The core mandate of every central bank is to decide and implement monetary policy, with the ultimate objective to preserve overall economic stability so as to support the economy to grow sustainably at its full potential in the long term. The Bank of Thailand (BOT) has since 2000 implemented monetary policy under the flexible inflation targeting framework, a popular regime adopted by many central banks all over the world. Under this framework, the Monetary Policy Committee (MPC), which is responsible for making monetary policy decision, puts emphasis on maintaining price stability through the setting of explicit inflation target alongside preserving economic growth and financial stability. A mission to maintain an inflation rate within the predetermined target range contributes to the clarity, transparency and accountability of monetary policy. These, in turn, enhance its credibility, a vital element for the success of monetary policy implementation.
The Monetary Policy Target
The MPC has conducted monetary policy under the flexible inflation targeting framework, putting emphasis on achieving price stability alongside preserving economic growth and financial stability. The MPC aims to strike an appropriate balance between each monetary policy objective, and stands ready to employ available monetary policy tools to ensure price stability, stable and sustainable economic growth while preventing risks to financial stability.
The MPC has to seek a mutual agreement on the annual monetary policy target with the Finance Minister, who will then forward the agreed target to the Cabinet for official approval. Currently, the Cabinet has approved headline inflation within the range of 1-3 percent as the medium-term monetary policy target as well as the target for 2022. This range target is deemed appropriate for the evolving economic environment as a result of the COVID-19 outbreak because: (1) Thai inflation going forward and in the medium-term is expected to reside close to the lower bound of the target. This is due to the gradual economic recovery and some potential upside risk factors from higher energy prices, supply chain disruption, and geopolitical conflicts, (2) this range target has successfully anchored inflation expectations as can be seen from inflation expectations still residing within the target, and (3) the two-percent target width provides adequate flexibility to address the volatility surrounding inflation going forward while supporting efficient monetary policy formulation under highly uncertain circumstances in order to attain price stability, promote sustainable economic growth, and ensure financial stability.
Monetary Policy Decision-making Process
The MPC, comprising three BOT executives and four external committee members, is responsible for making monetary policy decision. The MPC meets six times a year following a predetermined meeting schedule to set the appropriate level of the policy interest rate (1-day bilateral repurchase rate) given economic and inflation conditions and outlook, while also considering other available policy tools, in order to achieve monetary policy objectives.
At each meeting, the MPC evaluates economic and financial conditions, and risk factors that could affect outlook for inflation and economic growth, as well as financial stability, to decide appropriate monetary policy stance. The MPC Secretariat is responsible for reporting to the MPC latest developments in financial and real sectors from both domestic and external fronts, any factors that could affect prices of goods and services such as global oil and agricultural product prices, as well as risks to financial stability. The MPC will then consider economic and inflation outlook and decide whether to raise/maintain/cut the policy interest rate. In case of emergency, particularly when there is any incidence that has a severe and abrupt impact on the economy, the MPC may call a special meeting ahead of the usual scheduled meeting.
Communication of Monetary Policy Decisions
After each meeting, the press statement will be released at 2 pm. and the MPC secretary will hold a press conference at 2.30 pm. to announce the MPC decision and respond to queries from news reporters regarding their policy decision and view on the prospect of the economy. The BOT will release edited minutes of the MPC meeting on its website two weeks after the meeting to provide explanation on the evaluation of economic conditions and the committee’s views that affect monetary policy decision. Furthermore, the BOT will also release the quarterly Monetary Policy Report to explain in detail the prospect of the economy and inflation. The report also aims to communicate with the public and investors the MPC’s monetary policy decision and the reasons behind to enhance the public’s understanding on monetary policy implementation.
Monetary Policy Instruments
In order to keep the policy interest rate at the target rate set and announced by the MPC, the BOT relies on three main instruments including:
1. Reserve Requirements. Commercial banks are required to maintain minimum reserves on average over a fortnightly period at a specified percentage of deposits/liabilities base of the previous period. The current requirement is 6%.
2. Open Market Operations (OMOs), which are transactions undertaken in the money market by the BOT to adjust liquidity. The transactions will affect financial institutions’ deposits at the BOT and consequently short-term interest rates in the money market. OMOs are the primary instrument used to maintain the policy interest rate at the announced level and to ensure that liquidity in the financial system is at an appropriate level. Four main transactions conducted through OMOs consist of:
(1) Bilateral Repurchase Operations
(2) Issuance of BOT Bonds
(3) FX Swap
(4) Outright purchase/sale of securities
3. Standing Facilities, which are channels provided by the BOT for financial institutions to borrow funds from the BOT overnight by using eligible securities as collateral or to deposit funds overnight at the BOT to adjust their liquidity position at the end of the day.
