VI. Monetary and exchange rate policy options1
A. Introduction and Summary
1. In September 1998, Malaysia imposed selective exchange controls in order to achieve monetary independence. That independence has been used to reorient monetary policy toward the stabilization and recovery of the domestic economy. The authorities, however, have indicated that controls are intended to be temporary, and steps have already been taken in recent months to liberalize some elements of the controls.
2. This paper considers Malaysia’s monetary policy options in the context of a prospective return to a relatively open capital account. The fundamental choices are between returning to the pre-crisis regime involving very limited exchange rate flexibility, or moving toward a more flexible exchange rate regime. A more-or-less fixed exchange rate regime would imply that monetary policy could not be used to contain domestic inflation and stabilize output, at least over medium-term horizons.
3. In the 1980s and 1990s, the Malaysian economy has periodically been buffeted by significant external shocks including terms-of-trade shifts and large-scale capital flows. On such occasions, a sharp conflict has arisen between the objective of maintaining a stable nominal exchange rate and promoting domestic economic stability.2 To minimize the conflict between policy objectives in such situations, the authorities have responded with a variety of temporary administrative measures, including exchange controls. By their nature, however, such measures have tended to be adopted following crises rather than preemptively and, consequently, do not appear to have been very effective in insulating the economy from external shocks. In view of this experience, it is recommended that Malaysia move toward a more flexible exchange rate regime so as to facilitate the pursuit of domestic stabilization objectives within an open capital markets framework.
4. The paper examines flexible exchange rate policy frameworks consistent with the central objective of Malaysian monetary policy of maintaining low inflation: monetary targeting, inflation targeting, and nominal income targeting. Empirical evidence suggests that demand for Ml may be sufficiently stable to use as an indicator variable for policy, but further research would be needed to determine its suitability in the more demanding role of an intermediate target variable. Like central banks in most industrialized countries, Bank Negara Malaysia (BNM) concern over the stability of the monetary aggregates has led them to downgrade the importance of the monetary aggregates as policy indicators over the past decade. Empirical evidence also suggests that the alternative of direct inflation targeting may be a superior option for Malaysia. The main concern with practical implementation, in current circumstances in particular, is uncertainty regarding the level of “potential” or noninflationary output. If estimates of potential output are very uncertain, a less forward-looking but also less risky approach, such as nominal income targeting, might be appropriate, at least until potential output could be estimated with greater confidence.
5. The possibility of a mixed regime, involving some limits on exchange rate flexibility is also considered. In order to minimize the inherent conflict between policy objectives implicit in such a framework—and market testing of policy priorities—a fairly wide exchange rate target range would be required. An alternative approach would be to pursue inflation targeting with an element of exchange rate smoothing built in, but recognizing that this smoothing would likely come at a cost of higher cyclical variation of inflation and output and greater vulnerability to speculative pressures on the currency. Sterilized intervention in the exchange market to counter very short-term volatility would be compatible with maintaining a flexible exchange rate over the medium term.
6. Institutional and communications issues relating to the adoption of a policy framework involving more exchange rate flexibility are also discussed. Fundamentally, a more flexible exchange rate regime gives greater policy autonomy to the central bank. To ensure that such autonomy commands credibility, arrangements would be required to bolster policy accountability, mainly through enhanced public communication by the central bank.
7. In the annex, practical issues relating to the implementation of an alternative policy framework are discussed. These include: the choice of the target measure of inflation; factors affecting the width of the target range; the choice of the policy horizon and its implications for the weight placed on the exchange rate in setting policy; and key elements needed in the inflation forecasting framework.
8. With the eruption of the Asian financial crisis in mid-1997 monetary policy in Malaysia, as in most other countries in the region, was faced simultaneously by downward pressure on the exchange rate, falling asset prices, and financial system distress. A basic dilemma in formulating policy in these circumstances was whether to respond mainly to the prospect of weakening demand resulting from falling asset prices and increased liquidity constraints, or to focus primarily on resisting further weakness in the exchange rate and the impact of currency depreciation on consumer prices. Following the brief initial defense of the ringgit, monetary policy in Malaysia could be characterized as following a somewhat mixed strategy. Although downward pressures on the currency were not fully resisted, concern for the inflation outlook and continuing exchange market pressures led the stance of policy to be progressively tightened over the latter part of the year and into early 1998, through interest rate increases and administrative measures to restrict credit growth.
9. In the second quarter of 1998, the government shifted the stance of fiscal policy from restraint toward stimulus. By easing the policy dilemma facing monetary policy, the announcement of the fiscal measures likely contributed to some stabilization of exchange rate expectations. Nonetheless, by midyear, as evidence emerged of a very sharp contraction of activity and, consequently, a lowering of prospective inflation pressures, monetary policy also began to be eased.
10. Monetary policy was decisively reoriented toward domestic stimulus in September, with the imposition of controls on short-term capital flows and the pegging of the exchange rate against the dollar. In other words, the authorities responded to the policy dilemma or conflict by introducing an additional policy instrument capital—controls—in order to be able to pursue both domestic and external objectives simultaneously. In the period since September, interest rates in Malaysia have eased significantly, while the exchange rate has remained stable and official reserves have risen.3
11. The authorities have made clear that the controls introduced in September were intended as a temporary measure. Over the period since their introduction, controls have been liberalized in a number of areas. The most important modification to date has been the replacement of the one-year holding period restriction on nonresident portfolio capital with a system of graduated levies on repatriation of capital and/or profits.
C. Options in the Choice of Monetary Policy Frameworks
12. As restrictions on capital flows are further liberalized, the authorities will need to determine what form of monetary policy framework will best serve the achievement of their macroeconomic objectives on a sustainable basis.
13. A fundamental decision to be made in the choice of a monetary policy regime is between the commitment to a fixed exchange rate and the adoption of a flexible exchange rate regime. Frankel (1995) provides a clear exposition of the “impossible trinity” of simultaneously maintaining open capital markets, a fixed exchange rate, and monetary independence. Frankel also indicates that sterilized intervention by the central bank can only temporarily delay this trade-off. In Malaysia’s case, the return to international capital mobility will eventually require the authorities to choose between maintaining a fixed exchange rate, involving a loss of monetary independence, or adopting a flexible exchange rate in order to retain monetary independence.
A fixed exchange rate regime
14. In general, the case for a fixed exchange rate depends on the evaluation of the microeconomic benefits of a fixed exchange rate as compared with the macroeconomic costs of a loss of monetary independence.4 The optimum currency area literature, pioneered by Mundell (1961), identifies a number of key considerations that, in principle, should influence the evaluation. These include, notably, the degree of trade or product market integration of the currency areas (in a two country world, this would be equivalent to “openness”), the degree of labor mobility between the two countries, the extent of price and wage flexibility, and the degree to which the two areas are similar in terms of economic structure and exposure to asymmetric shocks.
