Understanding Bank Negara’s move

Bank Negara building

BANK Negara trampled market expectations by raising its key overnight policy rate (OPR) by 25 basis points (bps) to 2% from a record low of 1.75%. Market participants mostly projected that the first rate hike would happen in July.

To put things into perspective, the OPR was trimmed from 3% in the beginning of 2020 due to the already existing geopolitical tensions between the China and the United States, slower-than-expected growth of major trading partners, and dim spots in the domestic economy.

When Covid-19 came into the picture, its severe downside effects on the economy following mobility restrictions prompted the central bank to cut its rate further to help restart the economy.

By July 2020, the OPR had dropped to 1.75%. Twenty-two months later, the central bank sprang a surprise as it deemed the domestic economic growth is already on a “firmer footing” due to an outstanding external trade performance, stronger domestic demand, better labour market conditions and a full transition into endemicity.

Despite surging global energy prices plus a disrupted global supply chain network and higher transport costs, which are currently feeding into consumers and input prices, Malaysia’s headline inflation remained tepid at 2.2% in March, thanks to the various subsidies and price control measures imposed by the government. We believe that the pre-emptive measure was probably in keeping the rate differentials narrow amid a rising interest rate environment.

Not long ago, the US Federal Reserve (Fed) raised its federal funds rate (FFR) by 50 bps, marking the largest increase since the year 2000 and as an effort to calm down the red-hot inflation rate. With the way the Fed’s officials have been communicating, the likelihood for them to aggressively hike its interest rates in the coming months is definitely high as of now.

As a result, the yield spread between the US Treasury yield curve briefly inverted, signalling incoming recession. Looking at domestic side, we are seeing unprecedented historic high yield spreads of around 270 basis points when we compare between the yield of the benchmark 10-year Malaysian Government Securities (MGS) instruments and the OPR level itself.

To further gauge or project the policy path of Bank Negara, we need to look back.

In 2005, in spite of the persistently high oil prices and the downturn in the global electronics cycle, real gross domestic product (GDP) was estimated to expand by 5.3%, driven by the private sector, supportive macroeconomic policies, and favourable financial conditions.

Private consumer demand was sustained at a strong pace at 9.2% year-on-year (y-o-y) while the resilience in private investment (up 10.8% y-o-y) further supported the economic expansion.

At the same time, the Brent price was on a rising trend, reaching around US$64 (RM281) per barrel on average in August 2005, the highest level in record at the time, which in turn, pushed headline inflation to 3.7%, a level last seen in the 1990s.

By historical standard at that time, inflation was certainly elevated with the presence of both strong aggregate domestic demands, induced by a healthy labour market (3.5% unemployment rate), competitive credit environment and cost-push price pressure.

To ensure that the level of monetary accommodation is balanced with the need to ensure price stability, the central bank increased its interest rate at the end of the year.

As the economy began to show evidence of stronger growth, the risks were skewed towards rising inflation instead.

After maintaining the OPR at 2.7% in the first 11 months of the year, the OPR was raised by 30 basis points to 3% on Nov 30, 2005.

With domestic interest rates unchanged for most of the year, interest rate differentials between domestic and US rates turned negative in February and continued to widen as the US Federal funds rate steadily increased.

In spite of this, domestic liquidity continued to grow positively amid sustained inflows from the external sector. The inflows mainly reflected the return of foreign direct investment, export earnings and significant inflows of portfolio investment in the first half of the year.

As the economy entered 2006, the entrenchment of domestic economic growth coupled with higher commodity prices put significant pressure on the outlook for domestic inflation.

Rise in inflation

Historically, headline inflation had remained low and stable for several years only to emerge in the first half of 2006 due to rising global energy and commodity prices.

The rise in inflation since May 2004 was particularly felt by the general populace and the economy, which had grown accustomed to a history of low inflation.

Inflation began rising as a result of the removal of fuel subsidies and the upward adjustments to administered prices.

With the building of momentum in global commodity prices at the beginning of the year, inflation was expected to be higher than Malaysia’s long-term average.

According to data, headline inflation reached 4.7% in March 2006, a fresh new high since the Asian financial crisis (AFC).

Indeed, with inflation on a rising trend early in the year, there were heightened concerns over possible implications of a prolonged environment of negative real interest rates on the economy.

OPR up

The OPR was increased twice, on Feb 22 and April 26, by 25 basis points each time, taking the OPR to 3.5%.

Another episode took place in the year 2010 when Bank Negara hiked interest rates by 25 bps three times within a 12-month period.

To recap, the OPR was cut to 3.25% from 3.5% in 2008, by 75 bps to 2.5% at the onset of 2009 and further reduced to 2% to cushion the local economy following the Great Depression.

The Great Recession began when the US economy faced a significant slump in its property market starting from end-2007.

It was fuelled by multiple years of low interest rates up to 2004 and crazed house-buying, which in turn led to a mortgage debt bubble and the snowballing of highly speculative subprime mortgages.

Ultimately, as the housing bubble burst, the overly leveraged investment banks went bankrupt, and a credit crunch ensued.

The US gross domestic product contracted by 0.3% in 2008 and 2.8% in 2009 while the labour market shed more than 8.7 million jobs.

But the crisis did not end there as it spilled over into global economies and financial markets alike through the disruptions on global trade and production. Greece defaulted on its international debt, Portugal and Spain experienced extreme level of unemployment, while Ireland’s nourished economy tumbled.

Significant shrinkage

Domestically, the Malaysian economy contracted by 1.7% in 2009, constrained by a significant shrinkage of external trade and industrial production, which also affected business and consumer sentiment, employment and income level.

Combined with an aggressive easing of the monetary policy, the government proposed higher fiscal spending to offset the adverse effects from the crisis and spurring recovery on the private sector.

The labour market was disrupted when the unemployment rate briefly touched above the long-term average of 3.2% at 4%, while inflation was not a threat as it averaged 0.6% throughout the year.

But going into 2010, economic activity recovered as it rebounded strongly by 7.2% y-o-y, mainly driven by the low-base effects at its core, a recuperating private sector and external trade while being complemented by supportive monetary and fiscal policies.

In parallel, the unemployment rate fell to 3.2%, compared with 3.7% in 2009 while inflation remained manageable at 1.7% in average (2009: 0.6%).

Taking these into consideration together with the need to prevent financial imbalances and excessive credit growth, Bank Negara raised the OPR by 25 bps in March, May and July to 2.75% by the end of 2010.

Loan growth

At the time, total loan growth in banking sector had reached 12.7% while household and business loans grew 13.4% and 11.9%, respectively.

All in all, we are now prone to believe that Bank Negara may further raise its interest rate later in the year to address the rate differentials rather than inflationary pressures. We now envisage that the rate will be increased by 25 bps in July with a 40% chance of another 25 bps hike in September, resulting in the OPR to hover around 2.25% to 2.5% by the end of 2022.

As a comparison, the Fed will hike its key rate by 50 bps for two more times and another 25 bps so that the FFR range will be around 2% to 2.25%.

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