Three ways to anchor money: an inflation target, the exchange rate or another currency

What a monetary framework is

A monetary policy framework is the way a central bank ties down the value of money over time. The International Monetary Fund (IMF), in its classification of monetary policy frameworks, distinguishes four main types:

• Exchange rate anchor: the monetary authority stands ready to buy or sell foreign exchange at given quoted rates.
• Monetary aggregate target: the authority uses its instruments to achieve a target growth rate for a measure of money.
• Inflation targeting: the public announcement of medium-term numerical targets for inflation.
• Other: the country has no explicitly stated nominal anchor.

Frameworks change. The Bangko Sentral ng Pilipinas formally replaced monetary aggregate targeting with inflation targeting in January 2002, and Bank Indonesia adopted its Inflation Targeting Framework on 1 July 2005, replacing base money as its policy target.

The trilemma: two out of three

Economists describe the choice with the monetary policy trilemma. A country would like three things at once:

• a stable exchange rate;
• a monetary policy of its own, with interest rates set for domestic conditions;
• capital that can move freely in and out of the country.

It can have only two of the three at the same time. Obstfeld, Shambaugh and Taylor studied interest rates across countries over more than 130 years and found that the constraints implied by the trilemma are largely borne out by history.

Singapore shows one way to choose. The Monetary Authority of Singapore (MAS) manages the exchange rate and states that it does not control domestic interest rates or money supply growth.

How Southeast Asia chooses

Within the region, all of these choices can be found:

• Inflation target and a policy rate: the Bank of Thailand has used flexible inflation targeting since May 2000, with the policy interest rate as its key instrument and a managed float for the baht. The Philippines and Indonesia also target inflation (lesson 2).
• The exchange rate: since 1981, MAS has conducted monetary policy by managing the Singapore dollar exchange rate, because in such a small and open economy the exchange rate has a greater influence over domestic inflation than interest rates (lesson 3).
• Another currency: the Brunei Darussalam Central Bank describes a currency board, under which the Brunei dollar is pegged to the Singapore dollar at par and every note and coin issued must be backed (lesson 3).
• A dollarised economy: the National Bank of Cambodia aims at price stability, but says that in a highly dollarised economy the effective conduct of monetary policy is constrained. Its current instruments are the reserve requirement rate and foreign exchange intervention (lesson 4).

The same choices elsewhere

The same menu is used outside the region. The US Federal Reserve and the European Central Bank both target inflation: since January 2012 the Federal Reserve has stated that inflation of 2 percent, measured by the price index for personal consumption expenditures, is most consistent with its mandate, and the European Central Bank aims for 2% inflation over the medium term, measured by the Harmonised Index of Consumer Prices, and treats deviations on either side as equally undesirable.

Closer to the region, Hong Kong has run a currency board since 17 October 1983, keeping the Hong Kong dollar within a band of 7.75 to 7.85 to one US dollar. Where a currency is tied in this way and capital moves freely, the trilemma means the country gives up setting its own interest rates for domestic conditions.

Three questions for a lender

Before lending in a market, it helps to know which framework it uses. Three questions show what the framework means for the business:

• What anchors prices? Under an inflation target, the policy rate is the central bank's main instrument (the course on central banks and policy rates explains how it reaches loan rates). Under an exchange-rate framework or a currency board, the central bank steers or fixes the exchange rate instead.
• In which currency do borrowers earn, and in which do they borrow? Where both local and foreign currency are in use, a loan in one currency to a borrower who earns in another carries exchange rate risk.
• Where does liquidity come from in a crisis? The National Bank of Cambodia notes that, with high dollarisation, it loses its ability to act as lender of last resort.

The current policy rate or framework of each market is on the policy rates page.