Under inflation targeting, the emphasis is given to maintaining core inflation within the target range and, at the same time, achieving a balanced growth path. We use the 1-day repurchase rate as a policy instrument to keep the quarterly average of core inflation within the target range of 0-3.5 percent. If inflationary pressure heightens and thereby increases the possibility of core inflation breaching the target, interest rate has to be raised. Bearing in mind that a time lag of 4-8 quarters before a change in the policy rate can be fully transmitted to the rest of the economy, policy consideration needs to be forward-looking. Upward inflationary pressure over the past few years, due to higher oil prices, has been tamed by monetary tightening. We raised the policy rate 13 times between August 2004 and June 2006, bringing the policy rate to 5.00 percent from 1.25 percent per annum. Hikes in the policy rate have brought the money market and commercial bank interest rates higher over the past 2 years. Our policy response proved timely, with inflation and its second round effects well contained. Recently, domestic demand, particularly in private consumption and investment, showed signs of a slowdown, while economic momentum from exports was expected to moderate, given the prospects of the global economy in 2007. Since inflationary pressures have subsided in line with easing energy prices, monetary policy could be eased in support of a further expansion of the economy.
It can be very painful for both the economy and society to correct entrenched inflation – as I learned when I left this university in the mid-1970s – or indeed entrenched deflation. But monetary policy works through many channels in the economy. It affects borrowers and savers. It affects wealth – the value of houses and financial assets. It affects jobs and pay. And the impacts on individuals can be difficult to disentangle. Low rates, for example, can increase housing wealth and the value of pension investments while reducing the return on savings accounts. And to the extent that by smoothing the volatility of output monetary policy can prevent the adjustment to economic shocks leading to more persistent damage to the economy, it can prevent longer lasting loss of jobs and loss of pension values. A pension, after all, is in the final analysis a claim on the future economy – it is an investment, public or private, that has to be paid out of future revenues, dividends, capital values and taxes. However, these effects can be felt more powerfully when policy rates are at what appear to be very high or very low absolute levels. We are of course explicitly mandated to make difficult trade-offs. Most notably, when inflation is off track, they have to balance the speed with which it is brought back to target against the impact on growth.