The concept of inflation targeting is becoming increasingly popular in Asia. The latest convert is the Bank of Thailand (BOT) which has unveiled details of its move to formal inflation targeting. It will target a core rate of inflation and have a target band which for the 2000-2002 period will be 0.0-3.5%, and may be subsequently revised. The BOT also formalized its main interest rate tool as the 14 day repurchase rate, which currently measures 1.5%.
The BOT plan contains some encouraging elements.
Crucially, the BOT has targeted an appropriate measure of inflation in the core rate, which currently measures around 1.0% in y/y terms (headline CPI rose 1.17% y/y in April). If the BOT had chosen a less stable measure of inflation, say the headline rate, then swings in the business cycle would be exaggerated rather than moderated over the medium-term since the economy would find its self more vulnerable to external shocks such as a rise in oil prices or unfavourable weather conditions affecting the agricultural sector.
Since Thailand is a small open economy, the vulnerability of headline inflation to external shocks is high. This is an important consideration for the Philippines which may also move towards inflation targeting and where it will be vital for BSP to avoid targeting the headline CPI, 55% of which is food related and thus uncorrelated to interest rate settings. An inappropriate inflation target would provide a sell signal for a countryÆs asset markets and currency.
The BOT has not tried to be overly aggressive. The upper level of its inflation band is a wide 3.5% and BOT retains the right to alter this target in the future. While this flexibility will no doubt provoke disfavour with those who expected a bolder inflation target in the line of the ECBÆs 2.0% level, the reality is that as a developing country facing acute structural problems in its banking system, Thailand needs a wide degree of latitude over interest rate policy and thus greater ability to support growth over the medium-term.
An overly aggressive inflation target, for instance, would have added to our pessimism over ThailandÆs ability to restore the intermediation process in its financial system and thus support a firmer recovery in domestic demand.
Admittedly, some concerns remain over the choice of ThailandÆs inflation target. A lower band level of 0% for instance is too low. In the real world, price stability implies some form of positive inflation given the importance of ômoney illusionö, whereby a limited degree of inflation helps support consumer confidence by creating the perception of rising wages even if they are stable in real terms.
More importantly, 0% inflation risks flirting with deflation, which is always highly contractionary in terms of domestic demand. A higher floor level of the target band of say 1.0% would be preferable. As such, there is every reason to believe BOT would favour a level of inflation closer to the middle of the band. (Admittedly, BOTÆs 0% floor rate suggests it is not overly optimistic on quickly closing ThailandÆs output gap.)
What does the inflation targeting scheme imply for our year-end 43 forecast for USD/THB? In short, not much. Our view is based on the fact that Thailand is acutely vulnerable to the current global tightening cycle. Thai economic growth is extremely disappointing with the economy unable to sustain growth above 4.0%-4.5%, despite a large output gap resulting from recessions of 10.4% and 1.7% in 1998 and 1997 respectively.
Thailand can ill afford the reduction of export growth potential implicit in slower global demand growth. The BOT may have to off-set the effect of lower external demand by a more expansive policy towards domestic demand via lower rates. It may also have to tolerate a weaker currency to help prop-up export growth.
Indeed, even before we started raising our forecasts for the scale of the US monetary tightening, we felt there was a risk of lower Thai rates this year. We continue to highlight the risk of a 25-50 bps easing over the next 12 months. At the very least, the repo rate will remain constant this year despite higher US rates.
This suggests a sharply widening yield differential between the THB and USD, which will bias the baht lower. This is particularly true since ThailandÆs weak growth performance, and limited prospects for a swift resolution of the banking crisis (the disposal of NPLs is impeded by inadequate bankruptcy proceedings), is limiting portfolio inflows and FDI. (The BOT forecasts net FDI inflows to fall to $4.3 billion this year from $5.8 billion in 1999.)
The BOTÆs inflation target does not affect this forecast. ThailandÆs large output gap implies limited pressures on core inflation going forward. We anticipate sub-3.5% inflation both this year and next despite the forecast of a weaker THB and low rates.
Admittedly, greater tensions would emerge if BOT eased its two-tier market for USD/THB, since increased THB liquidity offshore would accelerate THB weakness and force us to raise our USD/THB target. This would create a possible tension between the interest rate requirements of the domestic economy and financial sector, and the inflation target in a climate of sharply higher imported inflation.
However, we do not anticipate a liberalization and hence maintain our year-end forecast of 43.0. The maintenance of the two-tier market, however, will imply a bias to an inverted offshore forward curve as the THB trends lower. Hence, inversion trades between the 1 month and 6 month forward curve when the curve moves towards a steep positive slope - as it is prone to do for short periods - is advised.
Desmond Supple is Head of Research, Asia with Barclays Capital.