Ong Chong Tee: Financial economics
Opening address by Mr Ong Chong Tee, Deputy Managing Director of the Monetary
Authority of Singapore, at the SKBI Annual Conference on "Financial economics", at
Singapore Management University (SMU), Singapore, 7 May 2012.
* * *
Professor Arnoud De Meyer, President of Singapore Management University
Distinguished guests, ladies and gentlemen, good morning.
Introduction
It gives me great pleasure to join you today at SKBI's second Annual Conference on
Financial Economics. Since its establishment in 2008, SKBI has pursued research on topics
in economics and finance relevant to Asia and the Singapore economy. A recent working
paper on "Testing for Multiple Bubbles" by Phillips, Shi and Yu, for example, sheds light on
techniques for identifying asset price bubbles, and has useful implications for the surveillance
strategies of central banks.1
I am privileged to join an outstanding line-up of speakers including keynote speaker
Professor Sir James Mirrlees. I think some of you may be familiar with his groundbreaking
work on optimal tax policy, and his modelling of the key role uncertainty plays in economics.
The Mirrlees Review, a recent review of the UK tax system chaired by Sir James, offers
invaluable practical lessons on optimal tax design, including specific recommendations for
the taxation of savings and wealth.
Structural change in the Singapore economy
The perfect financial storm of the recent crisis severely disrupted markets and economies,
and also shook key tenets fundamental to our understanding of economics and finance.
Established beliefs in efficient markets, asset price dynamics, and more, have all been called
into question.
Amid the flux in the global financial and economic landscape, Singapore also has its own
challenges. Resource constraints mean that we have to restructure the economy to depend
less on the labour force and more on productivity increases for growth.
During this period of transition, important adjustments in domestic resource costs and
consumer prices are taking place, alongside the usual cyclical developments confronting the
economy. Dealing with the confluence of factors affecting domestic prices has been
particularly challenging, for us at the central bank and equally so for consumers and
businesses. CPI-All Items inflation, for instance, has been elevated coming out of the recent
financial crisis, averaging 4.1% since 2010, much higher than the historical norm of below
2%. MAS Core Inflation, which excludes changes in accommodation and private road
transport costs, averaged a lower 2.0% over the same period.
Consumer price pressures have picked up more recently. CPI-All Items Inflation reached
almost 5% in Q1 this year and households may face higher price increases for specific
expenditure items. MAS is monitoring these and other cost indicators closely. Allow me to
take this opportunity to highlight some conceptual issues concerning price adjustments in the
economy and their implications for monetary policy. In other words, why is inflation higher
than what we have experienced historically, and is monetary policy responding in an optimal
way?
Implications for Inflation
First, it is important to recognise the complex interplay of demand and supply factors
underpinning the recent price developments in Singapore.
Demand-side pressures on prices have built up as domestic economic activity rebounded
strongly from the Great Recession of 2008/09. Regional demand has been firm, supporting
the continued expansion of many of our services industries, while strong employment
conditions in Singapore have underpinned robust consumption growth for a range of goods
and services. Sustained low global interest rates and capital inflows have supported the
demand for housing - a point I will return to later.
At the same time, supply-side factors have become more significant, with the immediate
constraints in labour and housing markets pushing up domestic costs. These reflect
structural capacity constraints in the economy. Policy measures are being put in place to
help the economy transit to a more sustainable model of productivity-led growth, as
Singapore's reliance on foreign workers is reduced. As the economy adapts and productivity
growth rises, price pressures are likely to subside and provide a lift to real wages, making
Singaporean workers better off.
Implications for monetary policy
My second observation is that the monetary policy stance has to be carefully calibrated to
take into account the multiple influences on consumer prices.
Monetary policy should act decisively to ease short-term inflationary pressures driven by
strong demand, through applying an appropriate constraint on overall economic activity. Our
studies continue to show that in our small, open economy, the exchange rate has a
significantly greater impact on growth and inflation compared to domestic interest rates.
Hence, MAS has been tightening monetary policy by allowing a stronger rate of appreciation
of the S$ nominal effective exchange rate since April 2010.
However, with respect to cost pressures arising from the supply-side, monetary policy should
aim to temper, but not fully offset. Higher labour costs in the short term due to permanent
supply-side shifts are part and parcel of the market's equilibrating process to guide the
economy to a sustainable growth path. But MAS will be vigilant to the risks that these price
developments can set off second-round price effects if left unchecked.
The appropriate monetary policy response thus depends on the nature and persistence of
the shocks that are affecting prices. Herein lies the monetary policy challenge: how do we
distinguish between the relative importance of demand and supply factors in driving cost and
price increases in the economy? On one hand, there could be a risk of keeping policy too
loose and unhinging inflation expectations. On the other hand, stamping out inflation
aggressively could forestall the important signalling role of relative price adjustments, as well
as add to transitional costs, including the negative impact on growth.
