​Dr.Kiatipong Ariyapruchya

Last Wednesday on 9 March 2011, the Monetary Policy Committee (MPC) of the Bank of Thailand (BOT) continued rate normalization by raising the policy rate by 25 bps to 2.50 per cent in response to inflation pressure amid rising oil and commodity prices as domestic demand picks up. Critics derided the recent hike as evidence of “inflation nuttery”, an unhealthy obsession with inflation. Even the name of BOT’s monetary framework- “inflation targeting” -seems to corroborate this view. After all, the critics argue, oil and commodity price increases are supply shocks and do not constitute inflation. Therefore, a monetary response is unwarranted and may even hurt the economy.However, the truth, as in many things, is more complicated.

First, the critics are partly right. The surge in oil and commodity prices is indeed not inflation. The supply-side shock of a rise in oil and commodity prices is merely a change in relative prices that reflects the welcome process of market re-balancing supply and demand to prevent shortages. Central banks should take care not to over-react to such price changes. However, and this is where the critics go wrong, supply shocks can result in inflation-something to which the central bank should take care not to under-react.

So if high oil and commodity prices do not count as inflation, what does? Inflation is defined as the persistent and general rise in prices. Let me give you an extreme scenario. Imagine waking up to find that the prices of all the goods in Tesco-Lotus and other places had gone up overnight. But wait, there’s more-your friends tell you that the price increases will continue for the foreseeable future, effectively doubling or tripling prices over the course of the year. This may seem hard to imagine because Thailand is one of a handful of countries in the world that has never experienced hyperinflation. In this regard, the BOT’s dedication to monetary stability, or the value of money, deserves credit, although I am probably biased.

So what exactly is the value of money? The value of money to society is its purchasing power- its power to command goods and services in exchange for itself thereby facilitating exchange in a market economy. Money-that is, paper money-in itself is worthless. Ultimately, the value of money is backed by the BOT’s word, not by gold or anything tangible. So why would you, or indeed anybody, believe in the BOT’s word? The reason is simple-trust. Or more precisely, trust earned through a long history of keeping inflation low and the value of money stable.

However, this trust can be undermined by excess demand from rapid economic growth. Let me give you an illustration. Imagine you own a factory in the robust Thai economy. Business is booming, orders are high, machines are humming around the clock and workers are becoming hard to find. Capacity is strained. You raise wages to compete with other businesses for scarce workers and inputs. You raise your prices too as production costs rise. In a robust economy such as Thailand’s, businesses everywhere will be pressured to raise prices in unison, resulting in inflation. More and more will come to expect future inflation, undermining trust. If you believe that prices are on the uptrend, you will raise prices in anticipation of higher prices. Others will follow suit. Thus an inflation spiral begins.

Now, on top of that, an oil and food supply shock is like adding fuel to the fire. This is the threat facing the Thai economy today. In such an environment, you, as the factory owner, will find it hard to distinguish between relative price changes due to oil versus overall inflation pressure due to demand pressure. There is now an even greater risk that beliefs, or expectations, about future inflation will become unanchored, leading to a feedback loop between inflation and inflation expectations. The experience of other emerging markets shows that this risk is very real. It is precisely this inflation risk that the MPC wants to pre-empt by continued normalization of interest rates to temper domestic demand.

The MPC hike of 25 bps last week was a small but significant step in anchoring inflation expectations. The hike in and of itself cannot do very much in terms of moderating domestic demand. But it can help anchor inflation expectations. Expectations, like trust, are maintained not only by a past history of low inflation but also by the promise to keep it low, communication of how the promise will be kept, and concrete actions to that effect. The promise is the BOT’s core inflation target. The action is the recent hike, on the heels of a series of small hikes. Each step, no matter how small, builds trust and credibility. And communication by the MPC shows that it is prepared to keep taking the necessary number of steps to keep its promise. Small steps do add up. Accordingly, the yield curve shows an upward trend in rates and surveyed inflation expectations show a modest rise. More action may be required to maintain credibility.

By now you may have conceded that inflation is undesirable and the rate hike justified. But should BOT’s primary focus be on price stability to the exclusion of growth? When I first joined the BOT, an ex-governor pointed out to me the significance of the BOT seal. The seal depicts Phra Siam Thevathiraj (Siam’s guardian deity) gazing into the distance and holding a bag of money by his side. The gaze symbolizes far-sightedness; and the bag of money the value of the Thai baht. He told me that monetary frameworks-fixed exchange rates, monetary targeting, and inflation-targeting-may come and go but BOT’s role remains the same, the sole guardian of the value of money.

History tells us that in the short-run, monetary policy can help the economy (e.g. BOT’s rate drop during the global financial crisis) but in the long-run, printing too much paper money is a sure path to economic ruin. This doesn’t mean that monetary policy has no role to play in the long-run; infact, countries that have achieved prosperity have only done so on the firm foundation of stable prices. After all, what good is your money if you can’t buy anything with it.

The opinions expressed in this article are the author’s own and do not necessarily reflect the official opinion of the Bank of Thailand.

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