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Thailand had since the financial meltdown enjoyed a benign inflationary environment with headline and core inflation ranging from 0.7-4.7 per cent and 0.2-2.3 per cent respectively. The recent oil upheaval has, however, changed all that. The explosive surge in the world price of oil coupled with a drastic increase in the price of food catapulted headline inflation to 9.2 per cent in July of this year with core inflation surpassing target rates for the first time since 2000.

Indeed, much controversy has centred on the role of monetary policy in putting paid to the underlying inflationary pressures. On the one hand we have economic pundits who argue that monetary tightening is unwarranted because soaring prices stem solely from temporary supply shocks - weather disruptions, geopolitical conflicts and other unanticipated hiccups - and speculation. Against this backdrop, raising interest rates to rein in inflationary pressures would be a futile exercise, they say, having the adverse effect of reducing aggregate demand, thereby putting a drag on growth and employment.

Given today's supply-side cost-push shock, why do most central banks around the world resort to interest rates as the policy instrument to combat inflation? The answer probably lies in their belief in monetarism, an economic doctrine which argues that "inflation is always and everywhere a monetary phenomenon", and their adherence to inflation-targeting theory. Implicit in this theory is the assumption that inflation reflects an increase in the supply of money and adjusting interest rates will increase or decrease money supply and hence inflation; based on the inverse relationship between interest rates and the inflation rate, monetary tightening is called for in the event that the latter exceeds the target level.

Some central bankers even argue that the real driving force behind rising world inflation is not so much a demand-led energy- and food-price shock but a very lax global monetary-policy stance. In industrialised countries the main culprits are the US Federal Reserve and its easy-money binge in response to the credit crisis, and the Bank of Japan's ultra-low interest-rate policy. Monetary policy is even easier in other parts of the world, notably Asian and East European countries as well as countries in the Middle East. It is thus hardly surprising that inflation is accelerating everywhere with food and energy prices being simply the first to react to the great monetary easing. To nip inflationary pressures in the bud, a central bank must be prepared to raise rates to much higher levels, and the domestic currency should appreciate sufficiently to offset rising import prices.

Another reason that has been propounded to support tighter monetary policy in Thailand is the abrupt change in the nature of the supply shocks. During the first oil shock of the 1970s, supply disruptions tended to be temporary in nature, but inflation persisted for several years thereafter as the aftermath of accommodative monetary stance. The second oil crisis of the 1980s, on the other hand, witnessed a significant decline in inflation after the short-term supply disruptions dissipated thanks to the adoption of restrictive monetary stance. Yet with the current oil upheaval, the rising price level is more than just a temporary blip as a result of the structural shifts in the demand for and supply of oil and food. Under such circumstances, an accommodative monetary stance could prolong the effect of exogenous shocks on inflation.

Tighter monetary policy can also help anchor inflation expectations, thus enabling inflationary pressures to dissipate as transitory shocks subside. This is particularly true in the case of emerging economies where oil and food account for about half of average household expenditure. In Thailand's case, food constitutes about 35 per cent of the consumer price index compared with about 15 per cent for advanced countries, so that changes in food prices have a much greater impact on inflation expectations and wage demands here. Thus tighter monetary policy is needed to anchor inflation expectations and prevent second-round price effects from permeating the economy.

To opponents of the inflation-targeters the above explanations do not hold water, as they are not strongly supported by either economic theory or empirical evidence. Accordingly it is absurd to increase interest rates in response to today's inflation. Rates would have to be increased to an unbearable level which would have a devastating impact on output and employment before inflation could be brought down to the target. Some opponents point to Turkey and South Africa, adherents of the inflation-targeting regime, as countries missing their inflation targets for many years. The former has become the first inflation-targeter to increase its inflation targets after missing them badly while blaming its failure on imported inflation. Turkey aside, there are several other inflation-targeting countries, both industrialised and non-industrialised, that are in breach of their inflation targets. By missing its inflation target for many years in a row, Turkey may be the first country to relinquish the inflation-targeting regime altogether.

Now that exogenous shocks have abated with the price of oil and other commodities declining sharply, inflation must have reached its acme in many parts of the world. Barring any new geopolitical conflicts or unforeseen natural calamities, global inflation should continue its downward trend, thereby lessening political pressures on the central banks in their conduct of monetary policy.

 

Suphachai Sophastienphong is the chief economist at Siam Commercial Bank