Guru Speak

Under the inflationtar¬geting regime, the policy interest rate is the primary tool to signal monetary policy, while the exchange rate has taken the back bench and only plays its conventional roles in transmit¬ting monetary policy and acting as a shockabsorber.

As a transmission channel, changes in the policy rate are expected to induce returnseek¬ing movements of capital, result¬ing in exchangerate changes being transmitted to the econo¬my.

However, evidence suggests that the exchange rate does not fare well in transmitting mone¬tary policy due to its weak link¬age with domestic interest rates. This is because the impact of interest differentials on capital flows may be overwhelmed by the effects of exchangerate expectations, portfolio diversifi¬cation, risk exposure and capi¬talaccount regulations.

When the transmission chan¬nel is clogged, the efficacy of monetary policy through the exchangerate avenue can be greatly diminished. Managing the rate directly through foreignexchange intervention can there¬fore enhance the policy impact on the inflation objective. Although managing the exchange rate is consistent with inflationtargeting, international experience sug¬gests little sup¬port on the evi¬dence of the explicit use of such policy.

Until recently, contradictory views on the con¬duct of monetary policy arose as increases in the world price of oil and other com¬modities exerted upward pressure on global inflation while the Thai economic recov¬ery remained soft. Under these circumstances, hikes in the poli¬cy rate to lower inflationary pres¬sure could prove to be unpopular.

Questions on the use of exchangerate management to supplement interestrate poli¬cy in bringing down inflation have again been brought up. These questions are valid because a strong currency can directly moderate the prices of import¬ed raw materials such as oil and finished import items in baht terms, thus alleviating the exogenouslyinduced inflation¬ary pressure.

We need, however, to bear in mind the limitations on the use of the exchange rate as a policy tool. First and of foremost con¬cern is to what extent we are able to manoeuvre the exchange rate in the desired direction. Due to the volatile nature of exchange rates, the ability to control them is limited, and the impact of foreignexchange intervention on inflation is rapid but shortlived. A change in the interest rate has a gradual but longlasting impact.

Whilst a change in the interest rate, which is easy to engineer, has a gradual but longlasting impact on inflation, changes in monetary policy lag.Given such limitations, the policy rate remains the major policy tool, while the use of the exchange rate should be supple¬mentary and only in the case of temporary inflation shock to help contain inflation expecta¬tions.

However, when inflationary pressure is persistent, the use of the interest rate is more appro¬priate, since prolonged foreignexchange intervention can lead to distortions in resource alloca¬tion. If the conduct of monetary policy were a game of football, the supplementary but essential roles of the exchange rate would be those of an MVP (most valu¬able player) who in the event never scores.

Views expressed are the author's own.