Chapter 7 Monetary Policy in the New Normal

Ana Corbacho, and Shanaka Peiris
Published Date:
October 2018
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Monetary policy frameworks in members of the Association of Southeast Nations–5 (ASEAN-5) economies have improved significantly since the Asian financial crisis. As elaborated in Chapter 2, the clarification of price stability objectives, including the adoption of explicit inflation targets in some countries, and the strengthening of central bank operations and transparency have been major milestones in the evolution of monetary policy frameworks. The transition to more consistent forward-looking frameworks allowed ASEAN-5 economies to withstand the global financial crisis well, as well as the commodity price cycle and the low-inflation environment of recent years.

A decade after the global financial crisis, the global macroeconomic and financial landscape continues to be influenced by its legacies. ASEAN-5 countries faced a protracted period during which most advanced economies’ expansionary monetary policies were not well aligned with domestic economic conditions in emerging market economies. Moreover, the new normal global landscape is expected to exhibit gradual normalization of monetary policy in advanced economies. However, an inflation surprise could suddenly tighten global financial conditions and prompt capital flow volatility. This global environment will further test ASEAN-5 monetary policy frameworks in the coming years.

This chapter focuses on the challenges posed by the new normal for ASEAN-5 monetary policy frameworks. The chapter first takes stock of the evolution of inflation dynamics in the region during the past two decades. The analysis provides a basic framework for assessing challenges and areas for improvement in the design and implementation of monetary policy. The chapter then presents the current global debate on the role of monetary policy in the new normal and discusses the implications for ASEAN-5 economies.

Drivers of ASEAN-5 Inflation Dynamics

The gradual improvement in monetary policy frameworks since the Asian financial crisis has resulted in lower average inflation rates in the ASEAN-5, both for headline and for core measures (excluding food and energy; Figures 7.1 and 7.2). The decline in inflation was particularly noticeable after the global financial crisis. Several factors explain the differences in inflation performance among the ASEAN-5 countries, from the degree of development in their monetary policy frameworks and economic structures to the fact that the region comprises both oil producers and heavy oil importers whose inflation is strongly exposed to oil price fluctuations.

Figure 7.1.
Headline Inflation in ASEAN-5 Countries


Sources: Haver Analytics; and IMF staff calculations.

Note: ASEAN-5 = Indonesia, Malaysia, Philippines, Singapore, Thailand.

Figure 7.2.
Core Inflation in ASEAN-5 Countries


Sources: Haver Analytics; and IMF staff calculations.

One of the legacies of the global financial crisis has been protracted low inflation. Technical innovation in extraction and production has triggered a significant structural change in the oil and gas sector, which, coupled with low demand pressure, may lead to commodity prices that remain below historical averages (Baumeister and Kilian 2016). The persistent below-target inflation in some large advanced economies (euro area, Japan) and the significant slack in the industrial sector in some large economies (IMF 2016) may also attenuate inflation pressure in the coming years.

Assessing potential changes in inflation dynamics is therefore fundamental to the formulation of monetary policy. For example, to what extent can low commodity prices and economic slack explain recent inflation dynamics? Have long-term inflation expectations remained well anchored since the global financial crisis? This section provides some quantitative evidence to answer these questions.

The empirical approach relies on the estimation of a Phillips curve at the country level, building on the hybrid New Keynesian Phillips curve specification in Galí and Gertler 1999, among others. The benchmark specification is as follows:

in which πt is headline consumer price inflation, π¯t denotes long-term inflation expectations, πt1MA4 is the moving average of inflation over the preceding four quarters, Y˜t1 is economic slack measured by the output gap, πtIM is inflation—imported goods and services in local currency (that is, including the impact of exchange rates)—and εt is the estimation error and is assumed to be a Gaussian white noise process (see Dany-Knedlik and Garcia 2018 for further details).

In terms of economic interpretation, the coefficient βt1 determines the extent to which inflation is driven by long-term expectations; that is, its forward-looking component, in contrast to the influence of lagged inflation, captured by (1βt1). The coefficient βt2 determines the impact of cyclical economic activity on inflation; that is, the slope of the Phillips curve. The effect of import (and oil) price inflation is captured by βt3. To identify changes in inflation dynamics over time—for instance, resulting from the evolution of monetary policy regimes or changes in the global environment, coefficients are allowed to vary over time, along the lines of IMF 2013 and 2016 and Blanchard, Cerutti, and Summers 2015.

Measures of long-term expectations are a crucial element of the empirical investigation. All central banks, including those of the ASEAN-5, regularly monitor inflation expectations, either through surveys or by extracting expectations from available financial instruments.1 Survey inflation expectations are a widely used measure of the private sector’s (long-term) inflation expectations. They are easy to collect and readily available for many countries. However, since the beginning of the global financial crisis, survey-based measures of inflation expectations have become increasingly disconnected from actual inflation dynamics, particularly in many advanced economies afflicted by significant disinflation pressure. Market-based indicators also have some important shortcomings.2

To establish a benchmark measure for long-term inflation, this section uses novel estimates of trend inflation for ASEAN-5 economies (Garcia and Poon, forthcoming; Figure 7.3). The qualitative results on the drivers of inflation dynamics are nonetheless similar to those that use Consensus Economics survey expectations (Figure 7.4; see also IMF 2016). Conceptually, trend inflation is the rate of inflation expected to prevail once the effects of temporary shocks in the observed inflation rate dissipate. Trend inflation is therefore a natural measure of future inflation, and the level of inflation expectations in the private sector should hold.

Figure 7.3.
Long-Term Inflation Expectations, Trend Estimates


Sources: Garcia and Poon, forthcoming-a; and Consensus Economics forecasts.

