Paper on inflation dynamics

Knowledge and understanding of inflation dynamics and its governing factors are of utmost importance to the conduct of monetary policy, especially now that public opinion on policy conduct is divided into two sides, the paper states.

On one side, arguments rest on the fact that because current inflation stems from supplyside factors that are beyond the control of monetary policy, a tightening stance is therefore not needed. Rather, monetary policy should become more accommodative to alleviate the financial burden on businesses and consumers. On the other hand, the opposite side views that monetary policy must be tightened to relieve pressures from continuously high resource utilisation and gradually accelerating inflation expectations.

Throughout the years, supplyside factors that have significantly affected Thai inflation are the world prices of oil and farm products, which together directly impact about onethird of the Consumer Price Index basket.

The analysis shows that in the past, when the prices of these commodities became volatile - for example, during the oil crises in 1973 and 1979, El Nino in 1982 and La Nina in 1988 - such volatilities would quickly disappear.

However, since 2001, the prices of oil and farm products have persistently increased and overall become more volatile compared to the previous periods.

This reflects the working of an additional source of pressure on top of temporary supply disruptions. In particular, demand stemming from strong economic growth and higher standards of living of consumers in emerging economies, especially China and India, in conjunction with the use of crops to produce biofuels, which has led to competition for resources between consumption and biofuel production.

As a result, the prices of oil and farm products are now more intertwined than during the past. At the same time, not only has supply, especially that of oil, become more priceinelastic, but supply disruptions from natural disasters and geopolitical risks have also increased in frequency.

As a result, the prices of oil and farm products could rise significantly and continuously like never seen before.

In an event that the underlying cause of rising inflation is more persistent in nature, the authorities must be mindful that inflation expectations which increase and persist at a high level for a protracted period could cause people to become inflationtolerant and set prices in the economy - namely wages and prices of goods - in a manner that would continue to keep actual inflation at a high level.

An important question is whether or not monetary policy can in fact change the above situation.

The study indicates that from 1971 to 1980, when Thai inflation initially rose as a result of incoming supply shocks, inflation continued to be high for several years (1977-1980) even as temporary shocks had dissipated. Empirical tests show that this was partly a result of monetary policy that was too accommodative at the time as the pegged exchange rate obliged Thailand's monetary policy to follow the loose monetary policy of the United States.

The writers also find evidence to suggest that during times of welldisciplined monetary policy, even if the general price level is hit by temporary shocks, the impact would neither be protracted nor deeply embedded into the inflation dynamics. From this analysis of historical experiences, we are convinced of the importance of achieving monetarypolicy discipline, regardless of whether the cause of inflation would be from the supply or the demand side.

The views expressed in the paper are those of the authors and do not necessarily represent the Bank of Thailand's policies.