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.. .. .. .. .. .. .. .. .. .. .. .. .. .. economics explorer series MONETARY POLICY & THE ECONOMY http://www.mas.gov.sg A closer look at the nuts and bolts behind monetary policy in Singapore – what its objectives are, how it is conducted by MAS, and how it affects the economy. Economic Policy Department .. .. .. .. .. The Monetary Authority of Singapore (MAS) is the central bank of Singapore. Like any other central bank in the world, one of its primary responsibilities is the conduct of monetary policy. This is clearly spelt out in the mission and objectives of MAS as "to conduct monetary and exchange rate policies to promote sustained non-inflationary economic growth". What Is Monetary Policy? In its narrowest definition, monetary policy is the central bank's policy regarding the supply of money in the economy. By changing the amount of money available, the central bank hopes to influence the level of economic activity, which in turn affects the general level of prices in the economy. How Does a Central Bank Conduct Monetary Policy? There are a number of ways in which central banks can increase or decrease the money supply. Some central banks affect money supply directly by increasing or decreasing what is known as the monetary base. This is made up of currency in circulation and cash reserves, which commercial banks keep with the central banks. Other central banks influence the interest rates at which commercial banks can borrow from them, otherwise known as the discount rate. In some small open economies, the central banks choose to anchor their monetary policy to the exchange rate, either by pegging the value of the home currency rigidly to another currency as in the case of a currency board, or by managing it more flexibly against a basket of foreign currencies. The choice of monetary policy instruments depends very much on the circumstances facing each economy. The chart below shows that the central bank could use a variety of instruments to attain its objective of price stability and sustained economic growth. .. .. .. .. .. Objectives of Monetary Policy Instruments of monetary policy: EXCHANGE RATE MONETARY BASE To achieve price stability As the basis for sustained growth INTEREST RATES Many economists now believe that the central bank should focus primarily on achieving price stability, or low inflation, in its conduct of monetary policy. This is based on cross-country experience over the last three decades, which shows that price stability is essential for sustainable economic growth. A Trade-off Between Inflation & Growth Not too long ago, during the 1960s and 1970s, economists and policy makers used to believe that they could bring down unemployment by deliberately stimulating the economy with monetary or fiscal policy, and incurring somewhat higher inflation in the process. This belief, however, was overturned by new economic theories and empirical evidence which emerged subsequently. The trade-off between a bit more inflation and a bit less unemployment can still be made in the short run. But experience has shown that attempts to apply it in the long run do not work. They simply result in everrising inflation. 2 .. .. .. .. .. Output Growth & Inflation: No Trade-Off (Average 1965-2003) 10 China Singapore Taiw an Korea Malaysia Hong Kong 6 Thailand Japan Output Growth (% p.a.) 8 Iceland Mexico Malaw i 4 US UK 2 Israel Indonesia Venezuela Turkey Chile Ghana Uruguay Sierra Leone Germany 0 Zambia -2 0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 CPI Inflation (% p.a.) Price stability is now generally accepted as laying the best foundation for sustained economic growth. Most economists and policy makers consider price stability to be in the ballpark of 0-3% annual change in the consumer price index (CPI). In such an environment, the prices of goods and services are not distorted by inflation and can serve as clearer signals and guides so that resources are allocated more efficiently. In addition, an environment of price stability is believed to encourage saving and investment as it prevents the value of assets from being eroded by unanticipated inflation. Monetary Policy Framework in Singapore Since 1981, monetary policy in Singapore has been centred on the exchange rate. This reflects the fact that, in the small and open Singapore economy, the exchange rate is a more effective tool in maintaining price stability. Why Is Monetary Policy Centred on the Exchange Rate? The choice of the exchange rate – rather than money supply or interest rates – as the principal tool of monetary policy has been influenced by Singapore’s small size and its high degree of openness to trade and capital flows. 