Figure 7.4.
Consensus Long-Term Inflation Expectations


Sources: Garcia and Poon, forthcoming-a; and Consensus Economics forecasts.

Empirical estimates of trend inflation in the ASEAN-5 countries confirm some important weaknesses in long-term inflation expectations from surveys (Figure 7.5). Compared with trend inflation measures, survey measures of inflation expectations for ASEAN-5 economies do have a quantitatively important level bias,3 in line with recent findings for the United States (Chan, Clark, and Koop 2015) and the euro area (Garcia and Poon, 2018). Recent literature suggests that these biases are the result of informational rigidities (Coibion and Gorodnichenko 2015; Mertens and Nason 2015).4 Specifically, although they exhibit some significant fluctuation over time, survey measures tend to be well above the level implied by long-term trend inflation, even when accounting for standard estimation uncertainty. Furthermore, survey measures also appear to be quite disconnected from official targets in the inflation-targeting ASEAN-5 central banks (Indonesia, Philippines, Thailand).

Figure 7.5.
Measures of Long-Term Inflation Expectations


Source: Garcia and Poon, forthcoming-a.

Note: The figure displays the estimates of trend inflation from Garcia and Poon, forthcoming-a, together with standard uncertainty bands, survey measures of long-term inflation expectations, and the inflation targets announced by the corresponding central banks.

Since the Asian financial crisis, inflation expectations have gradually become the most important driver of inflation dynamics across ASEAN-5 countries. This evidence is consistent with the conclusions reached in Chapter 2, confirming the forward-looking orientation of ASEAN-5 monetary policy frameworks. To illustrate the contributions of the different inflation drivers across the ASEAN-5, Figure 7.6 shows the median contribution of long-term expectations (that is, forward-looking dynamics), economic slack (measured by the output gap), non-oil import price inflation, and oil price inflation across countries and over time.5 By 2016, inflation expectations explained, on average, 60 percent of inflation dynamics in the region, well above economic slack, non-oil import price inflation, and oil price inflation, with each of these drivers explaining only about 10 percent. This result implies a substantial increase in the forward-looking component in inflation dynamics in ASEAN-5 countries since the Asian financial crisis, from about 40 percent between 1996 and 2001 to more than 65 percent thereafter. Close alignment of long-term inflation trends and inflation expectations with the central bank inflation target makes inflation dynamics more forward looking. This is critical to increasing the resilience of actual inflation to temporary shocks; for instance, from subdued commodity oil prices. In recent years, however, the decline in the contribution of inflation expectations during two challenging episodes for monetary policy; that is, the global financial crisis and the recent disinflation period, is also noticeable.

Figure 7.6.
Median Contribution of Inflation Drivers in ASEAN-5 Countries


Source: World Bank, Global Financial Development Database.

Note: For additional details see Dany-Knedlik and Garcia, forthcoming. The model is estimated using a standard Kalman filter with Gauss-Newton optimization and the Marquardt step method.

The quantitative impact of economic slack on inflation dynamics has declined across ASEAN-5 countries since the Asian financial crisis. This outcome suggests a flattening of the Phillips curve, as has been the case in many inflation-targeting and advanced economies over the past two decades (IMF 2016). Although the contribution of the output gap has been steadily declining and has remained relatively limited overall, its role strengthened around times of economic crisis, particularly around the time of the global financial crisis. Considering that the ASEAN-5 countries weathered the global crisis somewhat better than many advanced economies, the impact of the output gap around crisis periods points to potential specific effects, and maybe nonlinearities, that may not have been fully captured by the time-varying coefficients used. The results, however, match empirical findings of a muted impact of economic activity on inflation dynamics in advanced economies during the global crisis (Watson 2014, among others). This may have important implications for monetary policy in ASEAN-5 economies. For example, countries such as Singapore and Thailand—particularly affected by disinflation pressure triggered by low oil prices since 2014 and still facing below-target inflation—may be experiencing a recovery in inflation during the ongoing improvement in economic activity that is weaker than in the past. The euro area and Japan also provide examples of unusually weak responses of inflation to an acceleration in economic growth.

The quantitative importance of oil and non-oil import price inflation has also declined during the past two decades. Over the entire sample, these two components explained almost 20 percent of average inflation across the ASEAN-5 region. Their contributions have, however, fluctuated significantly. Both oil and non-oil import price inflation were major drivers of inflation during the Asian financial crisis, but their relevance has diminished substantially since then. Moreover, in the first part of the sample, 1996 to 2006, their contributions were highly correlated. In the second part of the sample, in contrast, they exhibited little correlation. These differences seem to reflect the higher degree of exchange rate flexibility now prevailing in the region compared with the late 1990s and early 2000s, leading to a lower impact from exchange rate adjustments in import inflation and a larger effect of global market prices.

The evolution of ASEAN-5 inflation dynamics reflects important structural changes since the Asian financial crisis. Differences between inflation dynamics with and without time variation in parameters help gauge the quantitative importance of those structural changes. Figure 7.7 reports the percentage contribution of the main inflation drivers discussed above that would have been unaccounted for using a constant-parameter model. The most important change to account for is the contribution of forward-looking dynamics, particularly during the 2000s, until the start of the global financial crisis, and during the most recent disinflation episode since 2014. Both episodes illustrate that capturing improvements in the ASEAN-5 monetary policy frameworks leads to larger contributions from inflation expectations to overall inflation dynamics, which, in the latter period, have provided substantially greater stability to inflation. Time variation in the slope parameter of the Phillips curve was most relevant during the Asian crisis, but was also influential during the expansion ahead of the global crisis. This evidence corroborates the importance of output gap contributions when actual economic activity deviates significantly from potential, in any direction. In addition, whenever time parameter variation is ignored, external influences arising from non-oil and oil import price contributions may tend to be underestimated.

