Modernisation of monetary policy

Inflation in Bangladesh has remained persistently high over the past several years, testing the limits of the country’s monetary policy framework. Structural constraints, shallow financial markets, and fiscal dominance have weakened the effectiveness of conventional monetary tools. Recent empirical research by Bangladesh Bank highlights the mixed and time-varying relationship between policy rates, money supply, and inflation. These findings underline the importance of a credible, forward-looking policy framework that is both market-oriented and well-coordinated with fiscal policy. This article briefly evaluates the effectiveness of recent reforms—particularly the shift to interest rate targeting, adjustments to the Interest Rate Corridor (IRC), and changes in open market operations—and assesses their implications for inflation management.
Effectiveness of Policy Instruments: There are both short-term and long-term impacts of the policy rates. In the short-term, generally two to eight months, there is a weak and inconsistent link between policy rate (repo) and inflation due to supply-side shocks.
In medium and long-term, usually nine months five years or more, there is a strong bidirectional causality, suggesting that while monetary policy eventually influences inflation, the central bank also responds to persistent price pressures.
Money Supply Growth: Traditional causality tests show that there are weak links between money supply growth and inflation. Time-varying analysis, however, reveals phases of stronger causality during periods of political instability and global shocks (for example 2006–2010; and 2017–2020).
Bangladesh bank practiced monetary targeting rule to control inflation until July 2023. Broad money (M2) was used as an intermediate target while reserve money as an operating target. M2 often referred to as components of currency in circulation (cash held by the public). Demand deposits refer to money in checking/current accounts while time deposits indicate fixed deposits or savings accounts. In Bangladesh, M2 is used by Bangladesh Bank to monitor liquidity in the economy and guide monetary policy decisions. It reflects the total amount of money available for spending and investment, changes in the M2 can influence inflation, interest rates, and economic growth.
Policy Reforms and Outcomes: Bangladesh Bank has shifted its approach on monetary policy as a part of reform and improvement of the monetary transmission mechanism and ultimately support the monetary policy objective of price stability and economic growth.
Shift to Interest Rate Targeting. In July 2023, the transition from monetary targeting to an IRC framework was aligned with international best practices. Monetary targeting had become ineffective due to the growth of digital finance and global integration. Success of the new approach, however, largely depends on stronger fiscal coordination and deeper markets. Current stance remains reactive, lagging behind inflation trends.
IRC Adjustments. Policy rates increased from 6.5 per cent to 10 per cent (July 2023–Oct 2024), narrowing the corridor band and adjusting standing facilities. The Weighted Average Call Money Rate (WACR) broadly tracked the policy rate, indicating operational improvement. Inflation persisted due to weak pass-through, shallow bond markets, and structural rigidities.
Open Market Operations (OMOs) Reform. A few measures have also been taken to reform the OMOs. The critical one is restructuring repo auctions - shifting from daily to weekly and phasing out term repos. Though intended to deepen markets and improve transmission, abrupt withdrawal of repo tenors created liquidity stress, and the interbank market remains shallow and volatile.
• As shown in Figure 1, the Weighted Average Call Money Rate (WACR) broadly tracked the policy rate within the corridor, reflecting an improvement in operational targeting. However, frequent adjustments in both the policy rate and standing facilities highlight the reactive nature of BB’s stance.
SWOT Analysis: There are both strong and weak sides of the reform. Strengths include alignment with international best practice via IRC, more transparent policy signals (like benchmark reference rate and crawling peg), and improved flexibility and transparency in OMOs.
There is, however, weak transmission due to underdeveloped financial markets. Reactive policy stance also undermines predictability and persistent inflation despite rate hikes indicates limited effectiveness. Moreover, delayed reforms in the foreign exchange market also strained the country’s foreign currency reserves.
Besides the strength and weakness, opportunities are also there like deepening bond and interbank markets which can strengthen transmission. Better fiscal-monetary coordination can enhance stability. Greater transparency boosts credibility and investor confidence. A long-term move toward a flexible exchange rate can also improve resilience.
Nevertheless, some threats also need to be taken into consideration. These include: (a) sustained inflation risks eroding policy credibility; (b) fiscal dominance which may constrain BB’s tightening stance; (c) external shocks like oil price hikes, global tightening may heighten vulnerability; (d) rapid depreciation of local currency may increase the risks of imported inflation and forex market instability; and (e) banking sector fragility may also amplifies risks of liquidity tightening.
Policy Assessment: Bangladesh Bank has taken necessary steps toward modernisation, but results remain mixed. The IRC framework has improved operational control, and OMO reforms have introduced greater flexibility. Yet persistent inflation reflects weak transmission channels, structural rigidities, and insufficient coordination with fiscal authorities. Without deeper markets and more forward-looking policy, credibility risks remain high.
Key Insights for Policymakers: Interest rate tools are less effective in Bangladesh than in advanced economies due to weak transmission. Money Supply Control has a limited impact on economies dominated by informal and cash-based activity. Inflation Drivers are often supply-side (food, fuel, energy), limiting the effectiveness of monetary tightening. Exchange Rate Volatility exacerbates inflation risks, especially given the country’s high import dependence and susceptibility to external shocks.
Policy Recommendations: Here are few recommendations to make the interest rate targeting approach.
Strengthen Transmission Channels. Deepen bond and interbank markets to improve the link between policy rates and lending rates and support the growth of secondary markets for government securities to enhance liquidity and market discipline.
Enhance Policy Coordination. It is necessary to establish stronger fiscal-monetary coordination to prevent government borrowing from undermining monetary tightening. Aligning the government’s subsidy, taxation, and borrowing policies with inflation control objectives of the central bank is also important.
Improve Forward Guidance. A shift from reactive rate hikes toward a proactive and transparent policy stance in near future and publishing the medium-term inflation forecasts and policy intentions to anchor expectations will be helpful to make the monetary policy operation more efficient.
Address Supply-Side Constraints. Complementing the monetary tightening with targeted fiscal and structural measures (e.g., food storage, energy efficiency improvements, and logistics enhancements) can be a key task in future. Developing policies to mitigate imported inflation, including diversified energy sourcing, will also necessary.
Advance Exchange Rate Flexibility. It is also necessary to continue the move toward a fully flexible exchange rate to reduce distortions and enhance external resilience and strengthen reserve management to mitigate the impact of external shocks.
Safeguard Banking Sector Stability. Monitoring the liquidity stress is critical as repo reforms and liquidity support facilities are phased out. The central bank also needs to strengthen bank supervision to prevent instability from undermining the effectiveness of monetary tightening.

Dr Sayera Younus is Senior Researcher, Centre for Policy Dialogue (CPD). sayera.younus@cpd.org.bd