3 .. .. .. .. .. Small Size & Limited Resources Openness to Trade Why the Exchange Rate Policy? Openness to Capital Flows Singapore’s small size and lack of natural resources means that we have to import even the most basic of our daily requirements, and export to pay for these requirements. This has resulted in a very open trade policy, with very few import restrictions. Just How Open is Singapore to Trade? As we can see from the chart on the following page, both imports and exports amount to well over 100% of Singapore’s GDP. Another indication of the openness of the Singapore economy is the high import content of final expenditure. As a matter of fact, out of every $1 spent in Singapore, 51 cents leak out as imports1. Openness to Trade: Ratio of Exports & Imports to GDP 230 200 % of GDP Imports 170 140 Exports 110 80 50 1965 1973 1979 1985 1991 1997 2003 What are the consequences of Singapore’s small size and openness? First, because it is too small to influence world prices, Singapore is a price taker. Producers in Singapore have to accept prices dictated by global supply and demand conditions. In addition, the high import content of domestic demand means that changes in world prices or in the exchange rate have a 1 According to the 1995 Input-Output Tables published by the Department of Statistics. 4 .. .. .. .. .. powerful influence on domestic prices, either directly or indirectly. Changes in the exchange rate to offset changes in foreign price levels would thus have a significant effect on inflation. Besides its direct impact on import prices, there is another, more indirect channel by which the exchange rate can affect domestic inflation. Because of the importance of exports in Singapore, the exchange rate can influence overall demand in the economy, and thus affect the demand for domestic resources, such as labour. For instance, a weak exchange rate can lead to stronger exports and aggregate demand, overheating of the economy, a tighter labour market, and consequently, higher domestic wages and other costs. Managing the exchange rate is thus the most effective way of maintaining price stability in a small, open economy like Singapore. It is relatively controllable by the central bank and bears a stable and predictable relationship with the objective of monetary policy, which is price stability. The importance of external demand also means that traditional monetary policy instruments such as money supply or interest rates, which largely affect domestic demand, have a smaller influence on the overall level of economic activity and, therefore, inflation in Singapore. What are the implications of Singapore’s openness to capital flows? In addition, because of Singapore’s role as an international financial centre, the economy is very open to capital flows. As a result, small changes in the difference between domestic and foreign interest rates can lead to large and quick movements of capital. This makes it difficult to target money supply in Singapore. Likewise, domestic interest rates are largely determined by foreign rates and market expectations of movements in the Singapore dollar (S$). As we can see from the chart below, the 3-month domestic interest rate has closely tracked its US$ interest rate equivalent over the years. Thus, any attempt by MAS to raise or lower domestic interest rates over a long period of time, would be thwarted by a shift of funds into or out of Singapore. US$ SIBOR & Domestic Interbank Rate 20 % per annum 16 12 3-m onth US$ SIBOR 8 4 3-m onth Dom estic Interbank Rate 0 1980 1984 1988 1992 End Period 5 1996 2000 2003 .. .. .. .. .. In the context of free capital mobility, the choice of the exchange rate as the focus of monetary policy in Singapore must imply relinquishing control over domestic interest rates and money supply. This constraint is what economists called the Open Economy Trilemma. In Singapore, therefore, monetary policy is synonymous with exchange rate policy. What about Inflation Targeting? Inflation targeting is a relatively new member of the family of monetary policy options. First adopted by New Zealand in 1990, a growing number of central banks – both in industrialised and emerging economies – have since implemented the inflation targeting framework. Characteristics of inflation targeting Frederic Mishkin defines inflation targeting as a monetary policy strategy that encompasses five key elements: · Absence of other nominal anchors; · An institutional commitment to price stability; · Absence of fiscal dominance; · Policy instrument independence; and · Policy transparency and accountability. The case for inflation targeting stems from the consensus that the primary goal of monetary policy in any country ought to be attaining and preserving a low and stable rate of inflation. Pros and cons of inflation targeting Inflation targeting is perceived to have several advantages as a medium-term strategy for monetary policy. The explicit inflation target is not only easily understood by the public, it is also highly transparent and can therefore help to increase the accountability of the central bank. Inflation targeting can also strengthen central bank credibility and reduce the costs of lowering inflation. To the extent that the government is actively involved in setting the inflation target, inflation targeting can help to bring about complementary fiscal policy. 