Figure 7.7.
Contributions from Time-Varying Parameters


Source: Authors’ estimates.

Note: Inflation dynamics show some differences across the ASEAN-5 countries, but they share some broad patterns. Box plots (Figure 7.8) over different subsamples show a relatively high degree of commonality in the country-specific contributions of the inflation drivers, but also suggest heterogeneous experiences across ASEAN-5 countries and over time (Figure 7.9).

Figure 7.8.
Contributions of Different Inflation Drivers to Inflation in ASEAN-5 Countries

Source: Authors’ estimates.

Note: Box plots depict the median and the interquartile range (25–75 percent). Outliers (coefficient estimates that are 1.5 times the interquartile range) are represented by ×.

Figure 7.9.
Contributions to Inflation Dynamics


Source: Authors’ estimates.

Note: The figure displays the estimated contributions of key inflation drivers to headline inflation from equation (7.1).

The main insights are as follows:

  • The rise in forward-looking inflation dynamics between the Asian and global financial crises was broadly shared among the ASEAN-5. However, interquartile and quartile ranges suggest some heterogeneity, likely capturing the different speeds of improvement in monetary frameworks. Since the global crisis there has been a slight decrease in both the median and the dispersion across countries, suggesting more similar challenges for monetary policy. (There is still a negative skew that reflects mainly Thailand’s position at the low end of the distribution.)

  • The impact of economic slack on inflation dynamics has been much more stable (although still low) over time and across countries, with narrow interquartile ranges. The large number of extreme values reflects simply the higher impact when the output gap is large, which, in turn, confirms that business cycles are relatively synchronized across ASEAN-5 countries.

  • Country dispersion in the contributions of non-oil and oil import price inflation is more significant and reflects both differences in the evolution of the underlying variables and the quantitative differences of estimated parameters across countries. The decline in non-oil contributions over time seems to be strongly shared across countries. For oil price contributions, the decline is quite natural given that the ASEAN-5 country group includes both heavy oil importers (Thailand) and oil producers (Indonesia, Malaysia).

Challenges Aheadt

Monetary policy frameworks across the globe are likely to continue evolving in coming years. Significant uncertainty surrounds the key characteristics of future monetary policy regimes, but some general aspects have already become the focus of significant attention in recent years. For example, the new normal global environment is likely to exhibit low natural interest rates that may constrain monetary policy space and pose a significant challenge for monetary policy to deliver healthy inflation levels. There also seems to be ample consensus that central banks are likely to communicate more actively than they did before the global financial crisis (Blinder and others 2016)6 and that strongly anchored long-term inflation expectations may be even more important in such an environment. Yet there is still no consensus on the usefulness of some of the unconventional monetary policies introduced during the global financial crisis in the regular conduct of monetary policy or their application to emerging markets.

In addition, central banks may also be tasked with broader mandates, such as financial stability, and may need to use macroprudential tools more extensively. The formal interaction between standard objectives (price and output stability) and financial stability considerations in the implementation of monetary policy, however, remains an area of important debate in both academic and policy circles.

Current conditions and the outlook facing the ASEAN-5 economies matter for the challenges they face and the implications for monetary policy frameworks. On the one hand, countries such as Singapore and Thailand seem to have been more severely affected by the declines in oil and commodity prices since 2014 and experienced a protracted period of very low (or even negative inflation) (Figure 7.10). On the other hand, although inflation has also experienced some volatility in Indonesia, Malaysia, and the Philippines since 2014, it has remained well in positive territory, and in most cases fairly close to central bank inflation targets. The rest of this section discusses issues that may become more relevant for the ASEAN-5 countries in the near future.

Figure 7.10.
Contributions to Headline Inflation


Sources: Authorities’ data; and authors’ calculations.

Note: The figure displays the contributions of food, energy, and core goods (excluding energy and food) to headline inflation.

Adjusting to the New Normal Global Environment

Monetary policymaking in the ASEAN-5 will likely continue to be influenced by the global macroeconomic and financial environment that emerged from the global financial crisis in many advanced economies. This section elaborates on three aspects of that new normal global landscape: (1) the normalization of monetary policy in the advanced economies, (2) the factors behind an inflationless economic recovery from the global crisis, and (3) low natural rates of interest.

As the recovery from the global crisis gains a firmer footing, some advanced economy central banks—most notably the US Federal Reserve—have started normalization following the extraordinary monetary stimulus. As shown in Chapter 4, US monetary policy and the global financial cycle have had important spillovers on financial conditions in ASEAN-5 countries. In the current circumstances, however, the impact of higher US interest rates on global financial markets may be more uncertain. First, the normalization of US monetary policy interest rates implies decoupling of the US monetary policy stance from that of advanced economies that may need to remain accommodative longer. Moreover, although there is broad consensus that normalization of US policy rates is in general good news for the global economy, the pace of implementation is more controversial. Given the uncertainty surrounding the economic outlook, the pace of normalization of US monetary policy will also be subject to uncertainty. With the gradual move to flexible exchange rates and the buildup of buffers, the ASEAN-5 countries are well prepared to face global financial volatility if there is a bumpy exit from unconventional monetary policies in advanced economies.

Considering the inflationless recovery in most countries in recent years, the shape of the Phillips curve, a benchmark framework for the analysis of inflation dynamics in most central banks, has been the subject of much debate. Although recent empirical evidence suggests a flattening of the Phillips curve (for example, Blanchard, Cerutti, and Summers 2015; Ball and Mazumder 2011; Kiley 2015), the focus of those analyses was mainly the surprisingly high inflation observed during the early stages of the global financial crisis in many advanced economies. This high inflation was often justified by the strong anchoring of inflation expectations and the presence of “shadow economic slack” (an unusual divergence between unemployment and overall labor market slack). Yet the low inflation in advanced economies during the ongoing economic recovery in recent years has further supported the presence of a weaker link between growth and inflation, at least temporarily.

