Why a Bank of Thailand interest rate hike
might be better in the long run
Dr. Supavud Saicheua's analysis
By Jon Fernquest |
Were you ever confused by your textbooks when you studied economics?
If you find the explanations that economists give confusing, then you will appreciate the clear explanation that Dr. Supavud Saicheua, head of research at Phatra Securities, gives today of why an interest rate cut is the best monetary policy choice for the Bank of Thailand (BOT) in the current economic situation.
Read more articles on monetary policy in Thailand from the archives.
Here is the article in full:
ECONOMY
Why must interest rates be increased?
SUPAVUD SAICHEUAMonday July 14, 2008
To raise or not raise interest rates, is the question...
'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?
Interest rate hike would keep inflationary expectations under control
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.
Current inflation targeting policy requires a higher interest rate
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.
Loosening Monetary Policy in US, a source of inflation in Thailand
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.
Hidden Long-term Costs of Inflation
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.
Monetary Policy, not Price Controls, to Fight Inflation
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.
(Source: Bangkok Post, op-ed section, 14-07-08, SUPAVUD SAICHEUA, temp-link)
Vocabulary:
Phatra Securities - a major securities firm in Thailand
in a timely manner, timely - happening at a time when it is most useful
expectations about future price increases would become self-fulfilling -
entrenched - difficult to change, because it is firmly established
expectations - what people believe will happen in the future
inflationary expectations - the inflation that people believe will occur in the future
anchor - tie down, prevent from moving or changing
anchor inflationary expectations - fostering stable public expectations about future inflation, so that these expectations are not changing all the time amplifying uncertainty about the economy and making business decisions difficult to make because you cannot predict future prices
err on the conservative side -
clamour - many people demanding something in a noisy and angry way
clamour for interest rate cuts - many people demanding reduced interest rates (in a noisy and angry way)
a modest increase - a fairly small increase
a modest rate hike - a fairly small increase in interest rates
curb - reduce or stop
credit - loans made, by banks or even by allowing customers to pay their bills slower
credit expansion - making more money available in the economy for loans
curb their credit expansion - stop the trend of loan growth
raise product prices sparingly - some companies raise their prices, but not all companies
disciplined - working in a controlled way
cooperation - people working together to achieve a shared goal
disciplined cooperation from market participants -
cost-push inflation - a sustained rise in prices caused by businesses passing on increases in costs such as energy, fuel, and labour to purchasers (See Wikipedia)
self-fulfilling prophecy - what is said or believed comes to be true because people believe it will happen
core inflation targeting policy - when a country's central bank has a monetary policy of moving the interest rate up and down to decrease or increase the core inflation rate (See Wikipedia)
core inflation - inflation excluding food and energy prices (See Wikipedia)
policy rate, policy interest rate - interest rates that the central bank sets to achieve its policy goal of price stability
price stability - a low steady inflation rate (prices not suddenly increasing, prices not moving up and down a lot)
the economic outlook - the likely state or health of the economy in the future
weakening economic outlook - the future looks keeps looking worse and worse
X stems from Y - X is caused by Y
loosening monetary policy - lowering interest rates, then credit and the money supply expand, output increases, and inflation increases also (that is, according to theory)
a calamity - an event causing damage and personal distress
financial institutions - a term used for banks, trust companies, credit unions, and perhaps other investment companies that deal with money, hold money, invest money (Source: Google definitions)
X burdened by Y - problem Y causes X a lot of difficulty
calamity to its financial institutions burdened by subprime losses
a penchant for Y - have a special liking for Y, have a tendency to do Y
our penchant for pegging our currencies to the US dollar -
credibility - believability, people belief that they will achieve goals when they state goals publicly
the BoT's credibility is being tested - what the BOT decides in this case will show whether they can achieve their long-term goals (instead of giving in to public pressure not to increase rates)
contain Y - control and prevent Y from increasing and spreading (for instance, the government managed to control the outbreak of Avian flue and prevented it from spreading)
contain core inflation at 3.5% - prevent core inflation from going beyond 3.5%
the target - what you aim to reach or achieve (See glossary)
prescribe Y - state that Y must be carried out
the prescribed target - a target, that they have stated must be achieved
exceed the prescribed target, breach the target - go over the target
outstanding - remaining, still existing, has not been settled and closed yet (See glossary)
government debt outstanding - money that the government has borrowed and not paid back yet
forego Y - do without Y (deciding not to have Y which you were planning to have)
in anticipation of Y - done while expecting Y to happen
pensioners - retired people living on a regular fixed income (a pension)
a incentive - a reward given to encourage people to act in a certain way
price controls - government regulations fixing prices of certain goods, in an attempt to control inflation
