Paiboon Pongpaichet

GIVEN the Bank of Thailand's repeated signals that interest rates are in the up-cycle, businesses and households have become more and more concerned that such a move to hike interest rates would stall the recovering economy, and worse pulling it into reverse.

Interest rates are one of the most important price signals in the economy, influencing key decisions made by businesses, households, and even the government. Thus, it is undeniable that an interest rate hike would have a broad-based impact on the economy. The interesting question, however, is whether the current upward trend in interest rates would increase the private sector's debt burden as well as affect their consumption and investment decisions to such an extent that economic growth is derailed as many people worried.

The main factors driving the Thai economy forward are a more sustained global economicrecovery, and strong expansion in domestic demand on the back of improved household and business sentiments. When these fundamentals remain sound, the growth momentum can continue to drive the economy without a need for low interest rates as was the case during the crisis. As such, the negative impact of an interest rate increase should not put us in reverse as some fear. On the other hand, given today's rising inflationary pressure and the still negative real interest rates, delays in raising the interest rate could put monetary policy behind the curve, increasing the risks of inflation and financial instability. This would create a larger negative effect on the economy down the road.

The current surge in upward pressure is due to both the supply side from the increase in global commodity prices, such as oil and food, as well as the demand side in line with our strong economic growth. If monetary policy does not react to such increase in pressure, inflation would continue to rise and the Thai economy may run a risk of facing similar problems to Vietnam. In that case, the high inflation (12.2 percent in January, 2011) not only resulted in loss of price competitiveness of exports, but also led to external imbalances and affected the wider economy.

The negative real interest rates are in fact an important risk in the eyes of policy makers around the world, not only Thailand. This is because prolonged negative real interest rates make the return on deposits, and hence savings, less than the rise in prices of goods and services. For those who rely on income from bank deposits, such a situation makes it harder for them to sustain their consumption.

Since the return from savings is unattractive, people are bound to lose incentive to save and turn to invest in risky assets such as stocks, gold and real estate in search for higher returns. The increase in speculative activities may cause market prices to deviate from fundamentals and create imbalances in those markets. The buildup of these financial imbalances is in fact a process of economic risk accumulation that in time, would eventually affect the overall economy. The obvious example is the case of the United States, where some economists cite that the recent crisis was partly caused by low real interest rates which remained negative for ten years. Such an environment in turn, induced higher investment in risky assets, especially in the real estate market. Finally, the enormous asset price bubble burst, resulting in one of the worst economic recessions not only for the United States but also the world.

Responsible policymaking requires that policy be set with a medium-term perspective. Thus although increasing the policy interest rate now would dampen the economy but if the size and pace of rate increases are appropriate, such a negative impact would be small compared to the cost of doing nothing and fueling the next crisis. And also the current monetary condition is still fairly accommodative.

This concept is like driving a car. If we think of the economy as a car and the policymaker as a driver, then when the car is going too fast, it is the driver's task to take his foot of the accelerator to slow it down. Although some passengers may complain that they would get to the destination slower, but this would be better than letting it go so fast and then having to slam on the brake, or worse, risk and accident down the road.

The effectiveness of monetary policy depends on market expectations. Therefore, creditability of policymakers is a crucial factor. In this regard, policy deliberations should be transparent and clear. This is a major reason why the Bank of Thailand has been consistent in signaling the upward interest rate path. Provided that the Bank of Thailand sends a clear signal and the market believes it and adjusts their business plans in line with that policy, then the negative effect of higher interest rates on the economy would be minimal.

But if monetary policy sends an unclear signal, market confusion could result and affect the planning of consumption and investment in the future. In this way, monetary policy would add undue volatility to the economy.

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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