For ASEAN-5 economies, the evidence presented in the section “Drivers of Asean-5 Inflation Dynamics” is also broadly consistent with the main findings for advanced economies. The strong role of long-term inflation expectations and their anchoring and the relatively low quantitative impact of economic slack on inflation dynamics, except during major recessions, are two key pieces of evidence with which to assess the region’s outlook for inflation. For example, ASEAN-5 countries particularly afflicted by low inflation (Singapore, Thailand) have also experienced relatively weak inflation dynamics in recent years despite an improvement in growth, in line with the experience of many advanced economies.

There is increasing evidence of a decline in natural real rates worldwide (from about 4 percent in the late 1990s to close to zero in recent years). Against this backdrop the surge in research on the level of interest rates is not surprising because the natural real rate has important implications for monetary policy (for example, Yellen 2015). The natural real interest rate is usually defined as a real interest rate consistent with an economy’s achievement of both potential output and price stability. In other words, it is the interest rate at which real GDP equals potential GDP and the inflation rate equals the inflation target. Recent estimates corroborate a dramatic decline in natural interest rates in Europe, the United Kingdom, and the United States since the start of the global financial crisis.7 In Asia, natural rates have also fallen in advanced economies (Australia, Japan, Korea), while in ASEAN-5 countries and other emerging markets they have remained relatively stable (Figure 7.11).

Figure 7.11.
Selected Economies: Real Natural Interest Rates

(Percentage points)

Source: IMF staff calculations using the methodology in Lubik and Matthes 2015.

Further research is needed to understand the reasons behind the lower natural rates. Global supply and demand for funds, shifting demographics, slower trend productivity and economic growth, emerging markets’ search for large reserves of safe assets, and a more general global savings glut have been proposed as possible causes (Council of Economic Advisers 2015; Rachel and Smith 2015; Caballero, Farhi, and Gourinchas 2016). Most of these causes bear little relationship to monetary policy, at least in the short term. Nevertheless, they reflect global trends that seem likely to be part of the new normal, particularly in advanced economies. And in a widely integrated economic and financial world, they are likely to affect monetary policymaking in other countries as well.

Evidence on the evolution of natural real rates in ASEAN-5 countries is mixed. Natural real rates in Indonesia, Malaysia, and Singapore have remained relatively stable. In contrast, the Philippines has experienced a significant decline in natural rates during the past two decades. In all those cases, the estimated level of the natural real rates remains somewhat higher than those for most advanced economies in recent years. Thailand seems to be in a different position, with a persistently lower natural rate than the other ASEAN-5 countries and, with the exception of Japan, than even most advanced economies.

A lower natural rate of interest has important implications for optimal implementation of monetary policy. A decline in natural real rates that turns out to be permanent, or at least highly persistent, as evidence suggests, would affect the appropriate stance of monetary policy. A central bank that fails to acknowledge a lower natural rate may set nominal policy rates too high, risking inflation rates that run below the inflation objective over time. Moreover, measurement of the natural rate of interest, similar to potential output, remains subject to significant uncertainty. Against this backdrop simple monetary policy rules—for example, those in which the first difference of the policy rate is a function of the deviation of inflation from its objective and the first difference of the output gap—can serve as broad guidance and perform well (Orphanides and Williams 2002).

Central banks in ASEAN-5 economies have not been constrained by the zero lower bound on their policy rates. However, in economies with very low natural real interest rates and low inflation, the possibility of a zero lower bound has become more likely, even from small shocks to economic activity. A numerical example based on a stylized monetary policy framework comprising a standard Taylor rule and a Phillips curve (as equation (7.1)) can illustrate this point. In Indonesia, given current inflation expectations and the natural real rate, real GDP growth would have to deteriorate to –0.15 percent for the nominal policy rate to hit the zero lower bound. In Thailand, facing lower inflation expectations and natural real rates, it would take a much smaller growth shock. Real GDP growth could fall to just 2 percent for the nominal policy rate to hit the zero lower bound. Such a difference of more than 2 full percentage points of real GDP growth gives significantly greater room for conventional monetary policy to operate and mitigate output losses. Moreover, any decline in inflation expectations would further increase the probability of the zero lower bound and the associated costs to economic activity. Kiley and Roberts (2017) study the frequency and potential costs of effective zero bound episodes in economic models. They advocate raising inflation targets and pursuing a very accommodative monetary policy stance to steer inflation above target whenever possible and gain additional space for monetary policy in the future.

Upgrading Monetary Policy Frameworks

In the new normal global environment, monetary policy frameworks in ASEAN-5 countries will likely need to continue adapting to uncertain and volatile economic and financial conditions. This section elaborates on three crucial challenges for ASEAN-5 monetary policy frameworks for the period ahead: (1) enhancing communication and transparency, (2) strengthening the monitoring of long-term inflation expectations, and (3) in countries that may face recurrent episodes of low (and below-target) inflation, considering unconventional monetary policies, higher inflation targets, and synergies with other policies.

Enhancing communication and transparency

Effective central bank communication is essential for managing inflation expectations and their impact on inflation dynamics. As economic structures and the monetary policy regime evolve over time, effective communication about the central bank’s objectives and strategy and the rationale for its decisions, along with the macroeconomic outlook, become critical for guiding private sector expectations and enhancing monetary policy effectiveness (for example, Blinder and others 2008).

