Monetary Policy under Flexible Inflation Targeting: Thailand’s Experience

1. Monetary Policy under Flexible Inflation Targeting: Thailand’s Experience

2. References • Mishkin, Frederic S. (1999): “International Experiences with Different Monetary Policy Regimes”, National Bureau Of Economic Research, Working Paper 6965. • McCauley, Robert N (2006): “Core versus Headline Inflation Targeting in Thailand”, Paper prepared for Bank of Thailand’s international symposium on “Challenges to inflation targeting in emerging countries”, Bangkok, 13-14 November 2006.

3. Overview Four Monetary Policy Frameworks Inflation targeting framework in Thailand Challenges ahead and policy issues 3

4. Monetary policy ultimate objectives • Price stability • Long-term growth and full employment

5. Monetary policy framework • Exchange Rate Targeting • Monetary Targeting • Inflation Targeting • No explicit announcement (Just-do-it approach)

6. Pros Low inflation (for developing countries) Stable environment for trade & investment Monetary discipline Cons Under free capital mobility, no monetary policy independence Crisis-prone Losing competitiveness Exchange rate targeting

7. Success of exchange rate targeting • Synchronize economic cycles with anchor currency economy • Appropriate level of exchange rate (no macroeconomic imbalance)

8. Monetary targeting • Monetary as policy anchor MV = PQ Conditions for success • Stable relationship between money and economic variables (growth & inflation) • Ability to control monetary targets

9. Pros Flexibility Cons Lack of transparency discipline Need credibility before adopt “Just-do-it” approach • No explicit announcement for policy anchor

10. Why monetary policy was revised? • Switch from fixed to a floating exchange rate regime • need for a new nominal anchor • Rapidly changing world economic and financial environment • Growing public awareness of information and news • Previous monetary policy not clearly defined

11. The search for a new nominal anchor consistent with flexible exchange rate regime % Change of the exchange rate regime Baht/USD Exchange rate Headline inflation

12. Features of appropriate monetary policy • Clear principles and framework • Transparent and examinable, consistent with good governance rules • Decisions based on sound principles, avoiding personal judgment, and easily communicated to the public • Clear responsibility and accountability • Promotion of long-term economic development • Strengthening of credibility for the central bank and Thai economy

13. General principles of IT Transparency To build up credibility Independence Accountability

14. II. Inflation targeting frameworkin Thailand

15. Current framework • Policy goal: Price stability • Policy target: 0-3.5% quarterly average core inflation rate 0.5 – 3.0% since January 2010 • Policy instrument: 1-day bilateral repurchase rate • Policy tool: Macroeconomic Model (BOTMM) • Responsibility: Monetary Policy Committee (MPC) • Communications policy: Inflation Report, press conference

16. Policy goal: price stability • Price stability is the overriding objective, in support of sustainable long-term growth. • Policy widely understood and agreed upon. • Clear, credible, and consistent. • Cooperation and regular consultation between BOT and the government (under the new BOT Act).

17. Choice of inflation measure to target(Core inflation) • CPI excluding some items that cannot be influenced by monetary policy, and retaining sufficient price information • Core inflation has less variation but on average is close to headline inflation in the long run • Targeting core inflation is the control of long-run inflation such that monetary policy does not have to accommodate supply shocks

18. Policy target: core inflation … based on prices of goods and services in the CPI basket but excludesraw food and energy items: • Rice and cereal products • Meat, poultry, and fish • Vegetables and fruits • Eggs and milk products • Benzene and diesel • Cooking gas and electricity

19. Choices of items excluded from core inflation for the case of Thailand Sample 1993:01 - 1999:12

20. Core inflation closely tracked headline inflation in the long run % YoY IT since May 2000

21. Target point or range (0.5 - 3.0%) Criteria in choosing the inflation target • Relatively low in comparison with past inflation • Consistent with inflation trend of Thailand’s trading partners and structure of the Thai economy • Chosen target range enhances export competitiveness and leads to currency stability • Does not pose constraint on economic recovery • Cushions temporary economic shocks and minimizes need to adjust monetary policy frequently

22. Policy instrument:1-day bilateral repurchase rate The use of 1-day bilateral repurchase rate as the key policy rate is expected to: • provide a transparent monetary policy signal. • provide a framework for a more effective transmission mechanism.

23. Transmission mechanism of monetary policy Time Horizon (8 Quarters)

24. Movements in policy rate (RP1D) % p.a. Interbank RP 1D

25. Monetary policy transmission mechanism % p.a. MLR Policy rate RD3M

26. Policy tool:Macroeconomic model (BOTMM) • Represents relationships between key variables in Thai economy. • Covers 4 main economic sectors (real, government, external, and monetary) and price indices. • Analyzes the impact on the economy from various exogenous shocks and policy changes.