15. The more closely integrated the two economies, the larger will be the microeconomic benefits of a fixed exchange rate. Indeed, taken to its logical conclusion, these benefits would be maximized by the formal adoption of a common currency, not by a pegged exchange rate or even by a currency board arrangement. The microeconomic benefits will be gained at least cost in terms of macroeconomic performance if the two economies are very similar in terms of structure, other policy settings, and exposure to external disturbances. In this event, loss of monetary independence has little meaning, since the partner country’s monetary policy would be appropriate for both. Alternatively, even if the two economies differ in important respects, if labor is highly mobile, or prices and wages are highly flexible, the gains from the pursuit of an independent monetary policy are very limited.5
16. In the case of Malaysia, it seems unlikely that the potential microeconomic benefits of currency integration with any of its principal trading partners—Japan, the United States, Singapore, and the Euro area—would outweigh the macroeconomic cost of an exchange rate union. Although the Malaysian economy is very open to trade, with the value of exports and imports each over 100 percent of GDP, its trade is not highly concentrated on any one partner country. The United States, Japan, and Singapore each account for 17 percent to 18 percent of Malaysia’s external trade, while the Euro area share is a little over 10 percent. The proportion of total trade invoiced in dollars is estimated to be much higher—around 70 percent6—than the share of trade with the United States, but is not likely to be markedly higher than for most other countries.
17. The high ratios of imports and exports relative to GDP may also give a somewhat misleading impression of the microeconomic benefits to be gained from currency integration with either the dollar or the Japanese yen. The very high ratios of imports and exports to GDP reflect the fact that much of Malaysia’s trade involves importation of materials for processing and reexport. For many of the firms involved in the traded goods sector, particularly the subsidiaries of multinationals, much of their financial activity is likely to be conducted in dollars, or possibly yen, whatever Malaysia’s exchange rate regime. Consequently, the potential saving to businesses in terms of exchange transaction costs or currency risk hedging would likely be significantly less than the trade numbers might suggest at first glance. This would be especially the case if full currency union did not occur, since transaction costs of currency conversion and some currency risk would still remain.
18. On the other side of the ledger, for Malaysia the macroeconomic cost of a loss of monetary autonomy could be substantial. Experiences of the 1980s and 1990s show that the Malaysian economy is subject to quite different macroeconomic developments than the U.S. and Japanese economies. Despite the importance of the U.S. and Japanese markets for Malaysian exports, Malaysia’s business cycle has shown significant divergences from the U.S. or Japanese business cycles. The emphasis placed on limiting movement in the nominal exchange rate of the ringgit against the U.S. dollar throughout the 1980s and 1990s very much constrained the ability of BNM to tailor its policy to domestic stabilization needs.
19. Indeed, the commitment to nominal exchange rate stability may have induced an element of procyclical monetary policy responses to shocks. In the event of shocks that affect the equilibrium real exchange rate, resisting adjustment in the nominal exchange rate forces adjustment to take place through domestic output and price performance. In 1985–86, for example, Malaysia experienced an adverse terms-of-trade shock, leading to downward pressure on the ringgit.7 To resist this pressure, interest rates were increased, accentuating the adverse output consequences of the terms-of-trade shock.8 In 1993–94, Malaysia experienced strong capital inflows, putting upward pressure on the exchange rate. Despite the recognition that the inflows could lead to overheating in the economy, interest rates were allowed to fall sharply in order to maintain exchange rate stability.9 These episodes suggest that a monetary policy framework based on very limited exchange rate flexibility may accentuate rather than dampen the cyclical output and inflation effects of the sorts of shocks to which Malaysia is exposed.
20. Malaysia’s experience also suggests that the use of administrative measures to supplement the main instruments of policy have not been particularly effective as substitutes for exchange rate flexibility in moderating the business cycle. Periodically through the 1980s and 1990s, BNM has introduced special measures to cushion domestic economic performance from disturbances while continuing to direct the main instrument of monetary policy—interest rates—toward stabilization of the exchange rate:
- In 1985–87, controls on deposit rates and lending rates were introduced to insulate domestic activity somewhat from increases in financial market rates.10
- In 1994, reserve requirements were raised; eligible liabilities were broadened to include external borrowing; the net external liability position of each bank was subjected to a limit; residents were prohibited from short-selling money market instruments to nonresidents; commercial banks were required to make deposits at BNM equivalent to the gross credit balances held in noninterest bearing vostro accounts (and such balances were included in the definition of eligible liabilities); and commercial banks were directed to cease nontrade related swaps and outright forward transactions on the bid side with foreign customers.11
- In 1998, selective exchange controls were imposed; guidelines were set for loan growth by individual banks; and restrictions on lending to certain sectors imposed in some cases and relaxed in others.
21. Such measures are generally regarded as likely to lead to inefficiencies and misallocation of resources. A more important drawback in practice appears to be that, because such measures are introduced in a discretionary manner, and with some reluctance, they tend to be applied too late to prevent much of the damage that they are intended to prevent. In this regard, Aziz (1995) provides a telling account of Malaysia’s 1993–94 experience with large-scale short-term capital inflows. Capital inflows began on a large scale in 1993, and a variety of administrative measures were adopted in early 1994 to contain the impact of the inflows. Nonetheless, most of the potentially adverse consequences of short-term capital inflows identified by Aziz—including downward pressure on domestic interest rates, rapid money growth, sharp increases in asset prices, and over-heating of domestic demand—did in fact come to pass.
22. Direct evidence on the degree of wage and price flexibility in the Malaysian economy is scanty. However, the fact that the major shocks to the Malaysian economy in the 1980s and 1990s did lead to large swings in output is a strong indirect indication that wages and prices are not exceptionally flexible in Malaysia. This, in turn, implies that monetary policy can have significant short-term effects on economic performance.
23. In short, Malaysia’s macroeconomic experience in the 1980s and 1990s strongly suggests that if BNM is to pursue a macroeconomic stabilization objective, a more flexible exchange rate regime vis-à-vis the dollar will be necessary.12
Flexible exchange rate regimes
24. Within a flexible exchange rate regime, the main alternative monetary policy frameworks for providing a long-term nominal anchor are monetary targeting, inflation targeting, and nominal income targeting. Each of these options is considered below, followed by a discussion of whether and how such frameworks might be supplemented by constraints on the degree of exchange rate flexibility.
25. The most traditional nominal anchor for monetary policy has been the use of a monetary aggregate as an intermediate target variable. The ultimate target implicit in this framework is nominal spending or income. For a monetary aggregate to perform well in the role of an intermediate target variable, three conditions should be satisfied:
- The relationship between money and nominal income growth should be predictable, at least over the medium term. If the relationship is unstable, then even if the central bank is able to achieve its intermediate target, there is no assurance that it will achieve its ultimate objective.
