Why has the MAS chosen to focus on the exchange rate rather than an interest rate in its monetary policy strategy? One reason is that the Singaporean economy, with a trade-to-GDP ratio of 336% in 2022, is much more open than the inflation targeting economies. World Bank data show that the trade-to-GDP ratio is about 50% in the antipodes, 70% in Canada and the UK, and 90% in Scandinavia. The extreme openness of the Singaporean economy makes it essential to control the exchange rate since exchange rate changes have a profound impact on inflation.
The reason the MAS has left its inflation objective undefined appears to be that it was not specified when the strategy was adopted and by the time inflation targeting became common the MAS had a long and successful track record that mitigated the need for any adjustment to its policy framework. The inflation rate in Singapore has averaged almost exactly 2% between 1980 and 2023.
The MAS publishes a measure of the Nominal Effective Exchange Rate (NEER) – which is a trade-weighted average of the exchange rate of the Singapore dollar. Several analysts have studied the MAS’s conduct of policy. A common approach, followed here too, is to assume that the MAS sets the quarterly rate of change of the NEER depending on the rate of change of the exchange rate in the previous quarter, inflation pressures and economic activity. Since preliminary work indicated that the leading indicator gap was more significant than the output gap, it was used in the analysis.
Estimating the model on data over the period 1980Q3 to 2019Q4, the explanatory power can be assessed by comparing forecasts, and the actual evolution, of the exchange rate in the period 2020-2023. In doing so, the actual values of inflation and the Leading Index gap are used. If the actual exchange rate falls within the confidence band associated with the model, it can be said to explain the data well.
While the NEER had been held broadly constant for an extended period, from October 2021 onward the MAS decided to tighten monetary policy to limit inflation pressures. This led to a marked appreciation of the NEER. Nevertheless, the actual and forecasted exchange rates are strikingly similar.
At the time of its policy meeting in January, the MAS expected economic activity to strengthen in 2024 and inflation to remain elevated but decline during the year. It viewed its monetary policy stance, and the continued appreciation of the exchange rate, as appropriate and noted that the sustained appreciation of the exchange rate will continue to dampen imported inflation and domestic cost pressures. Barring further external shocks, a stronger Singapore dollar is to be expected.
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