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Explaining inflation in Singapore

Explaining inflation in Singapore

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Inflation today has its roots in the 2008 recession.

By Yuen Yiling
Edited by Fang Shihan

FEBRUARY’S CPI data showed inflation slowing down just a little, to 5%. Not quite the level that would register as ‘healthy’, but not enough for an online screamfest circa 2008.

One source of inflation is expansionary monetary policy. When central banks raise money supply so borrowing money becomes easier, this allows people and businesses to have more available cash, leading to increased demand for goods and services. When the increased demand cannot be met by supply, prices rise, leading to inflation.

While Singapore does not fiddle with monetary supply, favouring tweaking the exchange rate instead, other countries do. And as an import-heavy economy, any monetary policy in economically powerful countries has an impact domestically.

To understand the monetary drivers of inflation in Singapore, let’s do some time travelling to the 2008 economic crisis. Back then, Lehman Brothers had just collapsed (leading to the minibonds protests in Hong Kong and Singapore), the collapse of the financial system was imminent and there was talk of a global economic slowdown.

Earlier that year in QE1, the central bank began their first round of quantitative easing (ie. printing more money), bought government bonds and financial assets to increase the money supply and reserves of the banking system. This, they presumed, would stimulate lending and further economic activity. However, a year later in October 2010, the US recovery was still weak, unemployment was high at 9.6%, and inflation was low at 1.1%.

This policy had a global impact. The presence of more dollar notes led to a fall in the value of the US dollar and this made the purchasing of foreign assets, cheaper. Great if you’re a Singaporean company buying out another company in the US, Or if you’re an internet shopper who’s shipping in a carton Victoria’s secrets underwear.

At the same time, the US was in a low interest rate environment, having slashed rates significantly to stimulate lending since the crisis began. Interest rates in the US stood at 0.19%, in contrast to SIBOR (Singapore Interbank Offered Rate) at 0.29%. This drove investors to borrow money from US banks, so they could park it in banks in emerging markets which had significantly better interest rates.

Combined with the presence of weak currencies in the developed world, ‘hot money’ began flooding in towards the developing world. Or, countries with better growth prospects like Singapore.

As a result, banks here depressed interest rates (over-supply of money from abroad) which lowered the costs of borrowing. This in turn released further liquidity into developing economies.

In October 2010, inflation in China hit a 25 month high at 4.4%. Investors from the developed world keen to seek more bang for their buck invested in commodities, equities and other asset classes such as property. This drove up prices, thus contributing to goods inflation. As an importer of intermediate and final goods globally, Singaporean firms and consumers faced higher prices.

Besides consumers, labour markets also faced tightening, due to the increased demand for goods and services arising from ample liquidity in the economy. Unemployment had fallen across Asia, reaching 2.1% in Singapore, and 4.1% in China. With too many jobs and too few workers, (real) wages began to rise.

Subsequently, wage pressures intensified due to both rising demand for more workers to produce more goods and the expectation from workers that the cost of living would increase. Rising wages led to increases in the cost of production, further fuelling goods inflation.

What drove inflation from then on was the vicious cycle driven by expectations of inflation – expecting higher prices, workers will ask for higher wages, leading to higher prices being realised, and workers expecting even higher prices.

Wages are currently not indexed to inflation. The policy of having the variable component of wages was implemented to take companies through tough times (by decreasing it), but never to help workers maintain their spending power income , or nominal income (by increasing it) during periods of high inflation.

The experience of monetary inflation is not unique to Singapore, but a phenomenon throughout most of Asia that had recovered from the downturn before the US did. It is also a manifestation of policy choices.

One way to dampen the cycle of ‘hot money’ flows is to allow currency appreciation, as MAS did in April and October 2010. As the Singapore dollar strengthened, local assets and goods became more expensive. This put a dampener on investors who were seeking to purchase assets in fast growing economies, thus reducing the inflow of ‘hot money’. A stronger Sing dollar also led to more expensive exports, putting brakes on the economy. Overall, this eased pressure on prices.

Another policy options include implementing capital controls to limit the amount of ‘hot money’ entering a country, or raising reserve requirements (like China) to hold back bank lending and asset purchases, or raising interest rates which would increase the cost of borrowing and limit it. Clearly, the choice of policy will be influenced by political and circumstantial considerations and will vary across different countries.