6 .. .. .. .. .. Inflation targeting is not without its problems, however. Since inflation is ultimately an economic variable beyond central banks’ direct control, inflation targeting also faces difficulties in implementation, both in the form of unforeseen shocks to the economy, and the long and variable lags in monetary policy. Should inflation targets fail to be achieved consistently, the central banks’ credibility might be compromised. Inflation targeting should therefore not be seen as a panacea for all economic ills associated with either excessively high or excessively low rates of inflation. It may fail to work if the underlying economic conditions and institutional framework are not right. Conversely, for monetary regimes that already enjoy a high degree of success and credibility, the marginal benefits of switching to an inflation targeting regime are not entirely clear. Singapore and inflation targeting In Singapore, our exchange rate centred monetary policy has served us well in delivering low and stable inflation for more than two decades. While the MAS does not prefer to operate a strict inflation targeting framework, many of its core elements as identified by Mishkin are present in Singapore’s monetary policy system. Thus for example, MAS monetary policy objective is firmly on attaining price stability, which is complemented by the government’s prudent and conservative approach towards fiscal policy. The MAS also has full independence in the formulation and implementation of monetary policy. Indeed, having achieved some degree of credibility in the financial markets, there appears little to be gained by the adoption of a formal inflation targeting regime in Singapore. Instead, a better approach – and one that MAS has already been investing resources in – is the adoption of some desirable features of the inflation targeting system, including the strengthening of the transparency of the monetary policy process. 7 .. .. .. .. .. Characteristics of Monetary Policy in Singapore The Singapore dollar is managed against a Basket of currencies of our major trading partners and competitors. The various currencies are assigned weights in accordance with the importance of the country to Singapore’s trading relations with the rest of the world. The composition of the basket is revised periodically to take into account changes in trade patterns. MAS operates a managed float regime for the Singapore dollar. The tradeweighted exchange rate is allowed to fluctuate within a policy Band, the level and direction of which is announced semi-annually to the market. The band provides a mechanism to accommodate short-term fluctuations in the foreign exchange markets and flexibility in managing the exchange rate. The exchange rate policy band is periodically reviewed to ensure that it remains consistent with underlying fundamentals of the economy. Thus, the policy band incorporates a ‘Crawl’ feature. It is important to continually assess the path of the exchange rate in order to avoid a misalignment in the currency value. The length of the policy review cycle is typically six months. A Monetary Policy Statement (MPS) is released after each review providing information on the recent movements of the exchange rate and explaining the stance of exchange rate policy going forward. An accompanying report, the Macroeconomic Review, provides detailed information on the assessment of macroeconomic developments and trends in the Singapore economy, and is aimed at enhancing market and public understanding of the monetary policy stance. The Transmission Mechanism of Monetary Policy As indicated earlier, there are two main channels or avenues through which the exchange rate policy of MAS affects inflation and economic activity in Singapore. These channels, along with several lesser ones, are collectively known as the "transmission mechanism" of monetary policy. 8 .. .. .. .. .. Import Prices A B External Demand Trade-weighted S$ Exchange Rate INFLATION Total Demand Domestic Demand B C Interest Rate A Expectations/ Confidence Asset Prices Channel A: Impact on Import Prices The first and most direct channel through which monetary policy in Singapore affects inflation is via the effect of the exchange rate on import prices. To understand how this channel works, let us look at a simple example. Suppose MAS depreciates the trade-weighted value of the S$, by selling S$ in exchange for foreign currency in the foreign exchange market. This means that the prices of foreign goods and services which Singapore imports will be higher when converted into S$. This has the direct effect of raising the prices that an average Singaporean household has to pay for imported goods and services that are consumed immediately. It also has the indirect effect of raising the prices of locally produced goods and services that use imported inputs. Some of these price changes, however, may take some time to work through the economy, depending on the speed and extent with which importers and retailers pass through the higher prices to consumers. 