27. Components of macroeconomic model

28. Macroeconomic model :Policy optimization Minimize Loss Function : Where = The difference between forecasted inflation and targeted inflation at time t = The difference between forecasted output and potential output at time t Subject to the macroeconomic model

29. Using optimal control to assist decision making Models & Optimal Control Results Monetary Policy Rules Put in quantitative form Policy Makers’ Judgement Interpretation Decisions Economic Condition Intuition Monetary Policy Discretion

30. GDP growth forecastadjusted for risk factors (as of January 2008) Annual percentage change (%) Remark: The fan chart covers 90 per cent of the probability distribution

31. 91.7 93.4 80.8 92.2 98.6 Probability distribution of the GDP growth forecast

32. Core inflation forecastadjusted for risk factors(as of January 2008) Annual percentage change (%) Remark: The fan chart covers 90 per cent of the probability distribution

33. Compare the probability of core inflation forecast 100.0 98.5 84.3

34. Benefits of fan charts What are the benefits of having fan charts? • MPC can voice their opinions. • MPC can signal risk clearly. • MPC can judge beyond the model. • Helps shape public expectations of GDP growth and inflation.

35. Responsibility:Monetary Policy Committee (MPC) • MPC consists of 7 members (of which 4 are from outside) • MPC meets 8 times a year with pre-announced schedule • Assess recent economic conditions and outlook • Set the direction of monetary policy • Approve the Inflation Report

36. Policy formulation process Data MPC meets 8 times a year 3 senior officials from BOT and 4 external members Forecast of output growth and inflation Policy rate decision Press release Policy implementation Inflation Report

37. Communications policy:Inflation Report • Clear monetary policy stance • MPC press conference after each meeting • Quarterly Inflation Report • Monetary policy information dissemination through: • http://www.bot.or.th • Publications • Public symposiums and workshops • Visits to educational and financial institutions

38. Inflation Report 2008

39. III. Challenges ahead

40. Challenges ahead • Choice of policy target • Exchange rate management under IT

41. Divergence between core and headline inflationseems to be persist %YoY Headline Inflation Mar 08 5.3 1.7 Core Inflation

42. Development of inflation: Adoption of IT (May 2000) to present • Before IT: Average of core is close to average of headline. However, core is less volatile, making it a better candidate in reflecting underlying inflationary pressure. • After IT:Prolonged Divergence • Energy and raw food prices are no longer temporary supply shocks. Changes in the demand and supply structures of these commodities are persistent. Nature of shocks are different. %YoY Upper Target for core inflation

43. Bumps caused by oil controlduring 2004-2005 Trend of energy and raw food are different from that of core 24m moving Index (2000M5=100) • Difference in trends especially after 2003 onwards implies that exclusion of energy and raw food results in loss of information on underlying trend • A prolonged break down in the relationship between headline and core inflation that would persist for some time to come Start IT Headline and CorePre- IT (1986M1 – 2000M4) Headline and CorePost- IT (2000M5 – 2007M12)

44. Structural change in the demand and supply of oil implies that price could rise further Change in Demand Change in Supply High demand with limited production capacity of bio-fuel Increases in investment in commodities Supply less sensitive to price OPEC continues to dominate market Lower ability to absorb shocks • Oil price likely to rise • Higher volatility • More likely to overshoot and remain high Higher probability of shocks • Geopolitics • Weather • Investor Speculation

45. In the same spirit, raw food prices could also rise further Change in Demand Change in Supply Higher demand from China and India Bio-fuel production Limited capacity to increase supply Low and declining ratio of stock to use Lower ability to absorb shocks Higher probability of shocks due to global warming Raw food prices likely to rise further

46. What next for Thailand? • Given the above analysis, it is clear that raw food and energy would play a more significant role in driving inflation dynamics, going forward. • It is also clear that other IT countries have moved away from core inflation. • Therefore, core or headline inflation?? • What is the target and how wide is the band (present: 0.5 -3.0%)? • The length of period for calculating the inflation rate (present: quarterly)?

47. Main considerations for monetary policy in Thailandat present under the inflation targeting framework: • The BOT’s inflation targeting framework has meant that domestic price stability remains the number one priority for monetary policy • How much weight should be given to economic growth? • In practice, much weight given to growth, particularly during the “hambuger” crisis • Policy rate reduction for four times during December 2008 and April 2009, from 3.75% to 1.25% • “Flexible inflation targeting” policy

48. Main considerations for monetary policy in Thailandat present under the inflation targeting framework: • At the same time, in the context of increased financial flows into the region, the BOT’s has to prevent excessive exchange rate volatility • The BOT has prevented volatile capital inflows from disrupting the domestic economy through • sterilized intervention to prevent excessive appreciation of the exchange rate • restrictions on speculative capital inflows (of various degrees) • liberalization of capital outflows to allow more balanced financial flows

49. Considerations in managing the exchange rate

50. The BOT’s exchange rate management • The exchange rate is allowed to move in accordance with market forces, under the following conditions: • The level of FX volatility does not disrupt the real economy • The exchange rate helps maintain competitiveness, as measured by the Nominal effective exchange rate (NEER), which takes into account currencies of major trading partners and competitors, using third market weights (and not just the bilateral THB/USD exchange rate) • The exchange rate is in line witheconomic fundamentals, as it could otherwise lead to the buildup of imbalances