When monetary policy cannot fully transmit

Bangladesh Bank's latest Monetary Policy Statement (MPS) leaves the policy rate unchanged at 10 percent, reaffirming its “contractionary” stance to bring inflation under control. The decision comes after nearly two years of monetary tightening, during which private sector credit growth slowed to around 5 percent in May, one of the lowest rates in decades.

Yet inflation has remained stubbornly high.

This apparent disconnect has fuelled a growing argument among business leaders and even some economists: if inflation has remained close to double digits despite a collapse in private credit growth, doesn't that prove contractionary monetary policy has failed?

It is a legitimate question. But it points to the wrong conclusion.

The problem is not the stance of monetary policy but the weakening of the transmission mechanism through which it influences market interest rates, savings and inflation expectations. The debate should therefore move beyond whether policy is too tight or too loose. The more important question is whether Bangladesh Bank's policy instruments reinforce or dilute the transmission of that stance.

Viewed individually, each measure can be justified. Together, however, they create an increasingly inconsistent policy framework. One instrument seeks to restrain aggregate demand through high interest rates. Another cushions borrowing costs for selected sectors through interest subsidies and targeted refinancing. A third limits banks' ability to adjust interest rates in response to market conditions. Together, they pull monetary policy in different directions.

Why hasn't inflation fallen faster?

Monetary policy affects inflation through several channels. Slower credit growth is only one of them. Changes in the policy rate influence lending and deposit rates, household savings, investment decisions, exchange-rate expectations and, ultimately, inflation expectations. Only when these channels work together does inflation gradually moderate.

Bangladesh's recent experience illustrates this well. Credit growth has slowed sharply despite abundant liquidity. According to the MPS, banks have increasingly preferred investing in government securities to extending private credit because of elevated public borrowing and heightened credit risks. Meanwhile, real deposit rates have remained negative, and lending and deposit rates have adjusted only partially to the policy stance.

Inflation has reflected not only domestic demand pressures but also exchange-rate depreciation, imported commodity prices, food supply shocks and administered price adjustments—factors monetary policy alone cannot fully offset. That helps explain why inflation has proved more persistent than the decline in private credit growth alone would suggest.

This distinction matters because Bangladesh Bank itself acknowledges that inflation reflects structural and supply-side factors beyond the reach of monetary policy alone. The challenge, therefore, is not maintaining a restrictive stance but ensuring that other policy instruments reinforce rather than dilute its transmission. Bangladesh's experience suggests that monetary tightening has operated more through the quantity of credit than through market interest rates—a pattern inconsistent with a well-functioning monetary transmission mechanism.

Weak inflation outcomes do not demonstrate that contractionary monetary policy is ineffective. They suggest instead that the transmission mechanism has remained impaired. The appropriate response is therefore not necessarily to abandon monetary tightening but to strengthen the channels through which it reaches the broader economy.

Some of Bangladesh Bank's recent measures, though individually understandable, may nevertheless weaken those channels.

Interest rates constrained from both sides

The latest interest-rate data illustrate why monetary transmission remains constrained. In May, the weighted average lending rate stood at 11.92 percent—12.12 percent for large industries and 12.58 percent for SMEs. The weighted average deposit rate was only 6.22 percent, although fixed deposits—the rates most relevant for attracting new savings—earned around 9.2 to 9.5 percent.

The newly introduced 4 percent intermediation spread cap risks reinforcing this pattern. At prevailing lending rates, it effectively limits banks' ability to raise deposit rates while preserving their margins. In principle, banks could increase both lending and deposit rates while maintaining the prescribed spread. In practice, however, lending rates much above the low-teens have proved politically difficult to sustain. The earlier 9 percent lending-rate ceiling, the compression of margins under the Six-Month Average Rate on Treasury bills (SMART) framework, and now the spread cap reflect a recurring pattern of administrative intervention whenever borrowing costs rise sharply.

The May data suggest that the weighted average intermediation spread was about 5.7 percentage points, well above the new ceiling. Banks can comply in only three ways: lower lending rates, raise deposit rates, or do both. None is costless. Lower lending rates dilute the intended tightening of monetary policy. Higher deposit rates, without corresponding flexibility on lending rates, reduce banks' ability to price credit according to risk and operating costs. That matters particularly for SMEs, whose loans are relatively expensive to originate and monitor. A uniform spread cap therefore risks encouraging banks to shift lending towards larger, lower-cost corporate borrowers while tightening credit conditions for smaller firms.

The challenge of policy coherence

The inconsistency becomes clearer when the spread cap is viewed alongside the Tk 60,000 crore financial support package.

A restrictive policy rate is intended to moderate aggregate demand by raising the cost of credit. The support package, by contrast, lowers the effective cost of borrowing for selected sectors through interest subsidies and targeted refinancing. The Tk 20,000 crore corporate facility will be financed from banks' own resources, with the government subsidising part of the interest cost, while the agriculture and SME components will receive refinancing support. Though they operate differently, both seek to maintain credit to priority sectors despite a high policy rate.

Each measure addresses a legitimate concern. Together, however, they send mixed signals. The policy rate tightens financial conditions, the support package cushions selected borrowers, and the spread cap constrains credit pricing. The issue is not any individual instrument but the coherence of the overall policy mix. Monetary policy is most effective when its instruments reinforce rather than offset one another.

Ultimately, monetary policy depends not simply on the policy rate but on confidence that changes in it will influence savings, lending and inflation expectations. Bangladesh Bank would argue, with some justification, that the spread cap protects productive investment during a difficult period. That concern is understandable, but there is an unavoidable trade-off. Administrative measures that limit the adjustment of interest rates may provide short-term relief for borrowers, but they also weaken risk-based pricing and reduce the transmission of monetary policy.

The latest MPS should therefore be judged not only by its decision to leave the policy rate at 10 percent, but also by whether the broader policy framework is internally coherent. A restrictive policy rate, a financial support package and a binding spread cap do not naturally reinforce one another; they pull monetary policy in different directions.

Bangladesh's monetary debate has become polarised between those who believe higher interest rates have failed and those who insist tighter policy alone will tame inflation. The debate should therefore move beyond whether policy is too tight or too loose. The more fundamental question is whether the surrounding policy framework allows the chosen stance to influence savings, lending and inflation expectations. Restoring that coherence may matter more than any single adjustment to the policy rate.