9 Weaker S$ exchange rate B Each S$ is worth less in US$ terms Imported goods cost more when converted to S$ Domestic price of imported goods goes up Price of locally produced goods that use imported inputs also goes up Inflation goes up Channel B: Impact on External Demand The second important channel through which monetary policy affects inflation in Singapore is its effect on aggregate demand in the economy. Continuing with our previous example, when MAS depreciates the tradeweighted value of the S$, goods and services produced in Singapore would be more competitively priced in world markets in the short term. This would increase the demand for Singapore’s exports from the rest of the world. In addition, domestic demand would also be boosted by a substitution effect as higher prices for imported goods increase demand for Singapore produced goods. This increase in domestic demand happens when Singapore households subsequently switch to locally produced goods and services when they realise that imported goods and services are relatively more expensive compared to its domestically produced substitutes. To meet the increase in export orders and domestic demand, companies in Singapore would raise their level of production, and require more production workers. As companies compete for the limited pool of workers in Singapore, they would inadvertently bid up wages. This is particularly so when the economy is operating at full or close to full capacity, as was the case in Singapore during much of the 1980s and 1990s. The end result is higher inflation, as companies pass on the higher wages that they have to pay, in the form of higher prices that they charge consumers. This transmission mechanism, i.e. Channel B, is somewhat more complex than Channel A and may take longer to work through the economy. Similarly, when MAS appreciates the trade-weighted value of the S$, inflation would be lowered through this indirect but significant “whiplash” effect via the output channel. For instance, with an exchange rate appreciation, goods produced in Singapore would be less competitive in world markets in the short term, thus lowering demand for Singapore's exports. In addition, domestic demand would be dampened by a substitution effect as lower prices for imported goods reduce demand for Singapore produced goods. The drop in external and domestic demand for Singapore products would lead to lower production and weaker demand for labour, which in turn results in moderating wages and consequently lower prices. However, this takes place at the cost of 10 .. .. .. .. .. reduced output. MAS’ internal studies have shown that this indirect channel has a significantly stronger impact on inflationary outcomes through its contractionary effects on economic activity compared to Channel A. This implies that to pursue a disinflationary strategy, we have to sacrifice output in order to lower inflation via the "whiplash" effect. In this instance, reducing inflation would involve short-term costs associated with a corresponding loss in output. Hence, policymakers in deciding the timing and extent of inflation reduction would have to weigh the benefits of lower inflation against the output cost of such a disinflationary policy. This is usually referred to as the sacrifice ratio, which is the cumulative loss in output, measured as a percent of one-year’s GDP, associated with a one percentage point permanent reduction in inflation. Weaker S$ exchange rate More competitive exports in the short term High export growth & overheated economy Rise in wages and rentals Surge in labour costs A Weaker Exchange Rate for More Competitive Exports? At first glance, it appears tempting to depreciate the nominal exchange rate so as to raise the competitiveness of our exports and boost export growth. Upon closer inspection, however, we find that because of the transmission mechanisms mentioned earlier, the export competitiveness gained from weakening the exchange rate is actually much lower than expected. A weaker exchange rate would indeed cause exports to rise in the short term as predicted. However, this high export growth would cause the economy to overheat, pushing up the demand for domestic resources like labour, and lead eventually to higher wages and prices via Channel B of the monetary policy transmission mechanism. A weaker exchange rate would also directly result in the higher cost of imported inputs for manufacturers via Channel A, and partially offset the gains in export competitiveness. In addition, our internal estimates have also shown that income effects on Singapore’s domestic exports are significantly larger than price effects. In fact, the results suggest that export demand responds twice as much to a change in income than an equivalent change in prices. 