Inflation targeting - from core to headline

From the pegged currency era before the Asian Financial Crisis, to the early days of the inflation-targeting regime, the Band of Thailand has adjusted its policy in response to developments in the global economy.

In its latest move, the central bank had proposed using the headline consumer price index (CPI), the broadest gauge of inflation, as the reference for monetary policy instead of core CPI. 

The rationale is that headline inflation is more easily understood by the public, as it also reflects changes in food and energy prices, which account for 27 per cent of the CPI basket. 

Most Asian economies, as well as Australia and New Zealand, use this method to set policy targets, with varying degrees of flexibility and some differences in policy objectives.

According to the proposal, headline CPI will be adopted as the monetary policy target next year, with a midpoint of 3 per cent and a 1.5-per-cent range, based on its annual average. The existing target range is 0.5-3 per cent for the quarterly average of core inflation. 

Elsewhere, this year Malaysia is using a headline CPI range of 2-3 per cent, Indonesia 3.5-5.5 per cent and the Philippines 3-5 per cent. The central bank has also stated that the 3-per-cent midpoint is broadly in line with Thailand’s trading partners and should not compromise the economy’s competitiveness, especially when exports account for about 70 per cent of GDP.

For this change to materialise, the central bank needs to get the nods of the Finance Ministry and Cabinet.

The central bank said the change should help “promote central bank communication and the anchoring of inflation expectation”. In this sense, there could be some benefit from the switch to headline CPI. 

While the central bank has often communicated to the public its forecasts for both headline and core inflation rates, we note that business’ inflation expectations have been mostly in line with the most recent rather than future inflation rates. 

This could be because using a core inflation range does not give businesses a clear signal about headline inflation or the policy target range for core inflation. Thus, businesses may have relied on their most recent experiences, plus some market forecasts. 

If the central bank changes its style of communication, by giving signals about inflation being above or below the midpoint, it could help to bridge the gap between expectations and policy targets.

This could also help anchor nominal wages in the future, especially for manufacturing, where the labour shortage in several industries has pushed wages up more rapidly than headline inflation, notwithstanding the recent increase in the minimum wage.

A second benefit is that the central bank would have a little more flexibility. Responses to near-term price changes, in order to achieve economic goals other than price stability, could be made more promptly.

For instance, when headline and core inflation diverge sharply, perhaps due to a surge in global energy or food prices, the central bank could opt to raise interest rates as a pre-emptive move, even when core inflation has risen only marginally, or is not projected to breach the target range. 

Such flexibility would allow the central bank to make a prompt response, which would benefit economic stability. Of course, the central bank has many other tools, such as the macro-prudential measures it has used to curb property prices in the past. 

However, these tools may not have such an immediate and economy-wide impact as the policy rate, although they have other advantages. They can target specific areas and also be implemented quickly without disrupting the direction of monetary policy.

Besides those two benefits, we do not think that the new approach will have a significant impact on the central bank’s monetary policy in the medium term and we expect it to maintain its 2-per-cent policy rate through the first half of next year to support the economic recovery.

For the initial stage of the transition, the central bank has chosen a wide enough range for its proposed target, which is largely in line with the core inflation range. This range should also help to ensure that fluctuations in inflation during the reform of energy prices would not disrupt the general thrust of monetary policy. That is, if the target range were too narrow, breaching the target may give rise to expectations of rate hikes.

 We can see that both headline and core inflation rates remained within the policy target range most of the time. The exceptions coincided with substantial changes in global commodity prices, such as before and after the Global Financial Crisis of 2008. From 2010-14, both inflation rates remained within the current and proposed target ranges. 

We also agree that the 3-per-cent midpoint is consistent with average long-term inflation, given that average headline inflation over the past 14 years was 2.7 per cent. The transition should not alter the public’s perceptions of long-term inflation.

Last but not least, we think it will be interesting to watch the development of the central bank. In recent years, it has made a few significant changes, including the disclosure of monetary policy committee (MPC) minutes, MPC votes and the use of market rates instead of a constant policy rate in its forecasting models. 

These are in line with the thoughts of two independent evaluators, Stephen Grenville and Takatoshi Ito, who were commissioned to make recommendations on Thailand’s monetary policy framework over 2000-10. 

As the economy develops, the central bank may propose further changes to the midpoint and the range, should they coincide with future policy objectives. Or, more economic objectives may be added to the policy framework due to the increased challenges faced by the global economy, including financial market stability.

Of course, as an inflation-targeting central bank, the Thai authority will face challenges in terms of communicating with the public as well as maintaining its credibility. Failure to maintain credibility will have serious implications for long-term interest rates, exchange rates and overall economic stability. 

Fortunately, it seems that the performance of the central bank has been satisfactory, at least in the eyes of Grenville and Ito. More information can be found on the central bank’s website.

 

Nalin Chutchotitham is Thailand economist at HSBC Global Research