FOR the first time since May 2000, the Federal Reserve has recently raised the Fed-funds rate by 25 basis points to 1.25%, marking the beginning of the end of the cheap money era.
For the past few years, in an attempt to support a flagging global economy, monetary policy world-wide has been at its loosest in decades, as indicated by historically low interest rates.
Lower returns on capital in the US have resulted in large inflows of capital into emerging economies, particularly into East Asia.
But with fears of losing competitiveness prompting many East Asian central banks to intervene aggressively in the currency market, domestic liquidity has exploded.
Excessive monetary expansion, however, carries inflationary consequences.
With so much money sloshing about, it is hardly surprising that the spectre of inflation is coming back to haunt central bankers with stronger than expected inflation showing up not only in the US, but in Europe and East Asia.
Although the rise, generally, could partly be attributed to the transitory surge in the price of oil and non-oil commodities, inflationary pressures are fundamentally well entrenched owing to the robustness of global growth, which is using up spare capacity quickly.
The Fed’s actions carry implications on the conduct of monetary policy globally, including Malaysia.
How are recent events going to affect the conduct of monetary policy in Malaysia? Will Bank Negara raise rates soon?
There are several reasons to suggest that Bank Negara would not raise rates just yet. That is because, external development aside, domestic considerations do have a big influence on the conduct of monetary policy.
Historically, the correlation between the US and Malaysian interest rates has been one of the lowest in the region while countries like Hong Kong, Singapore, Indonesia and the Philippines have much stronger correlation.
In addition, capital flows into Malaysia, unlike some North East Asian economies, have not been dominated by hot money.
The rise in interest rates has lessened the worries of Bank Negara in its operation to contain capital inflows.
In the face of capital influx, the need to keep an undervalued ringgit exchange rate fixed and interest rates stable has prompted Bank Negara to mop up the excess funds created through sterilisation.
The central bank, at end-June, has mopped up RM127.2bil from the banking system mainly through inter-bank borrowing and, to a lesser extent, through the issuance of T-bills.
The narrowing of interest rate differentials as well as the appreciation of the US dollar against other currencies should lessen the inflow of short-term money into Malaysia, relieving Bank Negara of the sterilisation headache.
Perversely, some might fear that the reduction in the rate differential would prompt a significant outflow of foreign capital.
In the face of the current rise in loan demand, this could reduce liquidity in the system, prompting an automatic rise in interest rates.
However, the outflow, if any at all, would be modest.
That is because, even with the recent Fed rate rise, the interest differential between Malaysia and the US, which has fallen from 1.7% to 1.45%, is still in Malaysia’s favour.
In addition, the pace of interest rate increase in the US, in the words of Greenspan in his recent testimony to the Senate Committee ‘will most likely rise at a “measured” pace.’
This allows businesses and household to adjust without imposing much financial strain.
The market expects the Fed rate to rise gradually to end the year at 2.25%, still below Bank Negara’s current intervention rate of 2.69%.
Even assuming the worst case scenario where there is considerable outflow, Bank Negara can always just pump back the liquidity into the system – “returning what it has once borrowed from the system”.
Despite the recent modest uptick, inflation in Malaysia has been benign in the past few years and is one of the lowest in the region.
Currently hovering at around 1.2%, it is lower than inflation in Singapore (2.0%), Thailand (3.0%), China (4.4%) and Indonesia (6.8%), the US (3.1%) and in the Euro area (2.4%).
Even removing temporary factors, the core inflation rate (inflation minus food and fuel) remains well below the overall inflation reading.
In addition, there are still little signs of overheating in the labour market.
In the first half of the year, nominal wage per worker in the manufacturing sector rose only by an annual pace of about 3.8%, little changed from the 3.9% average for 2003.
Furthermore, the prevailing excess liquidity in the system in the face of weak loan demand, has not resulted in the formation of asset bubbles.
The performance of the stock market, year to date has not been extraordinary while property prices have, on average, risen by only 10%-13%.
On the other hand, capacity utilisation has been on a rising trend.
From a low of 76% in September 2001, the utilisation rate has, generally, been on the up-trend to 82% in March 2004.
This and the better cash flows, must have prompted Malaysian businesses to shake off their earlier reluctance to invest.
Domestic investment has turned around since the third quarter of last year and firms are also beginning to borrow.
This turnaround should help alleviate supply bottlenecks.
Without a doubt, with real interest rates still negative, much tightening remains to be done in the US.
But given the balance of evidence, Bank Negara is not expected to tinker with its interest rate policy, at least for the rest of this year.
But if the Malaysian economy expands at about 5.5%-6.0% clip next year and if the Fed funds rate hit 4% by the end of 2005, there is a likelihood that Bank Negara would then move rates up gradually.
This, we suspect, is likely to begin mid-2005 as monetary policy gradually returns to a more neutral stance.
Kevin Chew is a Research Fellow at the Malaysian Institute of Economic Research (MIER)
Roy Lim Way Zhi (student with the University of Warwick) is an intern with the institute