Bangladesh Bank's January 26 monetary policy statement (MPS) told us that the taka experienced a depreciation of 20% against the dollar over the last 12 months (until January last), foreign exchange reserves declined to a level not sufficient enough to support three months' import bills, while inflation picked at 12%. 

The recent Bangladesh Bank (BB) data show that money growth was increasing at 20% plus while lending rates on various categories of loans (trade, housing, industry, agricultural and so on) are running at 20% in some banks as if the interest rates are racing to catch up with money growth and the 30% plus non-government organisation (NGO) lending rates - contributing to escalating anxieties to small business borrowers. 

The basic tenets of the principles of empowerment in reducing poverty underscore the creation of a new value added wealth from the use of credit at fair market interest rates. One may legitimately ask: What is that fair market interest rates?

In the US, the return that lenders have required over and above the inflation rate has swung between 1.5% and 6.0%, and has averaged about 3.0% historically. For instance, at 3.0% inflation, if lenders expected a return is also 3.0%, then one would expect a 30-year bond to yield 6.0%.

If inflation increases to 5.0% while the lenders expected return remains at 3.0%, the same 30-year bond would be expected to yield 8.0%. Additionally, tax provisions and small risk premium are added to the lending rate. Years of high interest rates in Bangladesh have deterred many borrowers from starting up a small business. 

Unarguably, inflation is the prime culprit that pushed interest rate higher and higher. The BB's claim of 12% inflation is disheartening -and the figure may even be understated to avoid generating steam in future expected inflation. 

Interest rates that we observe everyday are nominal interest rates that aren't adjusted for inflation. What matters to lenders, borrowers, and savers and so on are real interest rates - the real cost of borrowing -- which aren't observable and are estimated using the forecasts of future inflation? 

Real interest rate (RIR) is equal to nominal interest rate (NIR) minus expected inflation rate (EIR).
Expected inflation in the U.S. and other advanced economies are obtained from survey responses of consumers about their expectations of future inflation and also from professional forecasts, based on economic models. 

Typically, high NIR is associated with high inflation and low NIR is associated with low inflation. High actual inflation fuels higher expected inflation, discourages savings by reducing real interest rates and most of all erodes the wellbeing of the people in general and that of the poor, in particular.

In the US and other advanced economies, there is an increasingly widespread recognition of the expediency to charge loans at `real' interest rates. This is a welcome thinking because it covers loss of loan value due to inflation -- and at the same time make up the service cost.

This also recognizes the cliché that "it is often the availability rather than the cost of credit to poor people which is the constraining factor". To ensure long-term availability of loans requires that the loan fund does not erode through inflation, and that a degree of cost-recovery ensures sustainability.

The challenge, therefore, is to have an interest rate policy, which will bolster savings while keeping interest payments on loans affordable. The precursors to this is bringing inflation rate down significantly and then maintaining inflation targeting a high priority in the sequences of macro-economic policy goals.

Many people wonder why higher money growth has been leading to higher interest rates in Bangladesh unlike what we've been experiencing in the U.S. over the last three years. The explanation is somewhat technical. 
Consider a one-time increase in money growth. Initially, this is expected to lower interest rates (liquidity effect) in the very short run (lasting for weeks).

After the liquidity effects dissipate, interest rates are expected to increase driven by three other effects -- income, price level, and inflation expectations (IPE). 

The income and price level effects are realized through increases in aggregate demand (driven by higher money growth), which, in turn, drives up money demand and a new equilibrium rate in the money market. Higher price level means higher inflation and formation of higher expected inflation --and hence higher interest rates. Which of these effects are larger and how quickly they take effect are critical in determining whether interest rates will rise or fall with increased money growth. 

The composite effects of higher IPE brought about by higher money growth will always tend to increase interest rates -- however small it may be. Nevertheless, if the liquidity effect dominates the composite IPE effects, then the interest rate may not reverse to the pre-money supply increase level because of slow adjustments of price level and higher expected inflation. The historic U.S. data casts doubt on the validity of this proposition. 

An examination of the increased U.S. money growth in the 1960s and 1970s appears consistent with the large rise in expected inflation -- leading one to predict that the expected inflation effect would dominate the liquidity effect. According to Columbia University Professor Frederic Mishkin (former Federal Reserve Governor), "It is the only plausible explanation for why interest rates rose in the face of higher money growth." However, he does not dispute the recent findings from advanced econometric analyses --indicating that increased money growth temporarily lowers short-term interest rates. 

The BB's MPS is vaguely set out to bring down inflation rate to a single digit. What is it? Is it 9.9% or less? Bringing down inflation rate - say, to 9.0%-- by slashing money growth by 2.0 or 3.0% is simply illusory since money growth may not be the only precursor to higher price inertia.

Decrease in money growth must concomitantly accompany fiscal austerity through slashing government borrowing from BB and commercial banks. Then there're external factors such as oil price hikes, higher costs of imported machineries and other inputs. With 2013 election cycle fast approaching, fiscal restraint and higher tax collections don't seem palatable - and may be of the table.

My years of empirical research in monetary/macroeconomics convinced me to subscribe to the view that every change in the price level cannot be ascribed to monetary shocks. Particularly, in the short run, supply-side shocks - crop failures, exchange rate volatilities, and so on - certainly cause changes in the price level. 
The confluence of all these factors made me think that the BB's single digit inflation goal may be illusive in the near term. 

The writer, formerly a Physicist and Nuclear engineer, is Professor of Economics at Eastern Michigan University, USA.

Financial Express/Bangladesh/ 20th Feb 2012