- The relationship between adjustments in monetary policy instruments and money growth should also be stable. Otherwise, achieving the desired rate of monetary expansion will be very uncertain.
- Monetary growth should not have a lagged relationship with nominal income growth. If money growth is a lagging rather than a leading indicator of nominal income growth, then use of money as an intermediate target will lead to greater variability of nominal income than targeting nominal income more directly.13
26. Evidence on the suitability of monetary aggregates as intermediate targets is mixed. In a recent study, Dekle and Pradhan (1997) found that demand for narrow money as well as broad money in Malaysia was stable over the long term, but also that real interest rates only exerted a significant influence over narrow money growth.14 In addition, the authors did not find clear evidence that money growth led nominal income growth, a result consistent with the findings of Coe and McDermott (1997).15
27. The empirical evidence lends support to BNM’s use of the monetary aggregates as policy indicators rather than as intermediate targets. Alowi (1997) indicates that in the 1980s structural changes affecting demand for Ml led the BNM to shift its focus to M2, and then, in 1984, to M3. Subsequently, with the increasing development of the financial system, attention shifted increasingly away from money aggregates toward market interest rates and money market liquidity conditions as policy indicators.16 The evolution of BNM’s approach has been similar to those of central banks elsewhere: almost all central banks pay some attention to developments in money and credit aggregates, but since the 1980s, virtually all have demoted monetary aggregates from the traditional role of intermediate targets to the lesser role of just one of many economic indicators. Indeed, Svensson (1998) observes that despite its formal commitment to intermediate monetary targeting, in practice the “Bundesbank has systematically and intentionally missed its money target…,” implying that even the Bundesbank has normally based policy actions on considerations other than the growth of money relative to the target range.
28. In view of the questionable suitability of using monetary aggregates as intermediate policy targets, it would be sensible to consider the alternative of adjusting policy instruments directly in response to changes in the outlook for inflation relative to a publicly announced target, that is, to adopt an explicit inflation targeting framework.17
29. As with intermediate monetary targeting, a number of potential obstacles could make inflation targeting impractical. Masson et al (1997) identify three particular threats to the successful or sustainable pursuit of inflation targeting in developing countries: dependence of the fiscal authorities on seigniorage and inflation taxes; fragility of the banking system; and shallow capital markets.
30. Such obstacles are relevant to any monetary policy framework—not just inflation targeting—while a number of other considerations would favor inflation targeting in Malaysia:
- Although the Masson et al study indicates a relatively high seigniorage benefit to the Malaysian Treasury over the sample period used, it would not be reasonable to go so far as to suggest that the fiscal authorities are so dependent on this source of revenue that commitment to a low inflation environment would be dismissed as unsustainable.
- Banking system fragility is not particularly an argument against inflation targeting; systemic financial crises can undermine any monetary policy regime. In the Malaysian case, this provides a strong argument for linking the institution of a new monetary policy framework to progress in restructuring of the financial system.
- The likelihood of a systemic financial crisis may not be independent of the monetary policy regime in place. To the extent that inflation targeting (or monetary targeting) leads to dampening of cyclical booms and busts and associated swings in asset prices, it may be less vulnerable to banking system crises than is a framework based on much more limited exchange rate flexibility.
- Shallow capital markets, like financial fragility, complicate the implementation of any monetary policy framework, not just inflation targeting. The more important point is that the kinds of measures referred to in Masson et al as contributing to shallow financial markets hamper the effective implementation of virtually any monetary policy framework.18 Consequently, this is not so much an argument against inflation targeting as an argument for eschewing the kinds of measures that contribute to shallow capital markets.
- BNM already enjoys a reputation for maintaining low inflation, so that the adoption of an explicit target for inflation would not require a potentially difficult adjustment of private sector expectations.
- Inflation targeting requires timely, good quality economic statistics and a well-trained central bank staff able to analyze developments, provide high quality advice to the management on policy formulation, and communicate policy to the public. BNM is much better placed than most developing country central banks with regard to the availability of economic data and the capability of its staff.
31. Implementation of inflation targeting in Malaysia would require some modifications to the way in which policy is formulated and working through a number of technical issues. The main issues are discussed in somewhat greater detail in Annex VI.1, but are outlined briefly below:
- A target range for inflation would need to be specified. The center of the range should correspond to the authorities’ desired long-term average inflation rate and should take into account measurement biases in the price index. The width of the range needs to strike a balance between its role in influencing expectations of the public, and its role in providing policy accountability or discipline. The width of the range should also take into account whether the target inflation measure excludes most supply disturbances.
- The policy horizon for achieving the inflation target should also be specified. If inflation targeting is to be consistent with stabilization of output, the policy horizon should be long enough—typically one to two years—for the main influence of monetary policy to be exerted through its influence on aggregate demand. A particularly important implication of targeting inflation at the one- to two-year horizon is that the direct, but temporary, effects of exchange rate movements on inflation would not elicit a policy response. Policy would, however, respond to the longer-lasting effects of exchange rate movements on demand and expectations.19
- An inflation forecasting framework would need to be developed, linking adjustments in the stance of policy to medium-term output and inflation developments. The inflation forecasts would play a central role in formulating policy.
32. An important implication of lengthening the policy horizon is that it should tend to lessen reliance on administrative measures in implementing monetary policy. Pressures to resort to administrative measures would be lessened in two ways. First, resort to administrative measures tends to be most likely in the event of supply disturbances which generate a conflict between the central bank’s commitment to maintaining stable inflation and its desire to stabilize real activity. Administrative measures are used, in effect, to introduce additional policy instruments so that more than one objective can be pursued, at least temporarily. Lengthening the policy horizon to the one- to two-year horizon is specifically intended to minimize this conflict by placing the inflation objective beyond the influence of recent supply disturbances. Second, if the policy horizon is short relative to the speed of transmission of interest rate changes to activity and inflation, then there will naturally be a tendency to resort to administrative measures that may act more rapidly, even if they distort efficient operation of the economy. Lengthening the policy horizon will lessen this tendency or incentive toward quick but distortionary “fixes.”
33. Perhaps the most important technical challenge to effective implementation of inflation targeting is the difficulty of measuring the degree of excess supply or excess demand in the economy. As discussed in the Annex, Coe and McDermott (1997) constructed a measure of excess demand for Malaysia and found that it was an important explanator of inflation developments. However, the impact of the recent crisis on the current level of noninflationary output and its future rate of growth is bound to be quite uncertain.
