ECONOMY
SUPAVUD SAICHEUA
'The Bank of Thailand needs to raise interest rates in a timely manner otherwise expectations about future price increases would become self-fulfilling, causing inflation to be entrenched at a high level."
Or...
"Today's high inflation results from higher oil, food and commodity prices; not from excess demand. Raising interest rates to curb demand would hurt producers and consumers which can only make things worse."
Who is right?
I believe that a one percentage point hike in the policy rate is necessary to anchor inflationary expectations. Assuming that oil prices will average $110 per barrel in 2009, inflation in Thailand should fall from 7.2% this year to 4.2% next year.
Central banks need to err on the conservative side because politicians and businessmen will always clamour for interest rate cuts and oppose interest rate hikes. Economists compare inflation to toothpaste. It is easy to squeeze out toothpaste (allow inflation to rise) but extraordinarily difficult to put the excess back into the tube (bring inflation down).
A proven track record enhances central bank credibility in that its words and actions are taken seriously by market participants. A modest rate hike by a respected central bank will convince banks to curb their credit expansion, businessmen to raise product prices sparingly and labour unions to restrain their wage demands. Such disciplined cooperation from market participants will quickly curb inflation, avoiding the need for frequent and large adjustments in policy rates.
The counter argument is that Thailand faces cost-push inflation while demand is already weakening because of a global slowdown and political uncertainty. Why raise interest rates to weaken demand further? Recent price increases have led to moderate wage increases that are in turn tempting second-round price increases. A series of policy rate increases starting now is necessary to convince market participants that Thai policy makers are serious about inflation. If this is achieved, market participants will keep future price and wage hikes to a minimum, ensuring a self-fulfilling prophecy that inflation will be low.
The second reason is that the policy rate is currently too low. Since the Bank of Thailand (BoT) began its core inflation targeting policy in 2001, core inflation averaged 1.1% while the policy rate averaged 2.7%. This implies the BoT had kept its policy rate 1.6% above core inflation.
Core inflation was 3.6% in June and likely to stay at that level over the next six to nine months. The current policy rate is 3.25%.
Based on past experience, the policy rate should rise to 5.2%. Accordingly, many foreign investors believe that the policy rates will rise by two percentage points over the next 12 months.
With a weakening economic outlook and lower oil prices in 2009, I believe that a rise half that would be sufficient.
The third reason stems from the loosening monetary policy by the US Federal Reserve to insure against possible calamity to its financial institutions burdened by subprime losses. The Fed cut rates from 5.25% to 2% since last August. More telling, the US dollar has weakened from parity with the euro six years ago to $1.56/1 euro at present. Asia's current problem with inflation is no accident. It is the direct result of our penchant for pegging our currencies to the US dollar. Thailand is no exception. In acknowledging the need to contain inflation, the BoT has acted to contain further baht depreciation.
Finally, the BoT's credibility is being tested. It promised to contain core inflation at 3.5%. Moreover, the BoT endeavours to forecast inflation 12 to 18 months ahead so that presumably it would act to increase the policy rate whenever it anticipates that core inflation will exceed the prescribed target. In allowing June's core inflation to breach the target, doubts have already been raised about the BoT's commitment to inflation targeting.
There is no disagreement that inflation should be kept low over the long term. However, the short-term pain is often difficult to accept especially when the long-term consequences of allowing inflation to rise are not clear. In this regard, long-term interest rates provide some clues. Interest paid on 10-year government bonds since 2001 averaged 4.8%. It quickly jumped to nearly 6.2% toward the end of June when concerns about inflation was high. Signals from the BoT that interest rates will be raised may have partly accounted for recent falls in yield to 5.8% today. Failing to follow through could prompt yields to quickly rise again.
This would raise funding costs of the Thai government, corporations and consumers. There is government debt outstanding of 2.1 trillion baht on which interest is payable. The additional cost of financing this debt is 21 billion baht per year if long-term interest rates rise permanently by one percentage point. Corporations unable to issue bonds may forego investment plans or have to rely on bank loans but these have also risen in anticipation of inflation. Mortgage rates are already on the rise. That is, keeping policy rates too low for too long will hurt market participants and overall economic prospects by pushing long-term interest rates higher.
Inflation erodes the value of money and as such inhibits its usefulness as a medium of exchange, store of value and unit of account. A small amount of inflation (2-3%) is acceptable but anything above 5% will be harmful especially to pensioners and low-wage earners.
In the long term, an economy prospers mainly from investment (in equipment and in humans) and technological progress, not from attempts to keep short-term interest rates low.
Indeed, interest rates have fallen during the past 10 years partly because monetary policy successes have brought inflation down over the long term.
Finally, various government ministries (commerce and energy, for example) cannot control inflation but the price controls that they impose can make things worse. Inflation is a rise in the general price level and if this rise is kept high over a prolonged period then it is monetary policy, not the ministries that are to blame.
In preventing certain prices from adjusting to reflect their true costs, government price controls distort relative prices.
Price controls are meant to make essentials available to all at affordable prices. But they always end up creating shortages. Better to allow product prices to rise to reflect their true scarcity.
In that way, the incentive to produce more will not be blocked, ensuring adequate supply both now and in the future. Subsidies directed at the poor (such as in food and petrol coupons) are superior to price controls as a way of helping them cope with higher food and energy prices.
The author is head of research, Phatra Securities Public Co Ltd.
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