Wednesday, April 1, 2009

Make monetary policy more flexible

March 31, 2009

By Nizam Idris

THE Singapore Government delivered an aggressive fiscal stimulus package in January. What remains lacking may be a monetary policy stimulus. In my view, there clearly is a role for a more flexible monetary policy setting. The upcoming Monetary Authority of Singapore policy meeting next month would be a good occasion to consider this question.

Even as the rest of the world is easing monetary policy, Singapore's monetary policy actually tightened rather sharply in the months preceding the collapse of the US investment bank Lehman Brothers.

According to my calculations, Singapore's monetary conditions - a weighted average of the country's real interest rates and real exchange rate - have continued to tighten since the end of 2007 when inflation was rearing its ugly head.

MAS' choice of using the exchange rate as a policy tool, while leaving interest rates to float, means that Singapore's nominal interest rates have fallen alongside other global interest rates. But since the fall in inflation has outpaced the fall in nominal interest rates, real interest rates have in fact risen. Meanwhile, the Singapore dollar has been prevented from weakening in trade-weighted terms.

The typical argument against allowing the Singapore dollar to weaken is that it would be futile to do so, for exports will not be helped by a depreciating currency when global demand is weak. But that argument misses the point. Monetary policy now should be aiming not at boosting exports but at avoiding deflation - a prolonged period of falling general prices - an arguably more worrying phenomenon than a cyclical weakness in exports.

The Government did the right thing in pushing out an aggressive fiscal stimulus package ahead of many of its global peers. Such spending will help cushion the impact of weak global demand. But given the economy's dependence on exports, fiscal stimulus alone is not likely to be enough to negate the impact of a sharp fall in global demand. It will have to be complemented with a monetary boost.

Why should deflation be avoided? Surely a fall in general prices should be welcomed, considering that 2008 was a year of high inflation. But if entrenched, deflation can be debilitating.

It can induce consumers to delay consumption. Why buy now when you think things will get cheaper later? Deflation can also prompt firms to delay investment and hiring as they conclude whatever is produced now will be cheaper when they are eventually ready for sale.

Most importantly, deflation will set the economy on a 'debt deflation' course, where the real cost of the debt one holds would be increasing in terms of the things one can buy with the same amount of money relative to when the debt was first incurred. In effect, when deflation sets in, debts become more expensive while asset prices fall - a potent combination that could delay recovery.

Recall that in the wake of the 1997- 1998 Asian financial crisis, Hong Kong endured five years of deflation. But Hong Kong does not have any discretionary monetary policy tool to speak of. It effectively outsourced all of its monetary policy to the United States when it pegged the Hong Kong dollar to the greenback. In times of external shock, such as during the Asian financial crisis, when Hong Kong's economic cycle fell out of sync with that of the US, the lack of monetary policy tools can be crippling.

Singapore, by contrast, does have monetary policy options. It should use all the options open to it.

With global outlook still cloudy just after the unexpected collapse of Lehman last September, MAS adopted a neutral bias towards the Singapore dollar at its last policy meeting in October. While this was a shift away from the previous tightening policy bias - which essentially allowed the currency to strengthen against a basket of currencies - the October move did not allow for additional easing in monetary conditions as the Singapore dollar midpoint was not re-centred.

Inflation was then close to 7 per cent, a 26-year high. Almost six months later, a few things have become clear. For one, the global economy is undergoing a structural shift, dragged down by the collapse of the banking sector as we know it. Prices are expected to fall at an average of 1 per cent this year, deeper than anything we have experienced in 23 years. The economy is expected to contract at an unprecedented rate of 5 per cent this year.

Admittedly, there is a possibility of inflation returning if the recent measures taken by global central banks to boost money supply bear fruit. This too might be taken into account at MAS' April policy meeting.

Current conditions call for more than a run-of-the-mill recentring of the Singapore dollar policy midpoint to the floor of the current policy band. Such recentrings have occurred before, during short-term economic shocks such as the 2003 Sars outbreak. But they may prove insufficient in the current economic turmoil.

A more decisive recentring plus a widening of the policy band to account for the structural shift in the global economy would be more appropriate now. Not only would this provide the economy with the needed monetary easing but a wider band would also provide MAS with more flexibility to accommodate any unforeseen changes in price trend ahead of the next scheduled meeting in October.

A more aggressive monetary policy, to complement the bold fiscal policy the Government has adopted, is necessary to defend the economy against the threat of deflation while giving the central bank flexibility in adjusting to any unexpected return of inflation.

The writer is an executive director of currency research at UBS AG. The opinions expressed here are personal.

[Still so much to learn about economics. So pegging your currency to another (like the US$) is outsourcing your monetary policy. True, mostly true, sometimes true, true only from one perspective, or hardly ever true?]

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