INFLATION, driven by a combination of domestic factors such as rising consumer demand, structural inefficiencies and global factors such as fluctuating commodity prices and exchange rate volatility, is a persistent and complex challenge for Bangladesh. Inflation directly affects the purchasing power of households, influences business decisions and increases uncertainty in the broader economy. As a developing country aiming to secure sustainable growth, Bangladesh must take decisive action to control inflation in achieving long-term economic stability.
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Monetary policy tightening
MONETARY policy is often the first line of defence against inflation, with central banks typically increasing interest rates to curb excessive demand. An increase in interest rates makes borrowing expensive, which reduces consumer and business spending, thereby reducing overall demand in the economy. The Fisher effect theory suggests that nominal interest rates should adjust one-to-one with expected inflation, keeping real interest rates stable. However, our analysis of Bangladesh鈥檚 inflation dynamics reveals that the nominal interest rate only partially adjusts to inflation expectations.
Specifically, our research indicates that a 1 per cent increase in inflation leads to a disproportionately smaller rise in nominal interest rates. This limited adjustment is due to structural inefficiencies within the financial system, weak market expectations and an incomplete transmission of monetary policy across different sectors. As a result, while raising interest rates can help to mitigate inflationary pressure, it cannot fully control inflation in Bangladesh.
This finding echoes the experience of other emerging economies, such as Turkey, where aggressive interest rate hikes alone have proved insufficient to bring inflation under control. In Bangladesh, monetary tightening should still be an essential tool, but it must be employed alongside complementary fiscal and structural reforms to achieve lasting inflation control.
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Inflation targeting
ANOTHER promising approach to controlling inflation is the adoption of an inflation-targeting framework, which has been successfully implemented in emerging markets, including India and Brazil. Inflation targeting involves setting explicit inflation goals and aligning monetary policy to achieve the targets. In India, the Reserve Bank of India adopted inflation targeting in 2016, resulting in a reduction in inflation volatility from an average of 8鈥�10 per cent to around 4 per cent in recent years. This model has demonstrated that by clearly communicating inflation targets, central banks can manage expectations more effectively, reduce uncertainty and enhance their credibility.
In Bangladesh, implementing an inflation-targeting regime could yield similar benefits. The Bangladesh Bank could use this framework to provide a clear direction for monetary policy, helping businesses and households to plan their economic activities with greater confidence. A transparent inflation target would also reduce the volatility that often accompanies inflation in emerging economies, contributing to more predictable and stable inflation outcomes.
However, it is important to note that inflation targeting cannot succeed in isolation. For this framework to be effective, it must be supported by fiscal discipline, structural reforms and supply-side improvements to address the root causes of inflation. Without addressing these underlying issues, inflation targeting may only provide temporary relief rather than sustainable long-term solutions.
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Fiscal discipline
FISCAL policy plays a crucial role in shaping inflation dynamics, particularly in developing economies like Bangladesh, where large fiscal deficits contribute significantly to inflationary pressure. When the government runs a fiscal deficit, particularly one financed through borrowing from the central bank, it increases the money supply, leading to a demand-pull inflation. Our research suggests that a 1 per cent increase in the fiscal deficit as a share of gross domestic product leads to a nearly 1 per cent increase in inflation. This finding aligns with global trends, where fiscal imbalances often correlate with rising inflation.
To control inflation, Bangladesh must prioritise reducing its fiscal deficit through prudent fiscal management. This could involve cutting non-essential public expenditures and reallocating resources to more productive sectors, such as infrastructure, education and health care. Additionally, improving tax collection and broadening the tax base can help the government to generate the necessary revenue to finance its development projects without resorting to inflationary borrowing. Maintaining fiscal discipline is essential for alleviating inflationary pressures and creating a more favorable environment for investment and growth.
Countries such as Chile and Mexico have demonstrated that maintaining fiscal discipline, even during periods of economic volatility, can significantly reduce inflation. By applying these lessons, Bangladesh can strengthen its fiscal position and contribute to long-term price stability.
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Supply-side reforms
IN BANGLADESH, inflation is often driven by supply-side constraints, particularly in the agriculture and energy sectors. Food inflation is a major component of overall inflation, given the large share of food prices in the Consumer Price Index. Agricultural inefficiencies such as low productivity, poor storage facilities and inadequate supply chains exacerbate price volatility, especially during times of supply disruptions. Even minor disruptions in food supply can lead to significant price spikes, which disproportionately affect lower-income households.
Our analysis shows that improving agricultural productivity by just 1 per cent can reduce food inflation by up to 0.5 per cent. Investments in modern agricultural technologies, improved irrigation systems, better storage facilities and more efficient distribution networks are essential for increasing agricultural output and stabilising food prices. By addressing these structural issues, Bangladesh can reduce the frequency and severity of food price inflation, leading to more stable overall inflation.
In addition to agriculture, Bangladesh鈥檚 reliance on imported fuel makes it vulnerable to global energy price fluctuations, which directly impact inflation. The volatility of global oil prices, combined with the depreciation of the Bangladeshi taka, has led to higher energy costs, driving inflation upward. To mitigate this risk, Bangladesh should diversify its energy sources by investing in renewable energy, such as solar and wind power. Reducing dependence on imported fuel will not only stabilise energy prices but also contribute to environmental sustainability, a critical goal for long-term development.
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Exchange rate management
ANOTHER significant factor driving inflation in Bangladesh is the depreciation of the Bangladeshi taka, which increases the cost of imported goods, including food, fuel and raw materials. Given the heavy reliance on import, any depreciation of the currency leads to higher import costs, which in turn drive up inflation. Our findings indicate that a 1 per cent depreciation in the taka results in a 0.3 per cent increase in inflation over the course of a year. This highlights the importance of managing exchange rate fluctuations to control inflationary pressures.
To stabilise the exchange rate, Bangladesh should consider adopting a managed float system, in which the central bank intervenes to stabilise the currency during periods of excessive volatility. This approach has been successfully implemented in countries such as Malaysia and Thailand, where exchange rate management has played a key role in maintaining price stability, particularly during external economic shocks. By stabilising the exchange rate, Bangladesh can mitigate the inflationary impact of imported goods and create a more predictable environment for businesses and consumers.
Overall, our analysis of inflation dynamics in Bangladesh underscores the need for a multifaceted approach to controlling inflation. While monetary tightening is a necessary tool, it is insufficient on its own to address the complex causes of inflation. The partial adjustment of nominal interest rates to inflation expectations reveals that deeper structural issues must be addressed through complementary policies. A combination of fiscal discipline, supply-side reforms, inflation targeting, and exchange rate management is essential for achieving long-term price stability. By focusing on both demand-side and supply-side factors, Bangladesh can effectively manage inflation and create a more stable economic environment.
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Mostafizur Rahman is a research officer, Department of Economics, North South University.