34. When the level of potential output is uncertain, the inflation targeting strategy should become less forward-looking. Uncertainty regarding potential output and the extent of excess demand (the output gap) implies that forecasts of future changes in inflation, based on the output gap, will also be uncertain. In such circumstances, the logical response to uncertainty about potential output is to put more weight on current information about inflation.20 Putting greater weight on current inflation, however, runs the risk of inducing procyclical policy responses to supply shocks, unless policy focuses on a measure of core inflation that effectively filters out the impact of supply disturbances.21
35. The difficulty of estimating the level of potential output is also probably the strongest practical argument for the alternative approach of nominal income targeting.22
Nominal income targeting
36. Nominal income targeting is less forward-looking than inflation targeting, but less demanding in terms of the knowledge of potential output that is required. In contrast with inflation targeting, which involves policy adjusting in response to deviations of forecast inflation from the target, under nominal income targeting policy responds to deviations of actual nominal income from target inflation plus trend activity growth.23 Nominal income targeting, therefore, is less forward-looking than inflation targeting. However, nominal income targeting does not require estimation of the level of potential output; all that is required is an estimate of the trend growth rate of potential output.
37. Nominal income targeting may be preferred to inflation targeting if there is considerable uncertainty regarding the level of potential output. Nominal income targeting may lead to greater inflation and output variation on average than inflation targeting, because it is less forward-looking. However, McCallum (1997) argues that nominal income targeting is more robust than inflation targeting on the basis that serious errors in estimating the growth rate of potential output are less likely than in estimating the level of potential output. The key issue in choosing between these approaches, therefore, should be an assessment of the potential gains from a forward-looking policy approach as compared with the potential risk of large errors. In Malaysia’s current circumstances, where the level of potential output is quite uncertain, a policy approach closer to nominal income targeting might be preferred, at least initially, to a full-fledged inflation targeting approach.24
38. Nominal income targeting is not the only way to provide an element of insurance against significant errors in measuring potential output and, consequently, inflation pressures. An additional consideration is that nominal income targeting may not be the only way to provide robustness to the policy rule. One way to guard against persistent or systematic errors in estimates of potential output or its impact on inflation would be to place some weight on deviations of the actual price level from the path for the price level consistent with the inflation objective. Thus, for example, if the central bank was persistently underestimating the level of potential output, this would tend to lead to undershooting of the inflation target. Including a policy response to the differential between the actual price level and the level consistent with the inflation target would lead policy to be slightly looser than would otherwise be the case. Once again, to avoid inducing procyclical responses to supply disturbances, it would be preferable to define the price level in terms of the core inflation measure.
Limited exchange rate flexibility
39. An additional issue to consider is whether an inflation targeting or nominal income targeting regime could be combined with some form of limitation on exchange rate flexibility. The discussion so far has emphasized the need for exchange rate flexibility to be able to pursue domestic economic stabilization objectives. Nonetheless, it is also recognized that exchange rate variability or uncertainty might loosen expectations for inflation (at least for tradable goods and services), and would increase uncertainty faced by producers in the tradables sector. In addition, adding an element of exchange rate targeting might be justified as a form of insurance against gross errors in the measurement of the level or growth rate of potential output. Two approaches to limiting exchange rate flexibility are discussed below. It should be emphasized that these approaches focus on how to limit movements in the exchange rate over extended periods of time, rather than dealing with very short-term volatility in the exchange rate. The issue of very short-term volatility is discussed subsequently.
40. One approach would be to pursue domestic stabilization objectives (via monetary targeting, inflation targeting, or nominal income targeting) within the defined limits of an exchange rate target band. For a composite regime such as this to be sustainable, three important considerations would need to be borne in mind in setting the range:
- The exchange rate target would need to be consistent with the target for inflation built into the domestic stabilization objective. For example, if the domestic stabilization included an objective of, say 3 percent inflation, then the exchange rate target range should allow for the differential between this and the long-term expected foreign inflation rate.25
- The exchange rate target range would also need to be wide enough to be able to pursue domestic stabilization objectives to a meaningful degree. Basically, this would require that the range be wide enough to accommodate a reasonable estimate of the cyclical variation in the real exchange rate. If nominal exchange rate flexibility is not on the same scale, then cyclical adjustments in the real exchange rate will have to occur through changes in domestic inflation, primarily in the nontradables sector. The cyclical range of tradables prices relative to nontradables prices should thus provide a rough indication of the appropriate width of an exchange rate range consistent with domestic inflation and output stabilization objectives. The experience of inflation targeting countries such as Canada and New Zealand is that nominal exchange rate movements of over 20 percent over the course of a business cycle might be necessary. The higher degree of openness of the Malaysian economy and the concentration of exports in manufactures (making exports more responsive to exchange rate movements), however, suggests that a somewhat smaller rate of cyclical movement in the real exchange rate might be necessary for Malaysia.
- Sweden’s experience with exchange rate target bands is also salutary in this regard. In a paper written in 1992—before the collapse of Sweden’s exchange rate targeting—Svensson (1994a) argued that an exchange rate target range as little as 4 percentage points wide was sufficient to give Sweden a “sizable” degree of monetary independence. By monetary independence, however, Svensson meant the ability to exercise control over short-term movements in interest rates, not the persistent shifts in interest rates required to pursue domestic macroeconomic objectives.
- The setting of the initial level of the exchange rate range would need to take into account the estimated extent of over- or under-valuation of the current real exchange rate relative to a medium-term or cyclical average. Thus, if the real exchange rate were currently judged to be near a cyclical trough, the level of the target range should be set with the current exchange rate near the floor of the range in order to accommodate an expected cyclical recovery. Since measurement of equilibrium real exchange rates is extremely difficult, such an exercise would not be trivial, and the chances of making a significant error in the initial setting would be substantial.
41. The main difficulty with a monetary policy framework involving the pursuit of domestic stabilization objectives within an exchange rate target range is that it implies a sharp change in the objectives and conduct of policy whenever the exchange rate reaches the boundaries of the target range. In practice, this could lead to very awkward behavior on the part of the central bank. For example, in the event of a positive shock to demand, domestic inflation and output stabilization would indicate the need for tighter monetary policy and currency appreciation. If the exchange rate reached the upper limit of the target range, however, the exchange rate constraint would then require the central bank to start loosening interest rates to prevent any further appreciation.26
42. The example illustrates a fundamental tension involved in pursuing virtually any composite policy strategy: although an exchange rate target range may create a region of consistency between the domestic and external stabilization objectives of policy, the inconsistency is not fully eliminated. Financial market participants will be aware of this inconsistency and thus the behavior of the exchange rate will be affected even when it is well within the target range. Exchange rate expectations, and uncertainty surrounding those expectations, for example, will play a crucial role in determining capital flow responses to international interest differentials. If markets are certain that the central bank will be willing to abandon domestic stabilization to defend the exchange rate target range, market expectations and uncertainty will be quite different than if the central bank is expected to set a higher priority on macroeconomic stabilization, casting doubt on any formal exchange rate commitment.
