No doubt remains as to whether the Bank of Thailand will raise interest rates. The bank's governor has made it clear they must be raised to deter rising inflation, and that this must be done in a timely manner. Analysts have taken his speech as indicating a 25bp hike will be introduced at the upcoming Monetary Policy Committee (MPC) meeting scheduled for Aug 10.
The rate will likely to be raised further at the next two MPC meetings on Sept 28 and Nov 30 by another 25bp on each occasion. This will bring the total increase this year to 75bp, causing Thailand's Policy Interest Rate (1-Day Repo Rate) to stand at 1.25%.
But will such a small rise be able to a) slow down the current inflation rate of 7.1%; and b) discourage capital outflows? The US central bank (Fed) has already raised the US interest rate twice by 75bps, and it may bump it up by at least another 2% this year, bringing its Fed Funds Rate to 3% by year's end. By the time this article is published, the Fed would have raised its Fed Funds Rate for the third time.
In this article, I will answer three key questions. First, how can interest rate hikes lower inflation? Second, to reduce inflation, how much should the interest rate be raised? Third, what would be the economic consequences of raising interest rates?
I have been seeing people ask on social media how an interest rate hike can lower inflation. Many tried to answer but no one has it right. Most believe a rate hike would discourage people from consuming while encouraging them to save. With lower consumption, prices would then come down. Nice try. But in the real world, daily consumption is not interest rate-sensitive.
Interest rate hikes are a measure intended to suck money (liquidity) out of the economy. With less money to spend, prices of products drop. Let me give readers a hypothetical example. If there is 100 baht available in an economy to purchase 10 eggs, one egg would cost 10 baht. If that 100-baht money supply was reduced to 90 baht, each egg would be repriced at 9 baht. Lower money supply always turns into lower inflation. And squeezed money supply occurs when a central bank increases its interest rate and thus induces commercial banks to move their cash to the central bank for higher returns.
Still confused? That's okay. Many economists fail to understand this process, too.
The next question concerns how much the money supply should be reduced to lower inflation. This is easier to answer because economic theory provides an exact calculation: a 1% reduction in the money supply would reduce inflation by 1%. For instance, if the Bank of Thailand wants to reduce this year's annual inflation from the projected rate of 6.2% to a more acceptable target of 3.2%, the money supply would have to be reduced by at least 3%, or 738 billion baht.
Hang on a minute. Isn't the second question about raising the interest rate, not reducing the money supply?
This is correct. After answering question 2.1 above, one must proceed to question 2.2 namely: How much does the interest rate need to be raised by to achieve the desired reduction in the money supply? The answer is -- nobody knows. It is a process of trial and error. That's why central banks have to keep raising the interest rate until it achieves the desired effect. However, economic theory does provide some clues here. The final interest rate should be 2% over the desired inflation rate. According to our example, the final interest rate would be 5.2%, not the feeble 1.25%.
In my view, it is necessary to keep the domestic interest rate in tandem with the US interest rate movement to avoid capital outflows and currency depreciation. The Bank of Thailand governor claims the country can raise interest rates at its own pace and does not need to follow the US as capital outflows are not yet a problem. But real data suggests otherwise.
Since the day the Fed first raised the interest rate in mid-March to the latest available data on June 3, US$14.1 billion (495 billion baht) left Thailand, causing the Thai baht to depreciate 3.2% to 34.44 baht per dollar. Money must still be flowing out of Thailand because the exchange rate now exceeds 35 baht per dollar. Surely, the governor does not wish to see the Thai baht lose 13.1% of its value, as was the case with the Japanese yen, by not following international interest rate movements?
What will the economic consequences be? There are two scenarios to consider. Scenario A would involve raising this year's Repo rate by 75bp to 1.25% by year-end. Scenario B would raise the Repo rate to the theoretically suggested level of 5.2% by that same deadline.
Under Scenario A, assuming no further capital outflows, inflation would remain high at an average rate of 7% from June to December. This would cut the real purchasing power of Thai consumers, causing an economic contraction of 0.8% for the rest of the year. Stagflation would be the name of game.
But GDP contraction and high inflation will be the least of the problems facing the Thai economy. The real threat is the risk of capital outflow. As of now, the yield on Thai government five-year bonds is 2.72%, as opposed to 3.61% for their equivalents in the US. This gap will widen if the Fed keeps raising the rate faster than the Bank of Thailand. If 1 trillion baht of capital leaves Thailand to seek better yields elsewhere, the loss of liquidity would cause Thai GDP this year to shrink by 4.06%.
The 5.2% interest rate posited in Scenario B may sound scary, but this would produce a better economic outcome. First, inflation would be slashed by 3% to 3.2%. Best of all, there would be no more risk of capital outflows, keeping domestic liquidity intact. Moreover, a high interest rate would contract GDP growth this year to minus 1.68%.
To me, a contraction of 1.68% and 3.2% inflation sounds preferable to the risk of a 4.06% economic squeeze coupled with 6.2% inflation.
But while I would opt for Scenario B, I have a funny feeling the Bank of Thailand, under pressure from the government, will go with Scenario A.