Let me illustrate with the example of ongoing changes in our labour market. While the shift in
foreign worker policy is necessary to allow for a more efficient allocation of resources and a
more productive workforce, the latter will take time to come to fruition. During this transitional
phase, business costs are likely to rise somewhat as a result of tight labour market
conditions, before productivity gains catch up to offset the cost increases. In the short term,
the prices of some consumer services - especially those with high labour content - can rise
and indeed, have increased in the early months of this year.
Reflecting these considerations, the tighter monetary stance adopted by MAS in April 2012
was a calibrated move to facilitate the ongoing supply-side adjustments, while anchoring
inflation expectations. The policy stance was aimed at keeping the economy on an even keel
with GDP growth expected to come in at 1-3% this year. We expect that headline and core
inflation will ease gradually through the year, but along a somewhat elevated trajectory. Over
time, the cumulative appreciation of the exchange rate will temper the pace of price
increases in the economy. MAS is firmly committed to our objective of price stability over the
medium term, even as productivity improvements arising from the significant economic
restructuring will help to prevent higher costs from fuelling strong price increases.
To ease the immediate burden of price and cost pressures faced by households and
businesses during this period of transition, the government has implemented a wide-ranging
package of relief measures. These include targeted utility rebates that directly alleviate the
higher cost of living for households. Similarly, SMEs received a one-off cash grant in this
year's Budget to help offset higher business costs.
Implications for asset prices
My third point is that it is important to respond appropriately to rising asset prices, including
in the housing market.
Following the recent financial crisis, major central banks reduced policy interest rates to
historical lows. Credit growth in this region has recovered strongly, in Singapore and other
Asian economies. There is a danger that systemic risk can develop and crystallise in a
number of ways. For instance, low interest rates may encourage risky borrowing and lending
practices, to create a build-up of leverage in households' and banks' balance sheets. Capital
flows into Asia can also contribute to higher bank leverage, as well as asset price inflation,
with the risk of sharp corrections in asset prices should these capital flows reverse quickly.
Past experiences have shown that when highly leveraged asset markets correct sharply,
they can lead to enormous stress on the banking system and significant collateral damage
on the real economy. The views among central bankers have therefore increasingly shifted
towards the need to take pre-emptive measures at an early stage.
The global experience with monetary policy, however, suggests that broad policy instruments
like exchange rates and interest rates have very significant collateral effects, and are often
subject to long and variable lags before impacting asset markets. Instead, it is preferable to
consider a greater reliance on macro-prudential tools and other administrative measures
targeted at specific asset markets such as property, in an environment of strong capital
inflows and domestic economic growth. This will allow the central bank to better achieve its
financial stability objective, as well as serve as a counter-cyclical tool to dampen excessive
credit growth and price increases. But macro-prudential policy cannot be a substitute for
sound macroeconomic policies. Monetary and fiscal policies need to continue to focus on
correcting macroeconomic imbalances, with macroprudential policy focused on ensuring that
systemic risk is well-contained.
In Singapore and elsewhere in the region, authorities have implemented measures such as
Loan-to-Value (LTV) ratios and buyer/seller stamp duties to prevent the formation of asset
price bubbles. Our approach in Singapore has been targeted and incremental. Measures are
focused on discouraging short-term speculative activity that can distort underlying prices,
while encouraging greater financial prudence among property purchasers. Where supply
constraints can be ameliorated to relieve cost pressures in the housing, commercial and
industrial property segments, the government has done so directly.
Conclusion
I have highlighted a few issues and challenges arising from structural changes in the
Singapore economy. In these areas, there is much scope for further study including joint
collaboration between academia and policymakers. First, in robust statistical techniques to
identify demand and supply shocks in a dynamic economy. Second, in formulating robust
monetary policy rules in the context of ongoing supply-side changes in the economy. And,
finally, in developing early warning indicators for different types of inflationary pressures, and
assessing the efficacy of various macroprudential instruments. Partnerships with academia
can also play a key role in public insights and understanding of structural issues, challenges
and the policy trade-offs. In this regard, I encourage SKBI to be at the forefront of applied
financial and economic research that can help shape policy thinking.
An American opera soprano and actress turned self-help guru, Dorothy Sarnoff, once said:
"Make sure you finished speaking before your audience finished listening". This morning, I
am sure many of you are looking forward to the keynote address by Sir James Mirrlees as
much as I am. So allow me now to end my opening address here. Thank you for your kind
attention.