Monetary Policy Transmission Mechanism
A policy interest rate adjustment affects the economy through five main channels including money market and financial institutions’ interest rates, credit, asset prices, exchange rate, and expectation channels. The policy rate adjustment will, consequently, have an impact on economic activities such as private consumption, investment, imports and exports, and prices of goods and services.
• Interest Rate Channel: This is currently the most important channel. When the MPC cuts the policy interest rate, money market and commercial bank interest rates will drop accordingly, both on the borrowing and lending sides. Lower lending rates would encourage businesses to borrow funds for investment, while lower deposit rates discourage savings and urge savers to spend more. These, in turn, help boost economic activities and inflationary pressure. On the other hand, raising the policy interest rate would lead to a decline in economic growth.
• Credit Channel: When the MPC cuts the policy interest rate, money market and commercial bank interest rates fall, which reduces interest burden for businesses. Their balance sheet conditions and financial positions, therefore, become stronger, leading to lower default probability. This encourages banks and other non-bank lenders to lend more to businesses with lower lending rates. Businesses can then expand their investment, which helps boost economic activities and inflation. Furthermore, lower interest rates benefit balance sheet conditions of commercial banks due to lower costs of acquiring deposits. This raises supply of loanable funds and allows banks to extend more loans to the real economy. Economic activities will, subsequently, expand.
• Asset price Channel: Lower interest rates make savings less attractive in comparison with investment in other assets such as stocks, bonds and real estate. Therefore, an interest rate cut would spur demand for those assets and hence their prices, which will consequently lift the wealth of businesses and households. An increase in wealth leads to higher consumption. Meanwhile, higher real estate prices raise a possibility that households and businesses will be granted mortgage approval from financial institutions given higher collateral value. In addition, a rise in firms’ market value encourages firms to raise more capital in order to expand business or replace unproductive assets. This, therefore, raises investment spending. Increases in consumption and investment as a result of this channel will eventually boost up economic growth and inflation.
• Exchange Rate Channel: When the MPC cuts its policy interest rate, lower domestic interest rates relative to those of other countries will encourage capital outflow to invest in foreign assets. This decreases demand for Thai baht, and results in baht depreciation. The baht depreciation will make imported goods more expensive, and hence raise inflationary pressure. Moreover, it will make Thai exported goods cheaper for foreign buyers, thereby increasing demand for exports. This, in turn, benefits economic growth and inflation.
• Expectation Channel:The public’s expectations on future economic and inflation outlook can affect behaviors of economic agents at present. For example, when the MPC reduces its policy interest rate, if businesses and households anticipate an improvement in economic conditions going forward, they will be more confident to consume and invest. Apart from future economic growth expectations, another important channel is the effects of inflation expectations on price and wage setting behaviors. For instance, in the case where inflationary pressure rises and there is certain possibility inflation will be above the inflation target, raising the policy interest rate to lower inflationary pressure will help curb a rise in inflation expectations. This reduces both firms’ incentive to increase good prices and labors’ tendency to negotiate for wage increase, all of which result in more stable inflation. However, the effectiveness of this channel depends on the credibility of monetary policy. If the public does not believe that the MPC sufficiently raises the policy interest rate to bring down inflation towards the target, inflation expectations may rise. Workers will, therefore, demand higher wages, while businesses raise their product prices, which causes a rise in the inflationary pressure.
The five channels aforementioned transmit the effects of monetary policy to the economy. The transmission would require a certain period of time, but the time period may vary depending on economic and financial conditions. Past researches show that a complete transmission usually takes around 6-8 quarters. Besides, the effectiveness of each transmission channel could vary across times. The MPC will, therefore, closely monitor and evaluate the transmission effectiveness to ensure that monetary policy efficiently benefits the economy in the long run.
“To implement monetary policy, the BOT can never do everything by ourselves but we need to coordinate macroeconomic policies with other agencies to create favorable economic conditions for the country’s sustainable well-being,” said former Bank of Thailand Governor Puey Ungphakorn.