The central bank has to rebuild monetary policy buffer for future shocks. It is confident that a gradual normalisation of interest rate will not hurt economic growth although it recognises that the downside risks to growth will remain.
IN an almost synchronised manner, central banks in the world with the US Federal Reserve (Fed)leading the pack, are rushing to raise their key interest rates in a bid to tame soaring inflation and anchor inflation expectations.
The Russia-Ukraine military conflict-triggered energy and commodity prices surge in recent months had exacerbated the already elevated global inflationary pressures.
The cost and price shocks have collided with the strong recovery in demand for goods and services, upsetting the imbalances between supply and demand and pushing prices to higher levels.
Global inflation is forecast to reach 7.4% in 2022 – the highest level since 2008. This is compared with the average annual global inflation of 3.8% from 2001 to 2019.
Inflation is now running well above central banks’ targets in almost all advanced economies and most emerging markets as well as developing economies. The prices of fuel, electricity, food and raw materials are going up as well as wages and cost of services.
In most countries, cost-push inflation is the main culprit for price increases due to production disruptions, or increases in production costs such as high oil prices and raw material costs as well as wages.In the US economy, as the pressures of the supply and demand side are working together to push inflation up, the Fed is compelled to deliver stronger doses of interest rate and more hikes to bring inflation down.
But the Fed’s fast and over-triggering moves could risk a hard-landing for the US economy.
Why should Bank Negara normalise interest rate?
Following in the footstep of other central banks, Bank Negara has hiked the overnight policy rate (OPR) by 25 basis points (bps) to 2% in May and another 25 bps to 2.25% this month.
More rate hikes are expected ahead, bringing the policy rate to between 2.5% and 3% from 2022 to 2023 after taking into account the incoming data, implications of evolving external and domestic developments on economic growth prospects as well as inflation trajectory.
What is the rationale behind the move?
Our assessment indicates the following:
> Gradual removal of a high degree of monetary accommodation to build a policy buffer. Amid the presence of heightened external headwinds to global economy and downside risks to domestic economic growth, the continued recovery we are experiencing provides room for Bank Negara to continue removing the extra monetary accommodation delivered during the Covid-19 pandemic.
The central bank has to rebuild monetary policy buffer for future shocks.
It is confident that a gradual normalisation of interest rate will not hurt economic growth although it recognises that the downside risks to growth will remain.
The central bank maintained this year’s real gross domestic product estimate of between 5.3% and 6.3%. This will be largely supported by firm domestic demand on continued economic activities and recovery in the labour market.
We caution that the growing fears of global stagflation pressures, war in Ukraine, rising recession risk in the US economy and tighter global monetary conditions will darken the outlook of global economy in the second half of this year and in 2023. The International Monetary Fund does not rule out a possible global recession next year given the elevated risks.
> Keep a lid on inflation risk and expectations.
The current manageable inflation rate compared with other countries is largely being buffered by subsidies and administrative measures on fuel, food and some services.
But inflation pressures have widened in the broader economy to a degree that requires a gradual normalisation of interest rate.
Both headline and core inflation have been trending up to 2.8% and 2.4% respectively in May, reflecting the improvement in economic activity amid lingering cost pressures.
Anecdotal demand-side inflation pressures are slowly developing to reinforce the strong supply constraints cum cost-push inflation.
The upside risks to inflation remained given the uncertainties surrounding the global energy and commodity prices, war in Ukraine, supply disruptions as well as cost pressures.
It is expected that post the 15th general election, the kick-in of subsidy rationalisation and rollback of administrative measures will drive inflation higher in 2023.
Inflation expectations will also play a key role in determining the rise. If consumers or firms build the expectations of higher prices into future cost and price adjustments, wage negotiations or contractual price adjustments, they will set off another round of inflation.
Hence, a gradual hike in interest rate would serve to anchor inflation expectations
By raising interest rates on a gradual and measured manner, Bank Negara hopes to demonstrate its commitment to tame inflation risk and prevent the expectations of a persistently high inflation.
> As the economic recovery is continuing, keeping a prolonged period of low interest rates can induce financial imbalances by reducing risk aversion of banks and other investors as well as borrowers. If Bank Negara holds back on increasing interest rate, it will result in entrenched higher inflation expectations, prompting companies and employees to push up prices and demand higher wages.
If this happens, it will be extremely costly to bring inflation down. The central banks may be compelled to pump the brakes on the economy even harder to get inflation under control.
While we reckon that the higher interest rates will mean that households will have to pay more on mortgage and other personal loans, the percentage of variable loans versus the fixed rate is 75:25%. The improved income prospects for individuals and recovering sales for businesses should be able to cope with the increased cost of borrowing.
In addition, the price subsidies and controls as well as cash handouts to the targeted households will ease their financial burden.
For savers, the rise in interest rate will increase their fixed deposit income. But when inflation begins to move higher and get entrenched in our economy, it will hurt the people in the lower and middle-income income spectrum more than anyone.
In an inflationary environment, rising prices will inevitably reduce the purchasing power of some consumers and real income payers of fixed interest rates. We believe that Bank Negara will be nimble in responding to incoming data to assess the evolving economic and inflation outlook when making its monetary policy decision.
The interest rate adjustment will be on a gradual and measured manner without jeopardising the economy while keeping a lid on inflation.
Lee Heng Guie is executive director of the Socio Economic Research Centre. The views expressed here are the writer’s own.
