Inflation in Bangladesh has remained at a moderate single-digit level, despite a recent rise due to a cost-push from supply disruptions and wage increases. The political disturbances obstructed food distribution channels, resulting in constrained supplies and higher food prices. Stability in international commodity prices, weak domestic demand, and some appreciation of the nominal exchange rate combined with a restrained monetary policy, moderate the rise in inflation.
Declining inflation interrupted by cost-push
Cost-push-led inflation has resurged. Following some deceleration in the first four months, inflation has been moving in a relatively narrow range of 7-7.5% in recent months, higher than the 6-6.5% target (using the 2005/06 base). Inflation has increased since November, with large wage increases expected across all sectors of the economy and supply disruptions caused by political agitation and violence. Food inflation (y-o-y) has risen from 8.1% in July 2013 to 8.8% in February 2014 (see graph). Higher distribution costs due to the frequent nationwide strikes and the rise in food prices in India (which is correlated with Bangladesh food prices) contributed to this increase.
Non-food inflation declined in the first four months to 5% and then rose back, reaching 5.4% in February 2014. Cost-push from supply disruptions and demand-pull from expected wage increases are likely to have driven up non-food prices. These temporarily overpowered the impact of the decline in international commodity prices and the appreciation of the real exchange rate.
Inflation risk mitigated by restrained monetary stance
The stance of monetary policy and continued exchange rate stability should help contain non-food inflation as the impact of cost-push dissipates. Monetary policy pursued a restrained path, achieving broadly the targets for the first seven months of FY14. A slowdown in private credit growth contributed to an increase in excess liquidity, despite stepped-up sterilisation operations by Bangladesh Bank (BB) in response to overshooting of the target for the growth of net foreign assets.
Private sector domestic credit growth declined to 11.1% in January. Public sector borrowing grew by 11.5% through January 2014. Consequently, domestic credit growth slowed to 11.2%. All major monetary aggregates have remained within the targets established under the Monetary Policy Statement (MPS) in FY14.
Monetary management was challenged by a rapid buildup of foreign exchange reserves (NFA) in the banking system, due to a large surplus in the overall balance of payments. Compared with the program target of a 19.3% increase by end-December 2013, the actual expansion in the NFA through end-December was 35.2%. Yet BB managed to contain reserve money growth below target. Consequently, broad money expansion has remained below the target at 16.2%. BB undertook sizable sterilisation operations to mop-up the excess liquidity injected into the economy by issuing 30-day BB bills.
The MPS for the last half of FY14 rightly continues the policy stance maintained in the first half. The program framework limits reserve money growth to 16.2% and broad money growth to 17% by June 2014. BB will have a ceiling on net domestic assets as a key operating target. The ceiling for private sector credit growth of 16.5% has been kept in line with economic growth targets.
This is sufficient to accommodate any substantial rise in investment and trade-finance over the next three months. There is enough liquidity in the money market to support a pickup in the post-election economic rebound in demand for credit in the private sector. The MPS has correctly maintained government borrowing from the banking system within the original FY14 budget target. Thus, the envisaged stance does not accommodate potential inflationary pressures.
Inflation outlook is stable with some upside risks
Prudent macro policies will remain critical for restraining inflation. External, internal, and macro policy factors generally underpin inflation in Bangladesh. External factors include world food and energy prices. A rise in world food prices is translated directly to an increase in domestic food prices. With food accounting for a large proportion of the basket of an average household, an increase in domestic food prices leads in turn to a general increase in prices.
Similarly, a world energy price shock, such as an oil price shock, would affect domestic prices almost instantaneously. Internal factors include supply-side constraints, represented by weather or political shocks. Finally, accommodative policies, especially those involving a large injection of money into the economy, generally put upward pressure on prices through an impact on aggregate demand and the exchange rate.
Pressures on world commodity prices are anticipated to weaken in the short term because of well-supplied markets and strong global cereal stocks. In addition, decreasing fertiliser prices, unforeseen increases in the production of biofuels, and the continuation of sensible trade policies all point to a favourable outlook.
Nonetheless, higher oil prices, as well as deteriorating weather concerns among major producers and exporters (especially those in Argentina, Australia, and parts of China), constitute risks in the short term. Non-food inflation can be expected to be restrained by prudent macro policies despite higher wages and the rebound in domestic activity. The biggest risk on this front is further cost-push due to a return of political instability.