11 Inflation goes up .. .. .. .. .. C Channel C: Impact on Domestic Demand Besides the two main channels of transmission described above, MAS' monetary or exchange rate policy also impacts the economy through its influence on domestic demand, for example, via the interest rate, as can be seen in the following box. Changes in the monetary or exchange rate policy can also influence consumer confidence, expectations about the future course of the economy, and asset prices, although their ultimate impact on domestic demand and its timing are even more difficult to assess. How Do Interest Rates Affect the Economy? How does a change in exchange rate impact interest rates? The interest rate is the price at which money today may be traded off for money at a future date. In other words, it is the rate of return to savings or the cost of borrowing. The precise impact on domestic interest rates of a change in the trade-weighted S$ exchange rate is uncertain, as it depends on people's expectations about inflation, foreign interest rates as well as the exchange rate. The central bank can affect interest rates through its influence on market expectations of the future movement of the exchange rate. For instance, during the first half of the 1990s, MAS had a policy of appreciating the trade-weighted exchange rate so as to dampen inflation. As a result, the market expected the S$ exchange rate to appreciate over time, and this led to lower domestic interest rates. And how do interest rates affect the economy? Interest rates impact the economy via their effect on domestic spending on investment and consumption. For example, a rise in interest rates increases companies' borrowing costs, thereby reducing profits and increasing the return that they will require from new investment projects. As a result, this will make companies less likely to undertake new investments. However, the importance of this effect on companies depends on the nature of their business, their size and sources of finance. 12 .. .. .. .. .. In Singapore, it is reckoned that companies in the manufacturing sector may be relatively less affected by interest rate increases, as the sector is dominated by multinational corporations (MNCs) which rely on their own sources of funds, e.g. from their head offices. In contrast, companies in the building and construction sector may be more severely affected as they are more reliant on bank borrowing and their cashflows are much tighter given the long duration of their projects. Higher interest rates also affect the individuals and households, as they face new rates on their savings and debts, in particular mortgages. Any rise in mortgage interest rates will increase the monthly mortgage payments of households. This will reduce the amount of disposable income available to them to spend on goods and services. Moreover, higher interest rates provide a greater incentive for the individuals and households to save for the future rather than to consume now. The end result is a decline in domestic demand and lower inflationary pressures. So How Does the US Federal Reserve Use the Interest Rate? The central bank of the US, the Federal Reserve, uses the federal funds rate as its primary instrument for monetary policy. This is the rate at which banks borrow overnight reserves from one another. As the US is comparable to a large, closed economy, it can influence its own and worldwide interest rates. The Federal Reserve is able to affect the rates by performing Open Market Operations, which involve either the purchase or the sale of securities. For example, by selling securities, the Federal Reserve reduces the amount of reserves which banks hold. Banks then have less money to loan out. This exerts upward pressure on the federal funds rate, which in turn causes other interest rates in the economy to rise. Hence, by raising or lowering the federal funds rate, the Federal Reserve is able to influence interests rates, and by extension, domestic consumption and investment as well. 13 .. .. .. .. .. Transparency in Monetary Policy In recent years, many central banks including MAS have gradually shifted towards adopting greater transparency in monetary policy. The concept of transparency in monetary policy is multi-dimensional; it encompasses the clarification of policy goals, operating procedures and changes in policy stance, as well as the timeliness in reporting policy decisions to the general public. It also includes disclosing information on economic models and economic conditions that the policy decision is based upon. Why is transparency important? The principal argument for greater transparency is to promote accountability, improve market efficiency and enhance the clarity and efficacy of policy, which leads to better economic outcomes. Monetary policy can be made more effective if the public knows the goals and instruments of policy and if the authorities make a credible commitment to meeting them. Good governance also calls for central banks to be accountable for their actions, particularly in free and democratic societies. In establishing understandable rules and procedures, increased transparency in monetary policy would help to improve the workings of financial markets by eliminating unnecessary uncertainties and volatility, enhance central bank credibility, and foster better monetary policymaking by reducing the chances of policy being manipulated for political purposes. It therefore enhances the independence of the central bank in pursuing its objectives. What have we done to improve transparency? In recent years, MAS has made significant progress towards a more open and communicative policy on its monetary policy stance. We have devoted greater efforts to communicating our policy decisions more clearly and frequently to the market, media, and the wider public. One of the key initiatives is the announcement of our exchange rate policy stance in a formal Monetary Policy