ASEAN-5 central banks’ transparency has increased significantly over the past two decades, but there is scope for improvement. To strengthen monetary policy independence after the Asian financial crisis, all ASEAN-5 countries increased their exchange rate flexibility and made significant improvements in their operating frameworks, definition of policy objectives, and communication. Establishing price stability as a primary objective and explaining monetary policy decisions in publicly available reports are currently regular features across ASEAN-5 central banks. Indonesia, the Philippines, and Thailand—the flexible inflation-targeting countries among the ASEAN-5—also established explicit medium-term inflation targets. Indeed, an index of central bank transparency shows that from low scores of between 2 and 4 points in 1998, the transparency of ASEAN-5 central banks improved substantially (Indonesia, Philippines, and Thailand up to 9–10 points and Malaysia and Singapore 5–6 points in 2014; Dincer and Eichengreen 2014; Figure 7.12).8 However, those improvements coincided with a global trend among central banks, and compared with the top five central banks in the ranking, there is generally still room for improvement in transparency.

Figure 7.12.
ASEAN-5 Central Banks: Dincer-Eichengreen Central Bank Transparency Index

Source: Dincer and Eichengreen 2014.

Note: Top 5 = the top 5 central banks in the ranking: central banks of the Czech Republic, Hungary, Israel, New Zealand, and Sweden. Maximum score of 15 is based on central bank transparency across the following five dimensions: Political (3): policy objectives (explicit objectives, quantification, instrument independence) Economic (3): information used for monetary policy decisions (data, model, central bank forecast) Procedural (3): decision making (policy strategy, prompt account of deliberations, voting info) Policy (3): disclosure of decisions (prompt announcement, explanations, forward guidance) Operational (3): implementation (evaluation with respect to targets, shocks impairing the achievement of goals, explanation of decisions’ contribution to goals).

Central bank transparency scores and the degree of forward-looking inflation dynamics are strongly linked in ASEAN-5 countries. From a theoretical point of view, effective communication and transparency by the central bank should successfully align public long-term expectations with the inflation target and ensure a substantial degree of forward-looking behavior in price setting and inflation dynamics. The empirical results discussed in the previous section provide strong support for these theoretical considerations: both the time-varying estimates of the forward-looking coefficient, βt1, and the overall time-varying contribution of long-term inflation expectations, βt1π¯t, have been positively related to the evolution of the Dincer-Eichengreen transparency score for each country (see Figures 7.13 and 7.14).

Figure 7.13.
Coefficients of Forward-Looking Dynamics and Central Bank Transparency

Sources: Dincer and Eichengreen 2014; and Dany-Knedlik and Garcia, forthcoming.

Note: DE = Dincer-Eichengreen.

Figure 7.14.
Contribution of Forward-Looking Dynamics and Central Bank Transparency

Sources: Dincer and Eichengreen 2014; and Dany-Knedlik and Garcia, forthcoming.

Note: DE = Dincer-Eichengreen.

Looking ahead, the challenge for effective communication by ASEAN-5 central banks lies in the quality of information. Transparency about the responses to a rapidly evolving macroeconomic environment and the uncertainty surrounding the economic outlook, both at the domestic and the global level, as well as the necessary adjustments in monetary policy frameworks to cope with them, are likely to be fundamental parts of effective central bank communication.

Strengthening the monitoring of long-term inflation expectations

Improving the monitoring of long-term inflation expectations should be a top priority in the research agenda of ASEAN-5 central banks. The presence of a systematic discrepancy between survey expectations and inflation targets suggests that there is scope for strengthening the anchoring of inflation expectations in the region. Adding trend inflation estimates, such as those shown earlier in this chapter, to the regular tools that central banks use can inform monetary policymaking decisions, provide reliable information about long-term inflation trends, and help cross-check survey expectations. Trend inflation estimates have been more aligned with the inflation targets announced by the ASEAN-5 central banks, particularly in Indonesia. In the Philippines, trend inflation has been below target since 2014, but it is now on a gradual return path to the 3 percent target level. In contrast, in Thailand, trend inflation has been on a slow downward path since 2014, which may pose a more serious challenge for monetary policy. The analysis of trend inflation should help better assess the stance of monetary policy in these economies.

The evolution of trend inflation and the uncertainty surrounding the estimates also provide some important insights about the anchoring of inflation and the challenges for central bank communication. For example, trend inflation in Malaysia since 2005 has been significantly more variable than in Thailand and Indonesia. This difference may have occurred because Thailand and Indonesia adopted explicit targets for inflation, helping reduce uncertainty about long-term inflation trends. The evidence in the earlier part of this chapter, however, shows that Bank Negara Malaysia has nonetheless conducted its monetary policy effectively since 2005. Hence, trend inflation estimates may provide insights helpful to monetary policy regardless of the specific regime in place.

There is also scope for using the information from survey measures of inflation expectations more systematically. The level of long-term inflation expectations is just one dimension of their anchoring. For example, the degree of disagreement (the standard deviation of the point forecast among the survey participants) also provides information: if inflation expectations are well anchored around a given level—the central bank’s midpoint target—all survey panelists’ expectations should be very close to that value, and the discrepancy among panelists should be relatively limited. For ASEAN-5 economies, evidence from Consensus Forecasts suggests substantial disagreement among survey panelists—for example, on average, well above that for other successful inflation-targeting countries in the Asia and Pacific region, such as New Zealand (Figure 7.15).

Figure 7.15.
Disagreement about Long-Term Inflation Expectations

Source: Consensus Forecasts.

Policy responses against protracted periods of low inflation

The global financial crisis triggered significant changes in the practice of monetary policy. Many advanced economies faced serious disinflation pressure, cut policy rates to the zero lower bound or negative territory, and adopted unconventional monetary policies. Most of the policies adopted in advanced economies were introduced to improve financial and economic conditions rather than as a planned modification to existing monetary policy frameworks. As a reference, Table 7.1 provides a taxonomy of unconventional monetary policies. Whether the changes in the practice of monetary policy, motivated primarily by the financial crisis, will be temporary or permanent is uncertain at this point (Blinder and others 2016).

