What is MAS’ monetary policy framework and its rationale?
This section explains why the Singapore Dollar Nominal Effective Exchange Rate (S$NEER) is MAS’ chosen intermediate target for monetary policy and identifies the channels through which the exchange rate impacts prices in the economy.
It also clarifies that MAS’ exchange rate policy is Singapore’s only form of monetary policy. As Singapore’s monetary policy is centred on the exchange rate and its capital markets are open, domestic interest rates are largely determined by global interest rates and foreign exchange market expectations of the Singapore dollar.
2.1 Why does MAS use the nominal exchange rate as the intermediate target of monetary policy?
Unlike most central banks which target interest rates, MAS uses the nominal exchange rate as the intermediate target of monetary policy.
This is because, in a small and open economy such as Singapore, where gross exports and imports of goods and services are more than 300 percent of GDP and almost 40 cents of every dollar spent domestically is on imports, the exchange rate has a much stronger influence on inflation than the interest rate.
The nominal exchange rate, directly and indirectly, affects a wide range of prices in the Singapore economy, such as import and export prices, wages and rentals, consumer prices and output prices. (See Question 2.3)
Indeed, empirical research supports the view that the exchange rate is a relatively more effective instrument of monetary policy in very open economies, such as Singapore.
The IMF has also concluded that MAS’ monetary policy framework has served Singapore well in delivering domestic price stability.
2.2 What is the operating framework for MAS’ monetary policy?
The operating framework for MAS’ monetary policy is centred on managing the Singapore dollar against a basket of currencies along a typically appreciating path or crawl within a policy band. The framework is often referred to as the ‘Basket’, ‘Band’, and ‘Crawl’ or ‘BBC’ system.
MAS’ intermediate target of monetary policy is the Singapore Dollar Nominal Effective Exchange Rate (S$NEER), which is a trade-weighted basket
The S$NEER has a stable and predictable relationship with inflation, MAS’ ultimate target of monetary policy, which makes it a suitable intermediate target of monetary policy.
MAS focuses on the S$NEER rather than a bilateral exchange rate between the S$ and any particular foreign currency, as the trade-weighted exchange rate better reflects Singapore’s diverse trading patterns. The S$NEER also tends to be more stable than bilateral exchange rates (Chart 2.1), as it is not unduly affected by idiosyncratic factors in any one particular economy.
At each monetary policy review in April and October, MAS formulates monetary policy by setting a path for the S$NEER policy band to ensure price stability in the medium term. MAS does this by allowing the band to crawl or appreciate at different rates over time, depending on current and future expected price developments in the economy. (See Question 3.6)
MAS does not have a crawling peg to a basket of currencies. Instead, the S$NEER is allowed to float within a policy band that is set around the targeted crawl rate. When necessary, MAS can adjust the width of the band, as well as the level at which it is centred. (See Questions 3.7 and 3.8)
MAS’ monetary policy decisions are thus typically characterised by shifts in the slope of the S$NEER policy band (i.e. the rate of crawl) and occasionally by changes in the level of the mid-point or the width of the band.
MAS’ monetary policy guides the path of the S$NEER policy band over time to ensure that it remains aligned with domestic price stability.
Chart 2.1: S$NEER and Bilateral Exchange Rate with US$ and Japanese Yen
2.3 How does the exchange rate affect inflation in Singapore?
The exchange rate affects a broad range of costs and prices in the economy through two main channels: the ‘imported inflation’ channel and the ‘derived demand’ channel.
The ‘imported inflation’ channel reflects changes in the S$ prices of imported goods and services that arise from fluctuations in the nominal exchange rate.
For example, an appreciation of the Singapore dollar against the currencies of our major trading partners reduces the S$ prices of imported goods and services, which subsequently dampens the consumer prices that Singapore households pay.
MAS’ empirical research consistently shows that there is strong, and almost full, pass-through of exchange rate changes to import prices which, in turn, filter through to consumer prices with a time-lag.
The ‘derived demand’ channel operates when nominal exchange rate changes affect firms’ demand for domestic factors of production and hence the output gap.
