Time to unwind easy-money stimulus
BANK Negara has raised the overnight policy rate (OPR) by 25 basis points (bps) to 2% on May 11, marking the start of interest rate normalisation after two years of ultra-monetary accommodation to lift the battered Malaysian economy out from the Covid-19 pandemic.
During the pandemic, the OPR was reduced by a cumulative 125 bps to a historic low of 1.75% to stimulate the economy.
It’s time to unwind the excessive monetary accommodation before we reach a point where the risks of monetary expansion outweigh the benefits of cheap credit in an environment of high costs.
A prolonged period of low interest rates will cause the mispricing of capital and misallocation of financial resources into unproductive spending and investment.
They have discouraged savings and incentivised investors to indulge in risky investing behaviour for short-term gains. They have a negative impact on consumption for those who depend on interest income to meet their expenses.
According to Bank Negara, a firmer footing of domestic growth validates a gradual removal of the degree of monetary accommodation amid the increasing inflation pressure.
Both headline inflation and core inflation (measureing the underlying demand-induced inflation) are expected to move higher this year.
Core inflation increased by 1.7% in the first quarter of 2022 amid improving domestic demand and high-cost environment.
Bank Negara estimates that the headline inflation will increase by 2.2% to 3.2% while core inflation at 2% to 3% in 2022.
Global inflationary pressures and a series of aggregated supply shocks are showing no signs of abating, and they could worsen further. The supply constraints could take some time to catch up with the recovering consumer-demand.
Another wild card to exacerbate inflation is the potential rationalisation of fuel subsidy.
In addition, the weakening ringgit also adds to a new layer of higher imported cost on the prices of goods and services.
The pre-emptive rate hike by Bank Negara is timed on the stronger- than-expected economic growth of 5% year-on-year in the first quarter of this year.
It is appropriate to move now than later as interest rate adjustment has a three to six-month-lag impact on the economy.
A delayed action could make the increases in short-term inflation persistent if the underlying demand momentum gets stronger.
There is a concern that inflation expectations may become unanchored.
The supply constraint-induced cost-push inflation is now on the verge of developing into a wageprice spiral inflation.
The implementation of a steep 25% to 36% hike in minimum wage and its knock-on effect on other job grades would also fuel inflation.
With the rising prices of goods and services amid the shortage of workers, households may ask for higher wages to make up for the reduced purchasing power and firms may also raise prices to protect profit margins.
With the central banks in advanced economies, especially the US Federal Reserve, expected to raise interest rates higher to 3% or more by end-2022 to keep inflation from soaring, emerging market economies, including Malaysia, will continue to experience the gravity of capital outflows and downward pressure on their currencies.
The recalibration of monetary policy now is deemed appropriate to avoid the need for the front-loading of rate hikes later should inflation risk get built into the price and wage-setting process.
By then, Bank Negara may need to move interest rates faster and this will be disruptive to the economy.
Hence, the sooner interest rates are raised as economic activity recovers, the less interest rates will have to be increased aggressively later on to maintain price stability.
The central bank needs to stay ahead of the curve as it balances the risks between growth and inflation.
As soon as economic conditions allow, the priority will be to rebuild policy buffers, not just in monetary policy but also in prudential and fiscal policies. These buffers will strengthen our economic resilience against future shocks.
But the recalibration of monetary policy is not on auto pilot. The pace and scale of policy rate changes will depend on the strength of the recovery, level of output gap, inflation outlook and other economic indicators.
As stated in the Monetary Policy Committee’s statement, the removal of excessive monetary accommodation would be done in a measured and gradual manner to ensure that the monetary policy will remain accommodative to support a firmer recovery while keeping a rein on inflation risk.
Bank Negara will “methodically and systematically” normalise the policy rate to the point known as the “neutral rate” that it is neither too accommodative nor restrictive in supporting the economy.
The time lags necessitate a forward-looking and judgement where the economy is going to be and the anchoring of inflationary expectations.
Based on the past OPR levels, the OPR was between 3% and 3.25% from May 2011 to March 2019, and 3.5% from April 2006 to October 2008.
The interest rate outlook is for a gradual monetary tightening,
It is important that the market and public have a clear understanding of the central bank’s overall monetary stance and why the time has come to reduce monetary accommodation.
This is the foundation of a predictable and credible monetary policy.