Table 7.1.Overview of Unconventional Policy Measures Adopted since the Global Financial Crisis
Type of MeasureFormulation
A. Interest rate policySetting policy rates and signaling future path to influence market expectations
Negative Interest RatesPolicy/deposit rates below zero
Forward Guidance on Interest RatesCentral bank communicates on future policy rates
Expansion of Liquidity-Providing FacilitiesFixed-tender auctions, expansion of eligible collateral, etc.
B. Balance sheet policiesAdjusting the size and/or composition of the central bank’s balance sheet through purchases of financial assets
Quantitative Easing and Forward Guidance on the Central Bank Balance SheetPurchases of government debt and communication
Credit EasingModifying the discount window facility
Expansion of collateral/counterparties in liquidity operations
Purchases of commercial paper, asset-backed securities, and corporate bonds
Bank Reserves PolicyMoney market operations to enlarge monetary base
C. Exchange rate policiesIntroducing an exchange rate floor
Interventions in the foreign exchange market
Source: IMF staff estimates.
Source: IMF staff estimates.

The unconventional monetary policies adopted by various central banks were understandably chosen to take into account the characteristics of each country’s monetary policy transmission channels. In addition, the effectiveness of monetary policy in general, but of unconventional monetary policies in particular, depends strongly on the characteristics of the financial market and the financial sector structure through which they operate. For example, the impact of credit-easing policies depends on the conditions under which economic agents obtain financing (that is, the proportion of loan- versus market-based financing, degree of securitization, and so on). These considerations are important to bear in mind when assessing the potential application of unconventional monetary policies in other countries. Reliable quantitative evidence to assess the potential usefulness of unconventional monetary policies remains scarce; therefore, there is no consensus on their usefulness for the regular conduct of monetary policy.

Most available evidence on the usefulness of unconventional monetary policies focuses on situations in which the zero lower bound became a binding constraint for monetary policy. The introduction of unconventional monetary policies in many advanced economies followed the full use of space for conventional monetary policy. Hence, this evidence offers only indirect guidance for assessing whether unconventional policies should be used even when there is still room for conventional monetary policy. Recent research (for example, Quint and Rabanal 2017) finds that the benefits of unconventional monetary policies depend critically on the types of economic shocks hitting the economy. There are generally significant benefits in the presence of severe financial shocks, but only negligible benefits in the face of more traditional business cycle (supply and demand) shocks. Moreover, some recent research points to significant risks from unconventional monetary policies in emerging markets: in an analysis of a large panel of emerging market and developing economies, Jácome, Saadi Sedik, and Ziegenbein (forthcoming) show that credit easing may lead to large currency appreciation and substantially lower growth.

A higher inflation target could be a potential preemptive measure to raise inflation expectations and regain monetary policy space. Since average nominal interest rates would reflect the sum of real rates and expected inflation, raising the inflation target may help compensate for the lower (natural) real rate and raise inflation expectations. This approach could provide enough space to offset deflationary shocks and close output gaps (for example, Blanchard, Dell’Ariccia, and Mauro 2010). For the new target to be credible, however, its revision should be implemented through a comprehensive review process with clear and transparent communication to the public. Such a revision should be based on expected future real interest rates, the amplitude and nature of the shocks that are likely to hit the economy, and the necessary policy space to reduce the risk of recurrent low-inflation and deflation episodes. In those circumstances, setting a higher inflation target would not threaten the central bank’s credibility but reinforce it. Indeed, when supported by strong policy action to achieve the new (higher) target and clear communication of the central bank’s resolve, raising the inflation target can strengthen the monetary policy transmission mechanism through the expectations channel (see “Drivers of ASEAN-5 Inflation Dynamics” earlier in this chapter).

When space for countercyclical monetary policy is limited, backstopping monetary policy with other expansionary policies can also help avoid entrenched low inflation. Where appropriate, a broader strategy that entails the mutually supportive use of monetary, fiscal, and structural policies would be optimal (Gaspar, Obstfeld, and Sahay 2016). Nonmonetary macroeconomic stimulus, of course, would need to be credible and sustainable. Otherwise, it can also undermine monetary policy.

Fiscal stimulus amid low inflation and low interest rates can be particularly powerful. In such an environment, fiscal multipliers (that is, the impact of fiscal stimulus on growth) are likely larger compared with an environment in which monetary policy may need to counteract the fiscal push to avoid inflation pressure.9 To be effective, fiscal stimulus must be embedded in a framework that credibly ensures long-term sustainability and adequately manages fiscal risk. Moreover, a credible commitment to and an enduring practice of inflation targeting would allow monetary policy to reinforce fiscal policy. Box 7.1 presents a simulation for Thailand of the improved macroeconomic outcomes achieved by reinforcing fiscal and monetary stimulus to counteract low-inflation risks.

To the extent that the decline in natural real interest rates can be traced back to a decline in potential growth, structural reforms that strengthen economic potential can also be instrumental to rebuild monetary policy space. Structural reforms could have contractionary effects in the short term, while sectoral adjustments take place gradually. Yet, supported by measured monetary policy accommodation, they can increase potential output and growth. Appropriate demand-management measures can offset the negative short-term effects of structural reforms on the economy, thereby reducing the costs of productive structural reforms as well as social opposition from segments of the population that may be adversely affected.

Synergies between Monetary and Financial Stability Policies

The global financial crisis triggered a debate over whether monetary policy should focus primarily on price stability or also target financial stability. Before the global financial crisis, the prevailing view was that monetary policy should have one main (in many cases overriding) objective, price stability, and one instrument, usually a short-term policy interest rate.10 That paradigm had been widely successful over the previous three decades in most advanced and emerging market economies. Yet severe financial and economic crises have forced reconsideration of the role of financial market imbalances and asset price developments in the design and implementation of monetary policy.