For example, when economic activity (GDP) rises above the economy’s potential (a positive output gap), it may be a precursor of rising costs, and thus, an acceleration of price inflation in the period ahead.
In this instance, an appreciation of the S$—in the face of short-run price and cost rigidities—will dampen aggregate demand, leading firms to cut back on domestic production and hold back on investment and hiring. This causes the positive output gap to narrow, which reduces inflationary pressures.
Over the long run, MAS’ nominal exchange rate policy, like monetary policy everywhere, has no impact on real variables like aggregate demand and employment, and only affects prices. (See Questions 3.1 and 5.1)
2.4 Is MAS’ exchange rate policy Singapore’s only form of monetary policy?
Yes. MAS’ exchange rate policy is Singapore’s only form of monetary policy.
In most countries, the central bank conducts monetary policy by setting a desired level for a short-term interest rate which maps to the final target or targets of monetary policy.
MAS uses the exchange rate as the intermediate target of monetary policy in an analogous way. MAS sets a desired path for the Singapore Dollar Nominal Effective Exchange Rate (S$NEER) to ensure medium-term price stability, which is the sole and final target of monetary policy in Singapore.
In theory, there is equivalence between monetary policy frameworks centred on the interest rate and those centred on the exchange rate.
In classical economic models, an increase in domestic money supply by the central bank (expansionary monetary policy) reduces the domestic interest rate. At the same time, since the relative supply of domestic currency to foreign currencies increases, expansionary monetary policy is associated with a depreciation of the exchange rate.
MAS has chosen to use the S$NEER as its intermediate target of monetary policy because Singapore is a small and open economy, where gross exports and imports of goods and services are more than 300 percent of GDP and almost 40 cents of every dollar spent domestically is on imports. Accordingly, the exchange rate has a much stronger influence on inflation than the interest rate.
2.5 How are interest rates determined in Singapore?
Given Singapore’s open capital markets, interest rates in Singapore are largely determined by no-arbitrage conditions such as Uncovered Interest Parity (UIP) or Covered Interest Parity. The UIP relationship for Singapore has been corroborated in several empirical studies.
However, domestic interest rates can be at a discount (premium) to global interest rates when the S$ is expected to appreciate (depreciate) against other currencies.
In practice, the S$ SIBOR and S$ SOR have tended to be at a discount to the US$ LIBOR given market expectations that the S$ would appreciate against the US$.
The lower interest return in Singapore is thus compensated by the expected rise in the value of the S$ in international currency markets.
2.6 What is the role of MAS in the domestic interbank market?
Money Market Operations (MMOs) are conducted daily by the Monetary and Domestic Markets Management Department (MDD) in MAS to manage liquidity within the banking system.
These are distinct from the implementation of exchange rate policy as MAS does not use domestic interest rates as a tool to carry out its exchange rate-centred monetary policy.
Instead, MMOs are primarily used to ensure there is sufficient liquidity to meet banks’ demand for precautionary, reserve and settlement balances.
The extent and size of MMOs will depend on the net liquidity impact of autonomous flows on the banking system and the prevailing market conditions. Autonomous flows, for instance, include changes in the stock of outstanding Singapore Government Securities (SGS), where net issuance (redemption) of SGS drains (injects) liquidity from (into) the domestic banking system.
During times of financial market stress, banks may also desire to hold larger buffers of liquidity.
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Chow, H K, Lim, G C and McNelis, P D (2014), “Monetary Regime Choice in Singapore: Would a Taylor Rule Outperform Exchange-Rate Management?”, Journal of Asian Economics, 30, 63–81.
Engel, C (2017), “The Role of Exchange Rates in International Price Adjustment”, Macroeconomic Review, Special Feature B, Vol. XVI, Issue 1, April.
IMF (2015), Singapore – Staff Report for 2015 Article IV Consultation, 22 July.
Mihov, I (2013), “The Exchange Rate as an Instrument of Monetary Policy”, Macroeconomic Review, Special Feature A, Vol. XII Issue 1, April.