43. Of particular concern, given Malaysia’s experience since 1997, is the possibility that markets could move quickly to test the central bank’s commitment to defend an explicit exchange rate target range. If the range was sufficiently narrow to significantly constrain the ability of monetary policy to pursue macroeconomic stabilization, markets would see that the central bank would have a clear policy dilemma in defending the target range. This suggests that the introduction of a policy framework based on a relatively narrow target range for the exchange rate, coupled with domestic macroeconomic stabilization within the target range, would likely be challenged by markets, forcing the authorities to make a clearer choice of priorities amongst competing objectives.
44. An alternative approach to adding exchange rate considerations to a policy framework principally geared to inflation and output stabilization would be to introduce an element of exchange rate “smoothing.” In analyses applied to the U. S. economy, Taylor-type policy rules involving output and inflation stabilization objectives also commonly involve an element of nominal interest rate smoothing.27 Typically, interest rate smoothing is defended as a rational response of the central bank to uncertainty regarding the nature of economic shocks and the structural characteristics of the economy, including the level or growth rate of potential output. In the event of such uncertainties, caution in policy adjustments is usually warranted. In an open-economy context, such as Malaysia’s, a similar case might be made for exchange rate smoothing.
45. In practical terms, this would involve an element of “leaning against the wind” in response to movements in the exchange rate. This approach would differ from the exchange rate target band in two important respects. First, no explicit exchange rate commitment would be made. Second, the approach would focus on smoothing the path of the exchange rate rather than defending any particular level of the exchange rate. Both features would reduce the likelihood of speculative “attacks” on the currency, since there would be less scope for making profit at the expense of the central bank. In addition, the approach would permit accommodation of shifts in the equilibrium real exchange rate more readily than an approach focusing on defending particular levels of the nominal exchange rate. Nonetheless, it is important to recognize that excessive smoothing of movements in the exchange rate would compromise timely adjustments of the stance of monetary policy and, consequently, would lead to less satisfactory outcomes in terms of inflation and output stabilization.28
46. Actions to counter very short-term volatility in the exchange rate can be consistent with inflation or nominal income targeting. Inflation or nominal income targeting does require that the exchange rate be allowed to adjust over the course of the business cycle to counter upward or downward pressures on inflation. This does not, however, preclude the possibility of strong central bank responses to counter short-term volatility in the exchange rate. A number of points can be made in this regard:
- If inflation or nominal income targeting is pursued in a consistent and fairly transparent manner, speculation against the currency is likely to be reduced. Speculation is most likely to occur if the central bank’s objectives are unclear or its commitment to the policy is doubted.
- Even if the policy commitment is unquestioned, speculative pressure on the currency can arise if markets and the central bank come to different assessments of economic developments and their implications for the inflation outlook. In such circumstances, sterilized intervention can play a useful role, particularly as a signal to markets that the central bank’s interpretation of developments is different from theirs.
- The effectiveness of sterilized intervention in ending speculative pressures will depend importantly on market perceptions of the central bank’s willingness to adjust its policy instruments (effectively unsterilized intervention) to back up its view.
- Sustained pressure on the exchange rate may indicate a need for the central bank to reexamine the appropriateness of its policy stance. Although the central bank may have the best forecasting apparatus and better quality analysis than any other individual participant in the foreign exchange market, the market has the law of large numbers in helping to minimize errors or bias in assessing developments. In addition, market participants draw on somewhat different and typically more diverse information than the central bank, particularly with regard to developments outside the country.
- Among inflation targeting countries, approaches to countering short-term exchange rate volatility vary considerably. In most, the central banks do engage in sterilized intervention (New Zealand is the exception). In Canada, intervention has traditionally been fairly frequent but small in scale, while in other countries intervention has been relatively infrequent, but on a larger scale when it has occurred.
- In Canada and New Zealand, Monetary Conditions Indices (MCIs) have also been used to guide interest rate responses to exchange market pressures. The use of the MCI typically leads to some easing (increase) in interest rates if the currency strengthens (weakens) for reasons unrelated to changes in the inflation outlook. The MCI is not a useful device, however, if exchange rate pressures reflect changes in fundamentals (either at home or abroad).
Institutional and communications issues
47. Under a fixed exchange rate regime, the central bank’s policy objective is abundantly clear and its room for maneuver in pursuing objectives other than the exchange rate commitment is extremely limited. Imperfect capital mobility or asset substitutability may give some scope for pursuing other objectives, but not on a prolonged basis. In practice, the main area in which discretion may be exercised is in choosing when, or by how much, to adjust the exchange rate from time to time. With such limited policy autonomy, central bank accountability is in many respects a moot issue. For market participants forming expectations, the only real issue is the degree of the authorities’ commitment to defend the policy objective.
48. Under a flexible exchange rate, however, the central bank may have considerable room for discretion in setting policy while, at the same time, its objectives may be very unclear. The lack of clarity associated with exchange rate flexibility raises two important issues:
- If the central bank is given complete autonomy in determining monetary policy, then the room for maneuver under a flexible exchange rate regime would represent an important loss of democratic control over one of the principal instruments of macroeconomic policy. The performance of fiscal policy would remain ultimately accountable to the electorate, but monetary policy performance would not.
- By contrast, if the central bank were given no autonomy in setting policy, then the conduct of monetary policy would likely be strongly influenced by short-term political considerations. Of particular concern is the likelihood that monetary policy would be directed toward an inflationary policy of continuous economic stimulus, even though this would be damaging to the economy over time. Even if monetary policy were not exploited in this way, financial markets and private agents would be unlikely to rule out the possibility, and this itself would be damaging to economic performance.
49. In inflation targeting countries, institutional arrangements have sought to balance the ultimate need for democratic control over monetary policy with the need to insulate the conduct of monetary policy from short-term political pressures; that is, arrangements have aimed to achieve central bank independence within government, not independence of government. A key consideration in the design of such arrangements has been the recognition of their importance to the formation and anchoring of private sector expectations, especially in financial markets.29 In all of the countries that have formally adopted inflation targeting, institutional arrangements have involved two basic elements: (i) the government has set the achievement of low inflation as the unambiguous goal of monetary policy; and (ii) the central bank has been granted operational autonomy to pursue that goal, but also required to be accountable to the government and public generally for its performance in achieving the goal.
50. Specific details of how the goal of monetary policy is set varies somewhat from country to country. In countries that switched to inflation targeting from very limited autonomy under exchange rate targeting, relatively legalistic changes to institutional arrangements occurred, while in countries that already had flexible exchange rate arrangements and a fairly high degree of policy autonomy, changes in arrangements have been less legalistic:
- In Sweden, the goal of price stability, and the independence of the central bank to pursue that goal, has been enshrined in the constitution.
