Policy target setting
The Bank of Thailand (BoT) has conducted monetary policy under a flexible inflation targeting framework since May 2000. Under this framework, the BoT pays attention not only to ensuring price stability through setting inflation target (so-called "monetary policy target"), but also to preserving economic growth and financial stability.
Inflation target from May 2000 to December 2008
1) The use of core inflation as monetary policy target
Core inflation is a year-on-year percentage change of consumer price index (CPI) that excludes fresh food and energy prices, which comprise for instance prices of rice, flour, cereal products, meats, vegetables, fruits, electricity, cooking gas, and gasoline. The rationale for such exclusion is that prices of those excluded items are highly volatile in the short run and tend to be affected by factors beyond the control of monetary policy. Retaining these items in the target measure could, therefore, lead to too frequent changes in monetary policy stance, and may cause heightened economic volatilities. For example, in the case where prices of fresh food and energy rise, households' purchasing power declines, which negatively affects economic growth. If the central bank decides to tighten monetary policy to reduce inflation, the decline in consumption and economic growth can be exacerbated. The exclusion of those prices thus not only helps decrease volatilities of the target measure, but makes it better reflect underlying inflation pressures, particularly those stemmed from the demand side, which can be influenced by monetary policy.
Despite the exclusion of fresh food and energy prices, changes in the general price level can still be reflected in movements of core inflation, since goods and services that remain in the calculation of core inflation account for roughly three-fourths of the consumption basket. In addition, historical data shows that, despite some deviations in the short run, core inflation closely tracks headline inflation in the long run. Therefore, the maintenance of price stability through targeting core inflation will eventually lead to overall price stability in the long run.
2) Setting the target range for core inflation at 0-3.5 percent, by considering:
(1) The ability of people from various groups in the economy to adjust to changes in the price level, particularly retirees who mainly rely on interest income from savings, fixed-income employees, and labourers who have low wage-bargaining power. Those groups of people may be adversely affected by a too high inflation target, as their income may fail to catch up with inflation, which erodes their purchasing power.
(2) Consistency with prevailed inflation rates of Thailand's major trading partners and competitors. Ensuring that Thailand's inflation rate is in line with that of trading partners and competitors helps preserve export price competitiveness. Over the past 10 years (1999-2008), inflation of those countries averaged at around 1.8 percent.
3) The use of "quarterly-average" core inflation as the target
Given high volatility of monthly inflation figures, averaging core inflation over the quarter allows for better discernment of inflation dynamics. The use of quarterly average also allows the BoT and the public to detect faster whether inflation will fall outside the target range compared with annual or longer-period averages. Furthermore, it is consistent with inflation forecast from the BoT's macroeconomic model that the Monetary Policy Committee (MPC) employ in making monetary policy decision, which is available in quarterly frequency.
The MPC thus considered the 0-3.5 percent target range for quarterly-average core inflation to be appropriate for the Thai economy. The target band width was wide enough to provide flexibility for monetary policy to help cushion economic growth from any temporary shocks. The range target also minimized the need for the MPC to adjust monetary policy stance frequently to movements of inflation, thereby reducing interest rate volatility, which in turn enables smooth economic and financial activities.
Inflation target in 2009
The Bank of Thailand Act (No.4) B.E. 2551, explicitly specify procedures for reviewing monetary policy target in Section 28/8:
"By December of each year, the Monetary Policy Board, with a corporative agreement with the Minister of Finance, shall determine targets of monetary policy for the following year which shall be regarded as the guideline for the State and the BOT in implementing any measures to maintain the price stability. The Minister shall propose the agreed targets of monetary policy to the Cabinet for approving. Upon the approval, it shall be published in the Government Gazette."
Accordingly, the MPC and the Minister of Finance have carefully considered an appropriate inflation target for 2009, taking into account various important issues, and mutually agreed to propose a new inflation target for 2009 for which the MPC would
(1) Retain the use of quarterly average inflation target for the continuity of policy implementation.
(2) Narrow the target range from 0-3.5 percent to 0.5-3.0 percent. The lower bound of the target range was adjusted upwards by 0.5 percentage points in order to reduce the probability of deflation, while the upper bound was lowered by the same amount to signal unchanged monetary policy stance. The Cabinet approved the above target range on September 1, 2009.
Inflation target from 2010 to 2014
The MPC and the Minister of Finance have agreed to maintain the inflation target at 0.5-3.0 percent in each year. This target range was considered appropriate in supporting stable and sustainable economic growth going forward for the following reasons:
(1) Low and stable inflation would enable the economy to grow on a sustainable path in the long run.
(2) The target range of 0.5-3.0 percent was in line with prevailed inflation rate of Thailand's trading partners and competitors, which would help maintain the country's export price competitiveness.
(3) The low inflation target would help build up confidence of consumers and businesses in making consumption and investment plans.
Inflation target in 2015
The MPC and the Minister of Finance have agreed to propose a new monetary policy target for 2015. The new target was set for the annual average of headline inflation at 2.5 percent with a tolerance band of
± 1.5 percent. This replaced the core inflation target which had been adopted since the introduction of the inflation targeting framework. The rationales and details of such changes were as follows:
(1) The rationales for adopting headline inflation as the policy target
Despite the success of the inflation targeting framework with core inflation as a policy target in achieving price stability, some deficiencies with respect to the use of core inflation may reduce its effectiveness going forward. Compared to core inflation, headline inflation was better in reflecting changes in the cost of living since it captured changes in prices of all goods and services in the consumption basket, including raw food and energy prices which account for 27 percent of the basket. Therefore, headline inflation was more in tune with the public's understanding of what constitute the cost of living, and was used as a reference for consumption and saving decisions by households and for investment and price setting decisions by businesses. In addition, in recent years, core inflation has somewhat lost its ability to track overall inflationary pressure as it has diverged from headline inflation for much longer time period, compared to the past. This was likely because changes in raw food and energy prices had a larger influence on inflation dynamics.