Combining Monetary and Fiscal Stimulus in a Low-Inflation Environment

Macroeconomic simulations offer some quantitative evidence of the potential impact of joint fiscal and monetary stimulus within a stylized New Keynesian model calibrated for the Thai economy (see Clinton and others 2015 for details on the model). In Figure 7.1.1, a baseline scenario (blue lines) assumes a constant monetary policy rate and a cumulative fiscal stimulus of 1 percent of GDP over three years. The alternative scenario (red lines) incorporates

Figure 7.1.1.
Potential Impact of Joint Monetary and Fiscal Stimulus: Thailand

Source: IMF staff calculations.

(1) monetary easing, (2) additional public investment of a cumulative 1 percent of GDP sustained over the medium term, and (3) a phased increase in the value-added tax rate to 8.5 percent once the output gap closes. The alternative scenario, with joint monetary-fiscal stimulus, helps inflation reach the midpoint inflation target (2.5 percent) with a substantial improvement in the balance of risks; private investment crowds in, and the value-added tax hike stabilizes public debt.

The case for a stronger role for financial stability considerations in monetary policy has intensified in recent years. In an extreme version of the precrisis view, monetary policy should react to asset-price movements only to the extent that they affect inflation (and output) and only if it can effectively clean up the mess after a bubble bursts. The global financial crisis, however, showed that severe financial imbalances could grow under relatively stable inflation and output gaps. Moreover, the Great Recession that followed the global crisis showed that those financial imbalances entail significant macrorelevant costs, which argues for monetary policy that proactively mitigates the risk of a crisis rather than simply cleaning up afterward, a lean versus clean view.

Whether monetary policy should be used for financial stability purposes remains highly controversial. Although there is agreement that policy should aim to avert financial (and economic) crises—not simply deal with the implications once a crisis occurs—whether and to what extent monetary policy should be altered to contain financial stability risks, let alone whether financial stability should be an explicit mandate for the central bank, is far less clear. Indeed, even among central bank policymakers and senior officials there have been voices strongly advocating for explicit financial stability mandates (for example, Olsen 2015) and against (for example, Svensson 2014, 2016). Others represent a more balanced view (for example, Yellen 2014). Detailed discussions on the policy trade-offs can be found in Smets 2014 and Stein 2014, among others.

The benefits of financial stability considerations influencing monetary policy decisions should be carefully evaluated against potential costs. A leaning-against-the-wind policy, for example, to tame rapid credit growth and mitigate financial risks can imply tighter monetary policy (a higher interest rate) than justified by standard flexible inflation targeting. That policy would therefore entail costs from lower output and inflation in the short to medium term. Benefits would materialize mainly in the medium term, as financial risks are mitigated, the probability of a crisis is reduced, and the losses associated with a crisis, should one occur, are attenuated. Two questions are of fundamental interest in the debate: first, is there a case for leaning against the wind in the presence of financial imbalances? Second, should leaning against the wind invoke a quantitatively important deviation of policy rates from those implied by standard inflation targeting? Answering those questions requires the use of a dynamic quantitative macroeconomic model and counterfactual scenarios.

Available evidence suggests that even if the benefits of leaning-against-the-wind policies could outweigh the costs, the optimal deviation of policy rates from those implied by more standard (inflation–output gap) decision rules would be quantitatively small. On the one hand, Gambacorta and Signoretti (2014) and Filardo and Rungcharoenkitkul (2016) have argued that the benefits of leaning-against-the-wind policies outweigh any costs. Overall results from (mainly closed economy) New Keynesian models with financial frictions support the view that, absent other tools, monetary policy should adopt financial stability as a new intermediate target (Curdia and Woodford 2009; Woodford 2012; Ajello and others 2016). On the other hand, other research finds that the costs generally outweigh the benefits (for example, Svensson 2016). In addition, severe difficulties with identifying bubbles and the potential dangers and costs of influencing asset prices ex ante are often mentioned. Specific results are, to a large extent, driven by the features of the model, and further work is needed before more robust conclusions can be reached.

As discussed in Chapter 2, most ASEAN-5 countries have given preeminence to inflation in guiding monetary policy. As inflation has declined, both globally and in ASEAN-5 countries, monetary policy rates have also fallen, and in some cases even to historical lows. Low rates can contribute to excessive credit growth and the buildup of asset bubbles and thereby sow the seeds of financial instability, but prudential policies can mitigate the buildup of financial risks in a low-interest-rate environment (see also Chapter 6).

The case for leaning against the wind may be even weaker in small open economies. In such economies, financial stability concerns are more likely to arise from capital flows reflecting external financial conditions and the global financial cycle. For example, strong capital flows may exacerbate search-for-yield behavior, put upward pressure on domestic asset prices, and compress financial spreads (Sahay and others 2014). In those circumstances, financial stability considerations that would put pressure on the central bank to raise policy interest rates (or keep them at a level that is higher than warranted based solely on price stability considerations) may turn out to be counterproductive and exacerbate instability by attracting further capital inflows. Menna and Tobal (2017) provide quantitative evidence in support of this mechanism by extending the framework of Ajello and others (2016) to an open economy setting.

Tensions between price and financial stability mandates may also weaken the credibility of the central bank and the effectiveness of monetary policy. Monetary policy credibility and effectiveness in targeting inflation largely stem from transparency, predictability, and observable success, which are key underpinnings of the standard monetary policy framework. Interest rate decisions guided by financial stability concerns, in contrast, would have to be justified in reference to potential future events that are difficult to forecast, or even to define precisely. Thus, the possible trade-offs with respect to central bank transparency and predictability should be considered, and effective communication could become more challenging. Moreover, if, because of financial stability concerns, monetary policy is calibrated to allow inflation to remain below target for longer than otherwise desirable, there could be risks of destabilizing inflation expectations, leading to higher real rates and thereby penalizing growth and investment.