- In New Zealand, the basic legislation governing the central bank was modified to replace the multiple objectives previously specified with a single goal of price stability. The legislation also determined that specific details of the inflation target should be set out in a public contract between the finance minister and the governor of the central bank.
- In Canada and Australia, no change in central bank legislation was made. Instead, public agreements between the central bank governor and the minister of finance specified that price stability should be the overriding objective of monetary policy, together with specifics of the operational inflation target.
51. In Malaysia’s case, where policy discretion has previously been heavily constrained by the commitment to exchange stabilization, a relatively formal institutionalization of the goal of low inflation might be appropriate to underscore the change in the policy regime. At a minimum, BNM and the government would need to provide a clear public statement of the inflation objective, and the government would also need to give BNM an explicit mandate to formulate and implement monetary policy so as to achieve that objective.
52. Central bank accountability arrangements are broadly similar across inflation targeting countries. The key elements in common include:
- In all of the countries, the central banks have either been required (as in New Zealand) or have chosen to issue regular reports on the conduct of monetary policy in pursuit of the inflation target. In New Zealand and the United Kingdom, such reports are produced quarterly, while in Canada, Australia, and Sweden, such reports are semi-annual. Depending on the central bank’s legislation, these reports are directed either to the minister of finance, or to parliament directly. The important point, however, is that the reports are in the public domain, and usually provide the basis for parliamentary testimony by the central bank governor. Thus, whatever the details of the central bank’s formal accountability arrangements, in practice, central banks have provided accountability not just to the government of the day, but also to parliament and the public more generally.
- All of the central banks also engage in extensive public communications programs to explain their views on key issues in monetary policy in general and the current conduct of policy in particular. Such communication includes frequent speeches by senior central bank officials, briefings for journalists and financial analysts, hosting of conferences and workshops on monetary policy issues, as well as publication of articles and research papers on monetary policy topics.
53. Although most central banks provide some public accountability along these lines, in inflation targeting countries, greater emphasis tends to be placed on transparency regarding the formulation of policy. Moreover, since policy formulation is forward-looking, the central bank is unavoidably drawn in the direction of providing a forward-looking assessment of inflation and explaining its understanding of the policy transmission mechanism.
54. BNM’s current methods for providing public accountability are already quite good, but some modifications would be helpful. In particular:
- Reporting on the rationale behind policy decisions would need to be more explicit and more forward-looking.
- Consideration should be given to semi-annual reports on policy formulation.
- BNM should also make more of its research relating to the formulation and implementation of policy available to the public in the form of published papers or articles.
55. This paper suggests that as Malaysia moves toward liberalization of exchange control measures, the adoption of a flexible exchange rate regime would permit monetary policy to continue to focus on achieving domestic macroeconomic stability, reducing the likelihood and magnitude of the sorts of cyclical booms and slumps seen over the past two decades.
56. The paper also suggests that an inflation targeting framework or, initially, a less forward-looking approach along the lines of nominal income targeting, would be an attractive option. The reorientation of monetary policy toward domestic macroeconomic stabilization last September could, in fact, be seen as a significant step in this direction. A number of additional steps would need to be taken to focus policy on the medium-term inflation outlook and ensure that the policy framework is capable of anchoring public expectations. These include:
- Modification of BNM’s internal analysis of data and policy formulation process to focus on the implications of macroeconomic developments for inflation.
- Development of a reliable medium-term inflation forecasting framework. Essentially this requires a reasonable ability to forecast the impact of changes in interest rates on aggregate demand, and the ability to forecast the impact of changes in aggregate demand on inflation. The most problematic element of an inflation forecasting framework is usually the estimation of potential output. If a good estimate cannot be obtained, a less forward-looking approach based on nominal income targeting or core inflation targeting could be employed.
- Development of a reliable measure of core inflation.
- Estimation of the likely extent of upward bias in the measured rate of inflation, and determination of a suitable target range for inflation.
- Consideration of the appropriate form of institutional changes required to maximize the credibility of the commitment to achieving the inflation target, together with modifications to enhance BNM’s public accountability.
57. Ideally, technical issues relating to implementation of monetary policy under a flexible exchange rate regime should be developed prior to the formal public adoption of the framework. In practice, this is not always possible, nor does it appear to be essential. In the cases of Britain, Sweden, and Spain, inflation targeting frameworks were adopted shortly after their currencies were uncoupled from the ERM. In each of these countries, technical aspects of inflation targeting, as well as institutional arrangements, were sorted out later. The key requirement at the time was to provide an anchor for market expectations, and the announcement of inflation targeting frameworks provided this.
58. In Malaysia’s case, the authorities may have more time to prepare for the implementation of a flexible exchange rate regime, but it should not be taken for granted that the authorities will be able to choose the timing. A particular risk in current circumstances is that, with investment capital returning to the region and growing expectations that Malaysia will further liberalize its exchange controls, capital inflows on a significant scale could begin later this year. If that occurs, monetary policy will quickly be confronted with the dilemma of whether to allow the currency to float or to a large and inflationary increase in the money supply. In view of this possibility, examination of alternative flexible exchange rate frameworks should be considered as a high priority.
This chapter was prepared by Scott Roger (ext. 39417) who is available to answer questions.
See, for example., the comparison of the 1985–86 and 1997–98 crises in Bank Negara (1999).
It is not entirely clear how much the controls facilitated the easing of interest rates while maintaining exchange rate stability, since other countries in the region were also able to ease interest rates and see their currencies strengthen. Indeed, it could be argued that the controls were mainly effective in preventing the currency from appreciating rather than in preventing further depreciation. There can be little doubt, however, that the controls, together with the pegging of the exchange rate, have reduced short-term exchange rate uncertainty.
See, for example, Obstfeld and Rogoff (1995) or McCallum (1997). The principal micro-economic benefits of a common currency are generally regarded as being: (i) the saving in transaction costs associated with trade in goods and services; and (ii) the savings of (opportunity) costs resulting from exchange rate uncertainty. In some cases, these may be reflected in pecuniary costs of hedging; in other cases the cost may be in terms of business foregone. A detailed discussion of the issues and estimation of microeconomic benefits is found in Commission of the European Economies (1990).
Put slightly differently, if Malaysia was characterized by a high degree of international labor mobility and/or highly flexible wages and prices, there would be neither the need nor the scope for meaningful stabilization policy. The case for an independent monetary policy, therefore, largely presumes the existence of rigidities in labor and/or product markets.