Therefore, adopting headline inflation as a policy target would facilitate the central bank's communication with the public regarding monetary policy decisions and also strengthen monetary policy effectiveness in anchoring long-term inflation expectations. Lastly, every country that adopted the inflation targeting framework currently used headline inflation as a policy target.
(2) The appropriateness of setting the point target for headline inflation at 2.5 percent on an annual average basis with a tolerance band of ± 1.5 percent
Switching from the range to point target gave a clearer signal to the public regarding the commitment of monetary policy towards maintaining price stability, which should help strengthen its effectiveness in anchoring the public's long-term inflation expectations. Nevertheless, the tolerance band was needed to provide some flexibility for monetary policy to accommodate temporary fluctuations in raw food and energy prices. Such flexibility was crucial in supporting the economy to grow at its full potential alongside the mandate to preserve price and financial stability. The band width at 1.5 percent was considered to be appropriate in accommodating volatilities of raw food and energy prices to some extent.
(3) The switch from a quarterly average to an annual average was intended to reflect the forward-looking nature of monetary policy, which would help improve monetary policy flexibility, and to be in line with revisions of monetary policy target which had to be done cooperatively by the MPC and the Finance Minister on an annual basis.
Inflation target in 2016 and the medium-term target
The MPC and the Minister of Finance have agreed to propose the annual average of headline inflation at 2.5 ± 1.5 percent to be the monetary policy target for 2016 and the medium-term target. This target was considered appropriate due to the following reasons:
1) It was consistent with economic fundamentals. The mid-point of the target at 2.5 percent was in line with long-term inflation outlook, which were conducive to supporting the economy to expand at its full potential.
2) It was close to inflation targets of developing countries that adopted an inflation targeting framework, which would help maintain the country's price competitiveness.
3) It has so far well-anchored the public's inflation expectations, reflected by long-term inflation expectations that remained close to the mid-point of the target.
The purpose of additionally setting the medium-term target was to comply with time lags the effects of monetary policy were fully transmitted to the economy and inflation. Moreover, it allowed households and businesses to plan their consumption and investment efficiently.
The medium-term inflation target and the target in 2017-2019
The MPC and the Minister of Finance have agreed to maintain the annual average of headline inflation at 2.5 ± 1.5 percent as the medium-term target and the target for 2017 and 2018. The target at this level was considered conducive to supporting the economy to expand at its full potential. The tolerance band of ± 1.5 percent was also considered appropriate and sufficient to accommodate volatilities that may cause future inflation to deviate from the mid-point of the target in the short run. Nevertheless, changes in the global and Thai economic structure has affected inflation dynamics and outlook going forward. Therefore, the MPC would monitor and study those structural developments in order to ensure that the setting of monetary policy target and monetary policy implementation in the future were appropriate and were conducive to achieving the targets for price, economic growth and financial stability in an effective manner.
The medium-term inflation target and the target for 2020
The MPC and the Minister of Finance have mutually reviewed the appropriate inflation target and hence agreed to propose headline inflation within the range of 1-3 percent as the new monetary policy target. The new target replaces the use of an annual average of headline inflation at 2.5 percent with a tolerance band of ± 1.5 percentage points, which was in place since 2015. The rationales and details of such changes were as follows:
(1) A reduction in the target level is deemed consistent with the low Thai inflation outlook given the prevailing structural changes. These changes include (1) technological advancements, which reduce costs of production and boost supply of goods and services; (2) an expansion of e-commerce, which foster greater price competition, thereby reducing entrepreneurs' pricing power; and (3) the aging society, which will contribute to the decline in overall demand for goods and services going forward, since the elderly, which normally receive lower income after retirement, constitute a larger share of the entire population.
Headline inflation within such target range is also conducive to full-potential economic growth. In particular, the downward adjustment in the target upper bound is consistent with the limited upside inflation pressures given structural factors aforementioned, and ensures that the target range is not too high to affect households' costs of living. Meanwhile, the lower bound of the target range remains the same, since, if being revised downward, the lower bound could have been too low and trigger the de-anchoring of the public's inflation expectations. Given that market interest rates are partly determined by inflation expectations, any declines in expected inflation would therefore induce lower interest rates within the financial system. This would, in turn, lead to the buildup of risks to financial stability, and the more limited monetary policy space to deal with economic crisis going forward.
(2) The adoption of range target in place of point target (with tolerance band) enhances monetary policy flexibility in supporting growth and preserving financial stability more effectively, especially under the volatile and uncertain global economic circumstances.
Under the point target (with tolerance band) system, when headline inflation deviates away from the target midpoint in the short run, monetary policy is required to attain the midpoint in the medium term, which might have adverse side effects on other policy objectives. Meanwhile, the range target system helps lessen such an active need to get inflation back to the target midpoint, while allowing movements of inflation in the medium term to reflect more of the prevailing structural changes at any given time periods.
In the case that headline inflation breaches the announced target
A mutual agreement between the MPC and the Minister of Finance states that
"Should average headline inflation in the past 12 months or forecast of average headline inflation over 12 months ahead breach the inflation target range, the MPC shall send an open letter to the Minister of Finance to explain (1) reasons for the breach of target, (2) monetary policy actions in the past and going forward to support the return of headline inflation to target over an appropriate time horizon, and (3) the expected time frame for a return of headline inflation to target. Furthermore, the MPC will write an open letter to the Minister every six months if average headline inflation based on the above criteria remains outside the target range, while also report the progress of their policy actions as appropriate."