Macroprudential policy tools can help alleviate tensions between monetary and financial stability objectives.11 Discrepancies between monetary and financial stability mandates stem from attempts to achieve two different objectives with a single policy instrument, the policy rate. Using macroprudential tools to curb systemic risks may, however, ease those tensions. Indeed, in theory, targeted macroprudential measures to address specific sectors and risks can be more efficient and have fewer undesirable effects than economy-wide measures like the interest rate. As discussed in Chapter 6, ASEAN-5 economies have increasingly used macroprudential tools, especially housing-related and sectoral measures, to address financial stability concerns.

Moreover, Chapters 8 and 9 further elaborate on the future agenda necessary to strengthen macroprudential frameworks and exploit synergies between monetary and macroprudential policies to achieve price and financial stability objectives. The analysis in Chapter 9 shows that the combination of macroprudential tools and monetary policy can produce better results in terms of growth, inflation, and financial stability than simply leaning against the wind through the use of monetary policy to temper credit growth.


Monetary policy frameworks in ASEAN-5 economies have improved significantly since the Asian financial crisis and have worked well over the past decade and during the global crisis. Yet they are likely to be tested further by the global environment in coming years. There is still substantial uncertainty about the potential changes in monetary policy frameworks worldwide, and consensus on a new paradigm has yet to be reached.

Potential further refinements in monetary policy frameworks may well not be symmetric across ASEAN-5 countries. Differences in inflation performance vis-à-vis central bank targets over recent years and financial sector vulnerabilities may call for different responses to the global challenges brought about by the new normal. Yet all ASEAN-5 economies are in a position to continue to adapt their monetary policy frameworks, particularly through enhanced communication and better monitoring of inflation expectations.


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Surveys are a traditional source of information on long-term inflation expectations; they have been available several times a year for many countries over several decades. With the issuance of inflation-linked bonds in many advanced economies and in emerging markets, the so-called break-even inflation rate (BEIR)—the yield spread between comparable conventional bonds and inflation-linked bonds—has also become a crucial indicator of inflation expectations.

BEIRs often provide more timely information on investors’ inflation expectations than survey-based expectations. Yet, in addition to expected inflation, BEIRs may incorporate other factors, notably inflation risk and liquidity risk premiums, and are better interpreted as the overall inflation compensation requested by investors to hold nominal assets than as a pure measure of expected inflation. Among the ASEAN-5 countries, BEIRs are available only for Thailand.

For a detailed discussion of the relationship between trend inflation and survey measures in ASEAN-5 economies across additional dimensions, see Garcia and Poon, forthcoming-a.

Coibion and Gorodnichenko (2015) provide regression evidence that survey forecasts’ departure from full rationality may be related to information rigidities leading to a sluggish adjustment in (US) survey expectations. Such an interpretation is consistent with findings for euro area surveys. Mertens and Nason (2015) model inflation and survey expectations jointly, allowing the strength of the information rigidities to vary over time using an additional latent state and incorporating autoregressive dynamics and trend inflation.

To focus on the contributions of the main drivers in the rest of the section, the estimated impact of inflation persistence in equation (7.1) is replaced by iterating over the other factors (see also IMF 2016). To sharpen the discussion, particularly of the disinflation episode during 2014–16, the contribution of import price inflation is decomposed into non-oil import price inflation and oil price inflation by means of a regression on oil price inflation over a rolling window ordinary least squares estimation.

Blinder and others (2016) collected the views of central bank governors and academics by means of two independent surveys conducted between February and May 2016. Their results were based on 55 replies from central banks from 16 advanced economies, 32 Bank for International Settlements members, 20 inflation-targeting countries, and 12 countries hit by the financial crisis. The second survey yielded 159 replies from academic economists from the relevant research programs of the National Bureau of Economic Research and the Centre for Economic Policy Research.

See, among others, Laubach and Williams 2003, 2016; and Lubik and Matthes 2015. Results are generally model based, using either semistructural time series and filtering methods or formal (dynamic stochastic general equilibrium) macroeconomic models to examine the relationship between the equilibrium real interest rate and its possible determinants. Regardless of the specific methodology used, a common finding in these studies is that the equilibrium real interest rate has declined in recent years to a level not seen in decades.

It is important to note that Malaysia and Singapore are somewhat penalized in the index for not having an official figure for their inflation target even though their central bank mandates stress price stability.

When the economy is near full employment or overheating, the central bank would normally have to raise its policy interest rate in response to a fiscal expansion in defense of its inflation objective, crowding out private spending and dampening the multiplier effect (Auerbach and Gorodnichenko 2012).

The theoretical foundation for that policy framework is deeply rooted in New Keynesian models whose mainstream setting is a closed economy with nominal rigidities as the main, or only, friction and often without a financial sector. In this kind of model, the so-called divine coincidence (Blanchard and Galí 2007) through which stable inflation also kept output around its efficient level holds. In the presence of financial and other friction, however, a trade-off can emerge between stabilizing output around its efficient level and stabilizing inflation (Woodford 2003).

Macroprudential policy has been defined as the use of primarily prudential tools to limit systemic risk—that is, the risk of disruption to the provision of financial services as a result of impairment of all or parts of the financial system—and can cause serious negative consequences for the real economy (for further details see, for example, IMF 2015). It includes a range of instruments, such as measures to address sector-specific risks (for example, loan-to-value and debt-to-income ratios), countercyclical capital requirements, dynamic provisions, reserve requirements, liquidity tools, and measures to effect foreign-currency-based or residency-based financial transactions.

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