Statement (MPS) every six months since February 2001. In conjunction with the MPS, MAS has also released the semi-annual publication Macroeconomic Review (MR) since January 2002, with a view to share with the public our assessment of economic developments and outlook in Singapore, and the basis for the policy decision in the MPS. MAS also holds closed-door briefings with the press and with private sector analysts, to clarify any questions they might have on our policy stance. MAS has generally taken a more active role in raising public awareness of economic issues. It has reached out to its target audience through various means, including releasing publications via its website (such as the “Economics 14 .. .. .. .. .. Explorer” pamphlets and “Staff Paper” series), and conducting seminars and presentations for students, private sector analysts, and representatives from other local and overseas agencies. In addition, MAS released two monographs on Singapore’s exchange rate policy and on monetary policy operations in February 2001 and January 2003 respectively. MAS also organised a formal macroeconometric modeling conference in February 2000 to launch the Monetary Model of Singapore (MMS), and in the process help to enhance the public’s understanding of the economic model used by MAS. How has greater transparency enhanced monetary policy? MAS’ move towards greater transparency in monetary policy has been received positively by the media, market and wider public. In promoting understanding of the thinking behind the policy stance, it has helped to align the views of the market with those of the policymakers, thus reducing the need for otherwise heavy interventions by MAS to achieve the desired exchange rate outcome. Greater disclosure and clarity of monetary policy, backed by a long history of credibility, have helped to support and enhance the effectiveness of MAS’ management of the S$ exchange rate. It has also provided greater information to help affect price and wage settings and business decisions, particularly in the recent period of increased volatility in the economic environment. In addition, increased transparency has enhanced MAS’ reputation and image, and fostered the discipline and commitment to meeting its objectives. As greater transparency leads to more open debate and criticism, MAS would need to be able defend its policy objectives and decisions. The resulting competition of ideas and more open dialogue would invariably lead to better and more informed policymaking Constraints of Monetary Policy While it can ensure price stability for sustainable economic growth, monetary policy per se cannot affect the long-term growth capacity of the economy. In the long run, the growth of an economy is determined by supply-side factors such as technological progress, capital accumulation, and the size and quality of the labour force. Some government policies may be able to influence these supply-side factors, but monetary policy generally cannot do so directly. By providing a sound and stable macroeconomic environment, however, monetary policy can ensure the smooth and efficient functioning of the economy, thereby sustaining its growth. Apart from monetary policy, there are a number of other forces affecting output and prices in the economy. For example, the government's actions on its tax and expenditure programmes, i.e. fiscal policy, can have a significant impact on the economy as well as influence people's behaviour and expectations. 15 .. .. .. .. .. Fiscal policy can either constrain or abet central banks in their efforts to ensure low and stable inflation. It is well known that in the post-war years, many newly independent countries launched ambitious social programmes without sufficient tax revenues to pay for them. Often, governments resorted to borrowing and printing money to overcome their revenue shortfalls, leading to high indebtedness and inflation. Monetary Policy does not Work Alone It is important to appreciate that monetary policy does not work alone in Singapore. In addition to having the appropriate monetary policy stance and framework, the effectiveness of the system also depends on several other key factors. Most importantly, the appropriate macroeconomic policy mix, which requires the efficient co-ordination of monetary and fiscal policies, is essential in achieving sustained economic growth over the medium term. Other important factors include, an effective legal and judicial system, an efficient and robust financial sector and an enterprising and sound corporate sector. Supporting factors of monetary policy Prudent fiscal policy Deep and efficient financial markets Sound corporate sector Effective legal and judicial system Other forces affecting demand or supply can be difficult to predict and can affect the economy in unforeseen ways. This is particularly so for a small open economy like Singapore. On the demand side, these include external shocks such as the Asian financial crisis, which saw a slump in external demand for Singapore's goods and services. On the supply side, these include the oil shocks of the early 1970s and 1980s, and natural disasters such as floods or droughts, which raise costs and affect production. As these shocks affect output and prices, monetary policy can attempt to counter their adverse effects on the economy, although it cannot offset them completely. 