, multiple sources of financing exist—most notably the stock market and the bond market—alongside banks, which serve as the traditional source. In Bangladesh, however, the fundamental problem is that the stock market is yet to inspire public confidence. Companies belonging to the country's prominent industrial conglomerates are reluctant to list on the stock exchange.

As a result, securing necessary business financing from the capital market remains unviable. Meanwhile, the bond market is virtually non-existent.

Against this backdrop, business and commerce in Bangladesh rely almost entirely on bank loans. This structural imbalance can be identified as a key driver behind the country's massive volume of non-performing loans (NPLs).

Economists argue that in a country like Bangladesh, inflation cannot be controlled simply by raising the policy interest rate. The main reason is the government's lack of control over market mechanisms.

Bangladesh has been experiencing persistently high inflation for over three consecutive years. Despite the Bangladesh Bank consistently applying contractionary monetary policy during this period, inflation did not fall at the desired rate. This demonstrates that inflation is not driven solely by excess demand, but by deeper structural issues.

Supply chain vulnerabilities, currency devaluation leading to higher import costs, energy crises, transport and distribution hurdles, and a lack of competitive market structures continue to prolong the inflationary cycle.

Furthermore, weak market supervision and opportunities for market manipulation prevent natural price adjustments. Consequently, analysts emphasise that monetary policy measures alone—such as raising or lowering the policy interest rate—are insufficient to reign in inflation.

In developed countries like the United States, citizens routinely rely on credit. According to data from the macroeconomic analytics platform MacroMicro, consumer debt accounts for up to 20 per cent of total bank loans in the US, encompassing credit cards, vehicle financing, and personal loans.

Crucially, consumer credit outside this framework is virtually non-existent. Specialised agencies determine individual credit ratings based on purchasing behaviour, repayment consistency, and existing debt or deficits. This formal structure enables the government to regulate money flow throughout society relatively easily by adjusting credit terms.

For this reason, when the US Federal Reserve increases its policy interest rate, inflation gradually cools down. Recently, the Fed announced it would leave its policy interest rate unchanged, marking the fifth consecutive meeting in which rates were held steady.

Bangladesh lacks this structural setup. A vast segment of the population remains unbanked, transactions are carried out in cash, and a major portion of the informal economy operates entirely outside the banking system. Added to this are the presence of illicit money, smuggling, and counterfeit currency.

Taken together, the banking sector lacks the capacity to effectively regulate the total flow of money across society. As a result, raising or lowering the policy interest rate fails to control the circulation of money in the economy.

The fundamental issue is that if there is no demand for goods, lowering interest rates yields little benefit, as no one will be motivated to invest. Even with low interest rates, individuals will not be inclined to take out personal loans for consumption if they feel anxious about the future. The political instability of recent years has spread precisely this type of apprehension among the public.

What the economy requires most is demand, which is driven by confidence in future prospects. If people are worried about what lies ahead, demand will not recover. In such an environment, even if the monetary authority offers generous support, it will be ineffective because the private sector cannot generate that demand on its own. Fiscal policy can play a supportive role; for instance, the tax concessions on essential commodities introduced in the latest budget represent a positive step.

Analysts maintain that closed factories must be reopened swiftly and people returned to work. Social stability is essential so that citizens can plan for the future with confidence. Furthermore, when high inflation persists for more than three years, consumer purchasing power is severely eroded, preventing demand from picking up across the economy.

On the other hand, a country like Bangladesh still has vast unmet infrastructure needs. China previously fuelled its economic growth through massive infrastructure development, and India is currently following a similar path.

While substantial corruption undoubtedly marred infrastructure development over the past 17 years, this does not negate the actual necessity for infrastructure investment. Increased government expenditure in this sector would generate employment, which in turn would revive demand.

The policy interest rate is an important economic instrument, but it is not a magic wand. To control inflation effectively, robust market supervision, supply chain improvements, financial sector discipline, management of non-performing loans, capital market development, and structural reforms are indispensable.

Simultaneously, an environment conducive to employment, production, and investment must be fostered. Ultimately, the driving forces of an economy are not interest rates, but confidence and demand. Without aligning these two factors, monetary policy decisions alone will fail to deliver the desired results.

Controlling inflation is one of the primary responsibilities of the central bank, alongside its other duties. However, inflation is interconnected with numerous variables, including monetary policy, fiscal policy, supply and demand dynamics, exchange rates, production costs, and investment levels, and some other factors.

Therefore, if inflation is not brought under control, it will inevitably disrupt the formulation and efficacy of other economic policies.