Monetary Policy under Flexible Monetary Policy under Flexible Inflation Targeting: Thailand’s ExperienceInflation Targeting: Thailand’s Experience

2

ReferencesReferences

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

OverviewOverview

Four Monetary Policy Frameworks

Inflation targeting framework in Thailand

Challenges ahead and policy issues

4

Monetary policy ultimate objectivesMonetary policy ultimate objectives

Price stability

Long-term growth and full employment

5

Monetary policy frameworkMonetary policy framework

Exchange Rate Targeting

Monetary Targeting

Inflation Targeting

No explicit announcement (Just-do-it approach)

6

Exchange rate targetingExchange rate targeting

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

7

Success of exchange rate targetingSuccess of exchange rate targeting

Synchronize economic cycles with anchor

currency economy

Appropriate level of exchange rate

(no macroeconomic imbalance)

8

Monetary targetingMonetary 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

““Just-do-it” approachJust-do-it” approach

Pros

Flexibility

Cons

Lack of transparency

discipline

Need credibility before

adopt

No explicit announcement for policy anchor No explicit announcement for policy anchor

10

Why monetary policy was revised?Why monetary policy was revised?

1. Switch from fixed to a floating exchange rate regime

– need for a new nominal anchor

2. Rapidly changing world economic and financial

environment

3. Growing public awareness of information and news

4. Previous monetary policy not clearly defined

11The search for a new nominal anchor The search for a new nominal anchor consistent with flexible exchange rate regimeconsistent with flexible exchange rate regime

-3

0

3

6

9

12

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

-15

0

15

30

45

60

Exchange rate

Headline inflation

Change of the exchange rate regime% Baht/USD

12

Features of appropriate monetary policyFeatures of appropriate monetary policy

1. Clear principles and framework

2. Transparent and examinable, consistent with good

governance rules

3. Decisions based on sound principles, avoiding personal

judgment, and easily communicated to the public

4. Clear responsibility and accountability

5. Promotion of long-term economic development

6. Strengthening of credibility for the central bank and

Thai economy

13

General principles of ITGeneral principles of IT

Transparency

AccountabilityIndependence

To build up

credibility

14

II. Inflation targeting frameworkII. Inflation targeting framework

in Thailandin Thailand

15

Current frameworkCurrent 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 stabilityPolicy 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).

17Choice of inflation measure to targetChoice of inflation measure to target

(Core inflation)(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

Percent

Before IT

1986 Q1 -2000 Q1

Headline Core

Mean 4.66 4.59

Volatility (S.D.) 2.17 1.68

18

Policy target: core inflationPolicy target: core inflation

… based on prices of goods and services in the

CPI basket but excludes raw 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

19Choices of items excluded Choices of items excluded

from core inflation for the case of Thailandfrom core inflation for the case of Thailand

Weight Mean S.D.

Food 38% 4.6 1.73

Raw food 16% 5.3 1.66

Energy 6% 5.6 1.61

Controlled price 6% 5.4 1.74

Indirect tax 9% 5.2 1.43

Raw food and energy 22% 5.3 1.35

Headline inflation 100% 5.5 1.85

Sample 1993:01 - 1999:12

20Core inflation closely tracked headline Core inflation closely tracked headline

inflation in the long runinflation in the long run

-4

0

4

8

12

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Headline - Core

Core CPI

Headline CPI

% YoY

IT since May 2000

21

Target point or range (0.5 - 3.0%)Target point or range (0.5 - 3.0%)

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 l

eads to currency stability

Does not pose constraint on economic recovery

Cushions temporary economic shocks and minimizes need

to adjust monetary policy frequently

Criteria in choosing the inflation targetCriteria in choosing the inflation target

22Policy instrument:Policy instrument:

1-day bilateral repurchase rate1-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.

23Transmission mechanism Transmission mechanism of monetary policyof monetary policy

Time Horizon (8 Quarters)

24

0

1

2

3

4

5

6

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Movements in policy rate (RP1D)Movements in policy rate (RP1D)

% p.a.