16 .. .. .. .. .. Monetary Policy… an Art or a Science? There are a number of limiting factors that make the practice of monetary policy more an art rather than a science. Limitations of Monetary Policy First, despite the best effort of the national account statisticians, the central bank does not have up-to-the-minute, reliable information about the state of the economy. Economic data are limited because of lags in their publication as it takes time to capture the myriad transactions in the economy. Besides, some sectors of the economy are difficult to quantify and national account statisticians have to make do with estimates. Second, the central bank, or anyone for that matter, does not have perfect knowledge of how the economy works: its multitude of linkages, causes and effects. Third, monetary policy affects the economy with long and variable lags. The extent of the monetary policy impact can also be uncertain as the structure of the economy changes over time. How MAS deals with these limitations For these reasons, MAS relies on a host of economic indicators as guides to its monetary or exchange rate policy. These include monetary indicators such as the trade-weighted exchange rate, interest rate and money supply, and economic variables such as labour market conditions, inflation and GDP growth. Because of the lags in monetary policy, MAS formulates and conducts monetary policy in a forward-looking manner. This is accomplished by simulating and evaluating the impact of monetary policy over the medium term using macro-econometric models of the economy. As no model can fully capture the workings of the economy, MAS is not wedded to any single model and, instead, relies on several models and tools to inform on its policy. Uncertainty and the lessthan-perfect knowledge of the economy also call for some degree of humility and vigilance in the conduct of monetary policy, as well as regular reviews of policy as new information becomes available. 17 .. .. .. .. .. Conducting Monetary Policy amidst Uncertainty The global economy has been increasingly subjected to more frequent shocks. These include economic and financial as well as shocks of a geopolitical and idiosyncratic nature, such as terrorist attacks and medical pandemics. The sudden and unanticipated nature of such shocks makes it impossible for policymakers to predict accurately the occurrence of such events, and thus poses a significant challenge to monetary policymakers. Nevertheless, it is important for monetary policy to be formulated taking into account the risks associated with such negative shocks, especially given the severe consequences of these shocks. As such, policymakers need to identify and understand the sources of risks and uncertainty facing the economy at the present point in time, and to quantify such risks if possible. They then need to make reasonable assumptions about the economic impact and assign probabilities to the occurrence of these shocks. An assessment of the various possible outcomes under alternative choices for monetary policy must then be made. Finally, policymakers will have to arrive at a judgment and decision about the optimal monetary policy action that maximises the central bank’s likelihood of achieving price stability and sustainable economic growth over time. Indeed, Alan Greenspan, Chairman of the Federal Reserve Board of Governors, has explicitly recognised the role of uncertainty in the conduct of monetary policy. He mentioned that “uncertainty is not just an important feature of the monetary policy landscape; it is the defining characteristic… As a consequence, the conduct of monetary policy in the US at its core involves crucial elements of risk management, a process that requires an understanding of the many sources of risk and uncertainty that policymakers face and quantifying of those risks when possible.” 1 He highlighted further that “a central bank needs to consider not only the most likely future path for the economy but also the distribution of possible outcomes around that path. The decision-makers then need to reach a judgment about the probabilities, costs, and benefits of the various possible outcomes under alternative choices for policy.” 2 1 Greenspan, Alan (2003) “Monetary Policy under Uncertainty” at a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, 29 August. 18 2 Greenspan, Alan (2004) “Testimony of Chairman Alan Greenspan” at a nomination hearing before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, 15 June. economics explorer series The Economics Explorer Series aims to provide an accessible introduction to a broad selection of economic issues, ranging from monetary policy to trade to inflation. It is for anyone interested in taking a closer look at the economic issues affecting Singapore. #1 The Monetary Authority of Singapore #2 Monetary Policy and the Economy #3 Inflation All issues of the Economics Explorer Series can be downloaded from the MAS website at www.mas.gov.sg. 19