Central banks around the world are responsible for managing inflation, which is the rate at which the general price level in the economy changes. Central banks tackle inflation by implementing “monetary policy”.

MAS is Singapore’s central bank and the key objective of its monetary policy is to ensure medium-term price stability that is conducive to sustainable growth of the economy. This means ensuring that inflation is low and stable over a time frame of more than a year. Households and businesses can then plan for the longer term without worrying about prices rising too quickly, which provides a firm foundation for the economy’s growth.

Most central banks in the world today operate monetary policy by controlling domestic interest rates. In the past, many central banks conducted monetary policy by controlling the growth of money in the economy.

Since 1981, MAS has operated monetary policy by managing the exchange rate. MAS does not control domestic interest rates or money supply growth. Exchange rate policy is the only form of monetary policy in Singapore.

Why is the exchange rate Singapore’s monetary policy instrument?
Singapore is a very open economy, meaning it trades heavily with the rest of the world. The value of its exports and imports of goods and services in one year is more than three times the value of what is produced in the economy.

Singapore imports most of its basic requirements, such as food, energy and raw materials. Out of every dollar spent domestically, about 40 cents go to imports. At the same time, a lot of the goods and services produced in Singapore are exported to the world.

The Singapore economy is also very small compared to the world economy. Singapore buys and sells goods and services on international markets at prices determined by global demand and supply conditions. Singapore alone cannot influence these prices. In other words, Singapore is a “price-taker”.

The prices of goods and services that Singapore trades with the rest of the world are usually set in the currencies of our major trading partners. These prices are converted into Singapore dollars using the exchange rate. This Singapore dollar price is ultimately what consumers here pay.
 

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For an open and small economy, the exchange rate has a greater influence over domestic inflation than interest rates. This is why MAS’ monetary policy is centred on managing the exchange rate.   

How does MAS’ exchange rate-centred monetary policy work?

MAS manages the Singapore dollar against a basket of currencies of our major trading partners to maintain low and stable inflation over time.

Why a basket? Singapore trades with many different countries, buying and selling goods and services priced in a variety of currencies. Therefore, how the Singapore dollar performs in relation to the various currencies collectively is what matters, rather than the Singapore dollar’s exchange rate against any one particular currency, such as the US dollar or Malaysian Ringgit. The basket of bilateral exchange rates is combined into an index, which is also known as the Singapore dollar nominal effective exchange rate (S$NEER). This index is compiled by assigning weights to the currencies of Singapore’s major trading partners based on the importance of their trade relationships with us. MAS manages the S$NEER index when conducting monetary policy.

How do adjustments to the S$NEER affect inflation in Singapore? Singapore imports goods and services from a variety of sources—vegetables from China, chicken meat from Malaysia, and construction equipment from the US, and so on—and these items are priced in foreign currencies. Suppose that the prices of these imports increase due to some shortage in supply among our trading partners. In Singapore dollar terms, these items would become more expensive for consumers and businesses, assuming that the various exchange rates (or S$NEER) do not change. When the Singapore dollar prices of many items across the economy increase rapidly, inflation rises.

However, if MAS supports a stronger (or appreciating) S$NEER, also known as tightening of monetary policy, the higher-priced imports will become cheaper in Singapore dollar terms for consumers and businesses in Singapore. In other words, strengthening the exchange rate can have a significant and direct impact on lowering inflation in Singapore.

At the same time, a stronger S$NEER means that the Singapore dollar price of our exports become more expensive to foreign buyers when converted into their currencies. They may then buy less from us, thereby reducing demand. This indirectly lowers inflation in Singapore: as Singapore businesses receive fewer export orders from abroad, they can cut back on production. They may hire fewer workers or downsize to smaller factories and office spaces, which are domestic inputs into the production process. This reduction in overall demand “cools the economy” and reduces cost and price pressures. While this indirect effect is also significant, it takes a longer time to work through the economy.

These effects are reversed if the MAS eases monetary policy, i.e., causes the S$NEER to appreciate more slowly, or even weaken or depreciate.

Limits of monetary policy

Monetary policy takes time to work through the economy and affect consumer prices. This is because price-setting by businesses involves many other considerations besides the exchange rate. These include demand conditions, competitive pressures, lengths of business contracts, as well as other input costs.

For instance, if MAS tightens monetary policy, the Singapore dollar strengthens. This will lower import costs for businesses in Singapore dollar terms. However, they may not make immediate adjustments to the prices they charge to consumers.

This could be because other business costs, such as electricity, warehouse and transportation services, may be fixed under an existing contract. Businesses might only be able to adjust their prices after their existing contracts expire and they can re-negotiate new contracts with revised prices. Companies may also need to consider their rental and wage costs. Therefore, it may take some time before the lower import costs due to the stronger Singapore dollar are passed on to consumers.

Businesses will also take time to assess how demand for their goods and services might change in response to MAS’ monetary policy tightening. A stronger Singapore dollar makes our exports more expensive to foreign buyers. For instance, tourists—who contribute significantly to economic activity in Singapore—may find visiting Singapore too expensive if our dollar is much stronger than their home currencies. Such changes in demand will affect businesses’ production, hiring, and investment plans, and ultimately their pricing decisions too.

In other words, the effects of a monetary policy move by MAS take time to gradually flow through the economy. At the same time, the economic backdrop itself is ever-changing due to new developments in our trading partners or domestic conditions. This means MAS needs to pay close attention to a wide range of considerations when deciding on the appropriate exchange rate policy to secure price stability over the medium term.

In the next article, we will examine Singapore’s historical inflation experience.