Interbank

RP 1D

25

0

1

2

3

4

5

6

7

8

9

2003 2004 2005 2006 2007 2008

RD3M

% p.a.

MLR

Monetary policy transmission mechanismMonetary policy transmission mechanism

Policy rate

26Policy tool:Policy tool:

Macroeconomic model (BOTMM)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 modelComponents of macroeconomic model

28Macroeconomic model :Macroeconomic model :

Policy optimizationPolicy 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

),(0 y

it

n

i itLMin

])()()[2/1(),( * 2* 2 yyrgyLtttt

*t

yyt*

29Using optimal control Using optimal control

to assist decision makingto assist decision making

Models &

Optimal Control

Economic Condition

Results

Decisions

Put in quantitative

formInterpretation

IntuitionMonetary Policy

Discretion

Monetary Policy Rules

Policy Makers’ Judgement

30GDP growth forecastGDP growth forecast adjusted for risk factors adjusted for risk factors

(as of January 2008)(as of January 2008)

Remark: The fan chart covers 90 per cent of the probability distribution

Annual percentage change (%)

2

4

6

8

10

Q12005

Q12006

Q12007

Q12008

Q12009

2

4

6

8

10

31

Probability distribution of the GDP growth forecastProbability distribution of the GDP growth forecast

(Unit: per cent)

Probability

2007 2008 2009

Old(Oct 07)

New(Jan 08)

Old(Oct 07)

New(Jan 08)

New(Jan 08)

< 4.0 0.0 0.0 0.2 0.1 1.1

4.0 – 4.25 3.6 0.0 1.0 0.7 2.7

4.25 – 4.5 43.3 0.5 3.5 2.9 5.5

4.5 – 4.75 48.9 40.3 8.7 8.0 9.4

4.75 – 5.0 4.2 58.2 16.1 16.1 13.7

5.0 – 5.25 0.0 0.9 21.9 23.0 16.7

5.25 – 5.5 0.0 0.0 21.7 23.0 16.9

5.5 – 5.75 0.0 0.0 15.4 15.8 14.2

5.75 – 6.0 0.0 0.0 7.8 7.3 9.8

6.0 – 6.25 0.0 0.0 2.8 2.3 5.5

6.25 – 6.5 0.0 0.0 0.7 0.5 2.5

> 6.5 0.0 0.0 0.1 0.1 1.2

91.7 93.4 80.8

92.2

98.6

32Core inflation forecastCore inflation forecast adjusted for risk factorsadjusted for risk factors

(as of January 2008)(as of January 2008)

Annual percentage change (%)

Remark: The fan chart covers 90 per cent of the probability distribution

-1

0

1

2

3

4

Q12005

Q12006

Q12007

Q12008

Q12009

-1

0

1

2

3

4

33

(Unit : Per cent)

Probability

As of April 2003 As of July 2003

2003 2004 2003 2004

< 0.0 0.0 0.0 0.0 0.0

0.0 – 0.5 17.0 0.0 100.0 9.1

0.5 – 1.0 83.0 0.3 0.0 89.4

1.0 – 1.5 0.0 19.8 0.0 1.5

1.5 – 2.0 0.0 64.5 0.0 0.0

> 2.0 0.0 15.0 0.0 0.0

84.3

100.0 98.5

Compare the probability of Compare the probability of core inflation forecastcore inflation forecast

34

Benefits of fan chartsBenefits 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.

