Most prominently, global interconnectedness implies large and swift transmission of shocks across countries. A seemingly localized supply shock, such as the tsunami in Japan or the floods in Thailand two years ago, created ripple effects in various parts of the world by disrupting the global supply chain of production. From the perspective of most Asian economies, the abrupt economic contraction in the US and the euro area during the financial crisis were examples of external demand shocks. While such “real spillovers” generated by supply or demand shocks can be quite damaging, the avenues for dealing with them are apparent and relatively uncontroversial. Fiscal automatic stabilizers should be allowed to work fully and monetary policy could be eased to cushion the impact so long as medium-term inflation expectations are contained. Calibrating the policy response to these shocks may not be straightforward, but they do not, in of themselves, pose challenges to the underlying framework of policy. On the contrary, “financial spillovers” associated with extraordinary monetary policy easing in advanced economies have prompted many central banks and academics to do some soul searching about the appropriate framework, not just for monetary policy, but also for regulatory and capital account policies that can best deal with these shocks. It has been around five years that the US federal funds rate has been kept at the zero lower bound, and this has been supplemented with multiple rounds of large-scale asset purchases.
There was a spirited public debate whether such rate increases would invite more capital inflows. But we viewed that other factors, such as the strength of the domestic economy and high risk appetite of international investors, played a larger role in inducing capital inflows than a gradual increase in the policy rate. Our concern for medium-term financial stability was also a key element of policy deliberations at the time. Subsequently, things became more challenging as the Thai economy suffered domestic setbacks. As the boost from the government’s temporary stimulus measures dissipated at the start of this year, domestic demand slowed down markedly. At the same time, domestic credit growth was still quite high, stock prices continued to advance, and activity in the housing market remained brisk. Moreover, portfolio capital inflows continued and the baht was appreciating. This presented a dilemma and was an example of the difficulties posed by policy spillovers. Against the backdrop of weak global demand, we cut the policy interest rate. We contemplated the use of certain prudential measures, including those on capital flows, in order to complement domestic monetary policy as well as offset some of the impact of capital inflows on domestic financial conditions. But since the QE tapering talk began in earnest in May, the global financial environment changed dramatically, and with it the nature of the policy trade-offs. The communication by the Federal Reserve about possible tapering of its bond purchases was a key turning point for global financial markets. Financial conditions suddenly tightened in response.