Singapore exchange rate policy struggles with inflation

08-10-2007: Singapore exchange rate policy struggles with inflation
Commentary by DBS Group Research

SINGAPORE’s CPI inflation hit a 12-year high of 2.6% year on year (y-o-y) in July. While this was partially due to a two percentage point hike in the GST in July, some structural changes in the economy are also at play. Apart from imported inflation, which can be addressed with the exchange rate policy, much of the current inflationary pressure stems from domestic sources. Plainly, exchange rate policy is not very effective in dealing with domestically driven inflation. Policymakers will need to utilise non-monetary policies to complement the exchange rate policy if inflation is to be kept in check.

CPI inflation hit a 12-year high of 2.6% (y-o-y) in July and accelerated further to 2.9% in August. While the high readings in these two months were partially due to a two percentage point hike in the GST, structural changes in the economy were also responsible.

When the GST was first introduced in April 1994 at 3%, the CPI rose by 0.8% on the month. More recently, when the GST was raised to 4% in January 2003 and 5% in January 2004, the impact on the price level was about 0.3% and 1.1% respectively. The historical data pale in comparison to the 2.1% (month on month) surge in the price level in July this year. In a Nov 29, 2006 research note, we estimated the impact of the two percentage point hike in GST on the price level would be about 1.1 percentage points. Taking this into account, the “underlying” inflation rate in August is about 1.8% (y-o-y). This is considerably lower than the actual inflation rate of 2.9% (y-o-y), which includes the effect of GST, but it still represents a sharp acceleration from the near-zero rate of inflation Singapore enjoyed around the start of the year. Why is inflation — with or without GST impacts — accelerating so rapidly?

Inflationary pressure comes from both external and internal sources. To illustrate this, the various sub-components of the CPI basket are split into tradeables (mostly goods items to reflect imported inflation) and non-tradeables (mostly domestic produced services to represent domestically induced inflation).

Tradable CPI inflation suggests that imported inflation has been easing between January 2006 and June this year. The import price index shows a similar picture. Thus, the appreciation in the Sing dollar suggests that the policy stance of a gradual and modest appreciation in the NEER has helped keep imported inflation at bay.

While inflation targeting is not the only objective of the exchange rate policy, the effectiveness of the policy probably ends there. A large part of recent inflation is due to domestic pressures. Non-tradable CPI inflation has been rising since the third quarter of last year and points to a structural shift in underlying domestic inflation. Unlike monetary policy in most countries which alters interest rate levels, Singapore’s exchange rate policy — which alters the strength of the currency — is less effective in controlling domestically induced inflation.

Strong growth, averaging 7.8% for the last three years has squeezed out spare capacity and driven up input costs. Rental rates are rising rapidly as are prices. The current property market boom is likely to keep rentals and generally housing costs high for some time. Meanwhile, wages have increased rapidly and pushed up unit labour costs.

The risk to inflation is that it leads to secondary effects on asset prices and wages. Inflation has already depressed real returns to saving, bringing real (inflation-adjusted) deposit rates to -2.65% in August this year, the lowest on record. Deposit rates were low to begin with, thanks to abundant liquidity in the banking system. Money supply (M2) growth has been hovering at record highs of 20% since January.

As such, low real interest rates have led to record high loan growth of more than 10% since March 2007.

A negative interest rates scenario favours borrowers, and risks fuelling asset inflation. Left unchecked, this could translate into higher inflation. While no central bank is happy to see negative real interest rates alongside an economy growing at an above-potential rate, a monetary policy based on exchange rates means that interest rates are left to market forces.

Rising wages can also stoke inflation and erode competitiveness. Nominal wage growth has accelerated to 8.5% from 5.5% in 1Q2007 and 3% on average in 2006. With an unemployment rate already low at 2.4% and growth remaining strong, wage growth will be under pressure to accelerate further, absent policy measures.

The central bank (MAS) will hold its semi-annual monetary policy review on October 10 and is expected to maintain its current stance of a modest and gradual appreciation in the nominal effective exchange rate (NEER). Essentially, the exchange rate policy will stick to what it does best, keeping imported inflation at bay, especially when commodity prices continue to creep higher. In fact, we expect the NEER to move into the stronger half of the band as an expected improvement in exports provides room for a stronger currency.

Domestically, policymakers will, by default, have to pursue non-monetary measures to keep asset inflation (particularly property prices) in check. The swift response by authorities in recent months — such as the release of more housing transaction data to raise market transparency, stricter rules regarding en-bloc sales and the release of more Housing and Development Board (HDB) units and land for private residential development — provides a hint of what lies ahead in terms of policy response to asset inflation.

As more of the effects of the current boom in the private market spill over to the mass market (i.e., HDB resale flats), counter measures are likely to get tougher. The authority has an obligation to keep public housing affordable and that implies intervention to cool property markets from time to time.

High wage costs are probably something businesses will have to live with in the short run. There is little policymakers can do in the near term save for encouraging Singaporeans to return to the workforce and to continue importing more foreign labour. However, the key to justifying higher wage cost for businesses would be higher productivity, which is precisely what policymakers have been and will be focusing on in the longer term.

The economy is going through an era of internal rebalancing arising from shifts in domestic supply and demand. Restructuring over the years has improved supply side competitiveness and this helps keep inflation low. But expansionary fiscal policy and growing domestic investment demand is exerting pressure in the opposite direction. Domestic factors appear to be accounting for a growing portion of Singapore’s inflation of late. Because the country’s exchange rate policy (combined with an open capital account) means it has little or no control over interest rates, authorities will need to pursue non-monetary measures to prevent inflation from eroding the competitiveness of the economy.