Prepare for a rate hike

THERE is a view emerging out there that Bank Negara will have to raise the benchmark overnight policy rate (OPR) by the end of the year or early next year.

This view is premised on a strengthening economy, which usually means higher inflation as wages grow, unemployment comes down and consumption picks up. Earlier in the year, the market consensus was for no change in the OPR this year.

The last time the OPR was tweaked was almost a year ago, when policymakers decided on a rate cut of 25 basis points to 3%. Then, the economy was weaker.

The monetary policy committee meets on July 13 but the market consensus is for no-change in the OPR, as it would be too soon for the data to show a firmer trend.

But Malaysia’s economy has definitely strengthened, growing 5.6% in the first quarter and there is every indication that the economy will continue to pick up on exports growth and business spending.

Indeed, in the coming months, policymakers will change their view on the sources of inflation.

The prevalent view is that inflation has been cost-push driven, but as private consumption rises, inflation could very well be demand-pull driven.

Another factor that will pursuade policymakers to look into a rate hike is the weak ringgit. Don’t be fooled by all the headlines and salutary reports in recent weeks of the ringgit being one of the best-performing currencies in Asia, because compared to last year, it’s still well above four to the US dollar.

The direction that the US Federal Reserve (Fed) takes on further rate hikes as well as the start of the reduction of the US Treasury’s balance sheet used to boost the economy in the aftermath of the global financial crisis will also be factors that will have an influence on Malaysian policymakers.

The Fed has raised the federal funds rate twice this year. The benchmark US interest rate now stands at between 1% and 1.25% after another 25-basis-point hike last month. There could be two more hikes coming, which mean another 50 basis points.

Another two rate hikes will mean better interest rates for those invested in US dollars, while reducing the US$4.5 trillion balance sheet essentially means that the Fed will not buy more US bonds, which mean lower bond prices and rising yields. These rate hikes will put more pressure on the ringgit and a weak ringgit has contributed to core inflation, which picked up in May to 2.6% on a year-onyear basis. This has gone above Bank Negara’s target of 2.3% to 2.5%. Core inflation excludes food and fuel prices.

Inflation pervasiveness has also become more apparent as tracked by the central bank’s measures of everyday price inflation and perceived price inflation, which captures price increases in frequently purchased items (60% of the consumer price index basket), show a persistent trend higher than headline inflation, which includes food and fuel prices.

A hike in the OPR will help ease pressure on the ringgit and this will certainly help with inflation. The major factor holding back a rate hike is the risk to growth.

With Malaysia’s high household debt, there is the fear that a rate hike could crimp growth, especially in private consumption, which has been a mainstay of domestic demand given tepid spending from businesses until recently. However, the economy should be able to weather a 25-basis-point hike if growth stays resilient, wages rise, businesses continue to spend and jobs are created.