35Responsibility:Responsibility:

Monetary Policy Committee (MPC)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

Data

Policy formulation processPolicy formulation process

MPC meets 8 times a year

Policy rate decision

Policy implementation

Forecast of output growth and inflation

Press release

3 senior officials from BOT

and 4 external members

Inflation Report

37Communications policy:Communications policy:

Inflation ReportInflation 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 2008Inflation Report 2008

39

III. Challenges aheadIII. Challenges ahead

40

Challenges aheadChallenges ahead

Choice of policy target

Exchange rate management under IT

41Divergence between core and headline inflationDivergence between core and headline inflation

seems to be persistseems to be persist

-2

0

2

4

6

8

10

12

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Core Inflation

1.7

5.3

%YoY

Headline InflationMar 08

43Development of inflation: Development of inflation:

Adoption of IT (May 2000) to presentAdoption of IT (May 2000) to present

Before IT After IT

Percent1986 Q1 -2000 Q1 2000 Q2 – 2008 Q1

Headline Core Headline Core

Mean 4.66 4.59 2.59 1.02

Volatility (S.D.)

2.17 1.68 1.60 0.76

0

1

2

3

4

5

6

7

2000Q2 2001Q3 2002Q4 2004Q1 2005Q2 2006Q3 2007Q4

Core Headline

%YoY

Upper Target for core inflation

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.

44Trend of energy and raw food are different Trend of energy and raw food are different

from that of core from that of core 24m moving Index

(2000M5=100)

40

60

80

100

120

140

160

180

200

220

1986M12 1990M12 1994M12 1998M12 2002M12 2006M12

CORECPICPI ENERGYCPI RAWFOOD

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

.00

.05

.10

.15

.20

.25

-4 -2 0 2 4 6 8 10 12 14

HCPI_PREIT Kernel CORE_PREIT Kernel

Den

sity

.0

.1

.2

.3

.4

.5

.6

-1 0 1 2 3 4 5 6 7 8

HCPI_POSTIT Kernel CORE_POSTIT Kernel

Dens

ity

Headline and CorePre- IT (1986M1 – 2000M4)

Headline and CorePost- IT (2000M5 – 2007M12)

Bumps caused by oil control during

2004-2005

45Structural change in the demand and supply of oil Structural change in the demand and supply of oil

implies that price could rise furtherimplies 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

Geopolitics Weather Investor Speculation

Oil price likely to rise

Higher volatility

More likely to overshoot and remain high

Lower ability to absorb shocks

Higher probability of shocks

46

Higher demand from China and

IndiaBio-fuel production

Limited capacity to increase supply

Raw food prices likely to rise further

Lower ability to absorb shocks

Higher probability of shocks due to global warming

In the same spirit, raw food prices could In the same spirit, raw food prices could

also rise furtheralso rise further

Low and declining ratio of stock to

use

Change in Demand Change in Supply

47

What next for Thailand?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)?

48Main considerations for monetary policy in ThailandMain considerations for monetary policy in Thailand

at present under the inflation targeting framework:at 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

49Main considerations for monetary policy in ThailandMain considerations for monetary policy in Thailand

at present under the inflation targeting framework:at 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

50

Considerations in managing the exchange rateConsiderations in managing the exchange rate

Short-term Authorities can intervene to slowdown rapid changes in the

exchange rate, providing time for the real sector to adjust

Longer-term

Prolonged intervention would prevent the exchange rate

from acting as an automatic stabilizer for the economy

Prolonged intervention is unable to keep the real exchange

rate undervalued in the longer-term, as the market will lead

to an adjustment in prices, namely the nominal exchange

rate

51

The exchange rate is allowed to move in accordance with market forces, under the following conditions:

The BOT’s exchange rate management The BOT’s exchange rate management

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 with economic fundamentals, as it could otherwise lead to the buildup of imbalances

52

Challenges to monetary policy are fundamentally stemmed from

the impossible trinity framework as there are limitations to

maintain policy objectives given different economic settings

FX Stability

Capital MobiliityInterest rates (i)

autonomy

- Gap

Y - Gap

The Impossible TrinityThe Impossible Trinity

53

Financial imbalancesFinancial imbalances

Financial balances in 7 areas are also monitored

to safeguard economic and financial stabilities

– External sector

– Household sector

– Corporate sector

– Financial institutions

– Financial markets

– Real estate sector

– Fiscal sector