A possibility that may be worth considering is whether some members of ASEAN, including Malaysia, together could provide the basis of a common currency area. Trade with Singapore, Thailand, Indonesia, and Brunei together accounts for about 23 percent of Malaysia’s total trade, a higher share than its trade with Japan or the United States. In addition, the region’s economies also appear to be more prone to symmetric rather than asymmetric macroeconomic shocks, and there is considerable labor mobility between some of the countries. In principle, therefore, a common monetary policy in the region might be better suited to stabilization of the region’s economic performance than the de facto dollar peg of the past decade or more, and also yield some significant microeconomic gains. What would be required, of course, would be the establishment of a central bank for such a currency union. In view of Europe’s experience with the move to a common currency, the development of an ASEAN equivalent could not be considered as a realistic possibility for the medium term, but should not be ruled out as a long-term goal.
Demand for both broad and narrow money, however, displayed a significant upward trend (i.e., downward trends of velocity). A curious result was that homogeneity of broad money demand in prices was rejected by the data, indicating that a doubling of the broad money supply would not necessarily be matched by a doubling of prices in the long term.
Coe and McDermott found that monetary growth contained no leading information on the evolution of inflation beyond that contained in a measure of the output gap and lagged inflation.
In practice, the priority given to stabilization of the nominal exchange rate precludes any very meaningful role for the monetary aggregates in policy formulation, regardless of their formal role.
There is now a fairly extensive literature on inflation targeting. Debelle (1997) provides a good overview of practical issues. Svensson (1997 and 1998) gives a more theoretical treatment of some issues and provides extensive references to the literature.
Masson et al mention as factors that may lead to shallow capital markets: interest rate controls; high reserve requirements; sectoral credit policies; and compulsory placement of public debt; all of which they characterize as subtle forms of “fiscal dominance,” (p. 23).
In the context of recent developments, this approach would have implied a gradual easing of interest rates through the latter part of 1998 in response to weakening medium-term inflation pressures despite the prospect of a short-term rise in measured inflation as a consequence of currency depreciation.
See Smets (1998) for an analysis of how optimal weights in Taylor-type rules vary with uncertainty regarding potential.
Of course, if the measure of core inflation was itself subject to severe measurement problems, this would be no advance on inflation targeting. At least some of the alternative measures of core inflation reviewed in Roger (1998) involve similar problems to those in measuring potential output.
A common criticism of nominal income targeting is that national income statistics are only available with a significant delay, which would hamper timely policy adjustments. McCallum notes, however, that targeting could in fact be based on a combination of the CPI and industrial production, or nominal retail sales, or some other more timely proxy for nominal income.
It should be emphasized that nominal income targeting would not ensure good economic performance. The only claim is that it would be less vulnerable to very bad policy errors.
In fact, the exercise would be more complicated than this, since allowance should be made for inflation and productivity differentials between the tradables and nontradables sectors.
Svensson (1994b) also makes this point, arguing that nominal exchange rate targeting may lead to a procyclical, destabilizing monetary policy.
It could be argued that a form of inflation targeting but with heavy smoothing of the exchange rate versus the U.S. dollar more or less describes the pre-crisis policy regime in Malaysia, and points to the pitfalls of that approach. The description is not quite fair, particularly since it ignores the use of other policy instruments.
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The target measure of inflation
1. All inflation targeting central banks set their targets in terms of the Consumer Price Index (CPI) or some subset of the CPL Basically, the choice in favor of the CPI reflects the fact that in almost every country the CPI is the most widely known measure of prices and, therefore, the measure most relevant to the formation of inflation expectations. In addition, it is usually the highest quality price index constructed by the national statistical agency and is available much sooner than broader indices such as the consumption or national accounts deflators. In Malaysia, these same arguments would point to the CPI as the obvious measure on which to base an inflation target.
2. Nonetheless, inflation targeting central banks also routinely construct and use measures of “core” inflation in policy formulation and communication. As noted earlier, one of the attractions of inflation targeting is that, in the event of demand disturbances, the monetary policy will tend to react in a way that also stabilizes activity. That is, policy will tend to dampen inflationary booms as well as disinflationary recessions. In the event of supply shocks, however, inflation targeting could potentially lead to procyclical monetary policy responses. For example, in the case of an adverse supply shock boosting inflation while lowering growth, inflation targeting could lead to a tightening of monetary policy in response to higher inflation, and accentuate the downturn in activity.
3. Measures of “core” or “underlying” inflation are aimed at filtering out the direct impact of supply disturbances so as to give a more accurate impression of the persistent element of inflation relevant to monetary policy. As discussed in Roger (1998), there are a variety of techniques available to construct a measure of core inflation. A measure of core inflation should also improve estimation of the output gap Phillips curve. Development of a measure of core inflation for Malaysia would be a necessary element of the research agenda for developing an inflation targeting framework. Of particular concern are the government-administered prices that make up about 11 percent of the CPI basket. Such prices may introduce an unhelpful sluggish response of the aggregate CPI to developments in activity, leading to delay in adjusting policy and, consequently, greater volatility in output than would otherwise be the case.
The target range for inflation
4. An issue which arises in the context of almost any targeting framework—whether it is exchange rate, monetary, inflation, or nominal income targeting—is the specification of a target range. Among inflation targeting countries, specifications of the target range vary somewhat, and it is not obvious that any one approach is clearly superior to the others. A number of considerations should be taken into account in specifying a target range:1
- The location of the center of the range should correspond to the authorities’ target for the average rate of inflation over the business cycle. What the appropriate target rate should be is open to debate. In inflation targeting countries, the main factors behind the choice of the center of the target range have been:
- A very low target rate of inflation rate is appropriate.
- True price stability may correspond to a slightly positive measured inflation rate due to positive bias in the measured inflation rate.
- A slightly positive rate of true inflation may be preferable to true price stability in order for monetary policy to be able to achieve, on occasion, negative real interest rates.2
- The appropriate width of the target range should also reflect a number of considerations:
- If the primary purpose of the range is to serve as an accountability or disciplinary device for the central bank itself, then a fairly narrow range is probably desirable. A narrow range will limit the central bank’s room for discretion in setting policy and encourage timely policy adjustments in order to keep within the range.
- If the target range is regarded more as a signal to the private sector that the central bank expects to be able to keep inflation within a particular range most of the time, then reasonably wide bounds are sensible, since a narrow range will tend to result in more frequent excursions from the range, undermining confidence in the central bank’s commitment to keeping inflation under control.
- The volatility of the target inflation measure also matters. If the measure is strongly affected by supply disturbances, then a relatively wide target range is appropriate in order to be able to accommodate the impact of such disturbance without frequent excursions from the range. However, if the central bank’s target or accountability is specified in terms of a measure of core inflation—as is the case in most inflation targeting countries—then a relatively narrow target range is appropriate.
- An additional argument in favor of a relatively wide target range stems from the proposition that a trade-off may exist between the variability of inflation and the variability of output. In this case, attempting to keep inflation within a very narrow range may result in a significant increase in output variability. The validity of this proposition is open to doubt, particularly if the measure of inflation used for accountability purposes is a measure of core inflation.3
5. In most inflation targeting frameworks, choices have favored target rates of inflation in the range of about 1 percent to around 3 percent, together with fairly narrow bands - less than 4 percentage points. To date, inflation targeting countries have succeeded in keeping inflation within the target range most of the time. Moreover, although there have been experiences of over- or under-shooting of the (undershooting in Canada, and overshooting in New Zealand), such excursions did not lead to financial market instability or a noticeable impact on inflation expectations.4
6. In Malaysia’s case, before specifying an inflation target range, it would be advisable to consider whether biases in the CPI are likely to be similar to, or greater than, those indicated in the industrialized economies. In addition, it would be advisable to carry out at least some investigation of measures of core inflation in order to assess how much less volatile such measures might be than the official CPI. Judging by Malaysia’s past inflation performance, however, it seems unlikely that the level or width of an inflation target range for Malaysia would need to be significantly higher or wider than in other inflation targeting countries.
The focus and horizon for policy formulation
7. In an open-economy context such as Malaysia’s, monetary policy will affect inflation outcomes through two distinct channels: a “direct” channel via the impact of exchange rate changes on prices, and an “indirect” channel via the impact of changes in economic activity on price pressures:
- The “direct” transmission channel, generally regarded as having the most immediate impact is through the impact of policy-induced changes in the exchange rate on the domestic currency prices of “tradables;” goods and services whose prices are primarily determined in world markets. The second, more indirect and, typically, slower-acting channel of monetary policy transmission to inflation is through the impact of interest rate and exchange rate changes on demand pressures in the economy. In this case, the influence of monetary policy is primarily on the prices of “nontradable” goods and services, which are largely determined in domestic markets.
- In view of the openness of the Malaysian economy, there is little doubt that monetary policy could exercise substantial control over the evolution of inflation through the direct channel That is, monetary policy could be used to move the exchange rate in order to achieve desired outcomes for the tradables component of whatever measure of inflation was being targeted. This, in fact, is more or less the approach that is used in Singapore. In a small, extremely open economy, where the target price index is predominantly made up of tradables, this approach is entirely sensible; indeed, it underlies McKinnon’s (1963) linking of trade openness to the determination of optimum currency areas. The importance of tradables prices in the Malaysian CPI, however, is not nearly as great as the ratios of imports and exports to GDP might suggest. In fact, imports of final consumer goods make up only about 6 percent of imports, or roughly 10 percent of GDP. Obviously the CPI also contains many goods whose prices are at least partly determined in international markets and, therefore, affected by exchange rate changes. Nonetheless, the CPI is much less sensitive overall to exchange rate changes than is the Producer Price Index, as has been vividly illustrated over the past year.
- The “indirect” transmission channel operates through the effects of changes in both interest rate and induced exchange rate movements on demand pressures in the economy which, in turn, affect wage and price inflation. Although inflation targeting could be implemented using the direct, exchange rate channel of influence on inflation, the standard approach to inflation targeting is to focus primarily on the indirect activity-based channel of influence over inflation. Consequently, monetary policy actions are directed toward adjusting aggregate demand so as to increase or decrease inflation pressures and, eventually, inflation outcomes. The basic reason for focusing on the indirect, activity-based channel of policy transmission is that, in the process of stabilizing inflation, policy will also tend to stabilize activity.
8. In practical terms, the standard approach to inflation targeting involves adjusting the stance of policy in response to deviations of projected inflation from the target inflation rate, with the projection horizon long enough to be dominated by the indirect, activity-based channel of transmission. The need to react to projected inflation reflects the fact that policy adjustments take time to influence excess demand pressure in the economy, and these, in turn, take time to affect inflation outcomes. In inflation targeting countries, the central banks typically gear policy adjustments toward controlling inflation projected out six to eight quarters into the future.
9. This approach would differ in some important respects from the current method of policy formulation in Malaysia. In particular, policy adjustments would be based on changes in the inflation outlook (and risks surrounding it), rather than on shifts in priorities between multiple objectives. Although developments in output, real interest rates, international competitiveness, money and credit growth and other variables would continue to be important inputs into the policymaking process, policy would be adjusted on the basis of their implications for the medium-term inflation outlook, and outcomes for such variables would not be policy objectives in their own right.
10. The development of a medium-term inflation forecasting apparatus basically requires two elements: (i) an aggregate demand relationship providing a link between adjustments to policy instruments (usually a short-term interest rate) and aggregate activity in the economy; and (ii) an aggregate supply relationship linking aggregate activity to inflation. In developed economies, the aggregate supply relationship is usually described by a Phillips curve in which deviations of inflation from expected (or past) inflation are related to deviations of actual output from “potential” or trend output (the output “gap”).
11. An important empirical issue for applying inflation targeting to Malaysia is whether there is clear evidence of positive relationship changes in inflation and excess supply or demand in the economy. Coe and McDermott (1997) examined this issue for a range of countries including Malaysia.5 The results indicate that a standard output gap Phillips curve can be readily fitted to Malaysian data. Indeed, the model fits better than in most other countries in the sample. The authors also find that the movements in the output gap feed through to inflation fairly quickly in the case of Malaysia.
12. Coe and McDermott’s results suggest that inflation targeting would be likely to deliver better control over inflation than monetary targeting. In addition to testing whether the output gap could explain the evolution of inflation, Coe and McDermott also tested whether monetary growth could provide additional explanatory power beyond that already provided by the output gap. In the case of Malaysia, the authors found no additional explanatory power. This result is consistent with the results of Dekle and Pradhan which suggest that money growth may be caused by output growth rather than vice versa.
The objective would be to minimize the risks of a “liquidity trap” occurring in the event of deflation. The validity of this so-called “Summers effect,” however, is debated (particularly for open economies) and has not been explicitly cited by any inflation targeting central bank as a reason for targeting positive measured inflation.
It may be noted that Coe and McDermott do not use a standard Hodrick-Prescott filter to estimate potential output. In the standard filter the smoothing parameter is set at 1,600. Implicitly, the value of the smoothing parameter involves an assumption about the proportion of output variation due to supply disturbances and the variation due to demand disturbances. The value of 1,600 is calibrated to U.S. data, and may be quite inappropriate elsewhere. In particular, in small open economies such as Malaysia, supply shocks may be much more prevalent, indicating the use of a lower smoothing parameter. The Coe and McDermott filter allows the value of the smoothing parameter to be determined endogenously.