This article first appeared in The Edge Malaysia Weekly on November 5, 2018 - November 11, 2018

THE rate of inflation, as measured by the Consumer Price Index (CPI), is influenced by a confluence of factors.

These include changes to the overnight policy rate (determined by the central bank), exchange rate volatility, wage levels, energy prices, fiscal position of a country, demand-cost related issues and economic growth.

This year, the CPI grew 1.3% year on year in the January-to-August period.

In comparison, over an eight-year period between 2010 and 2018, the long-term average inflation rate hovered at 2.5%. The lowest increase during the period was recorded in February 2015 when inflation gained a mere 0.1%, while the highest rise was seen in March 2017 when it expanded 4.9% year on year.

An analysis of inflation in Malaysia in the Economic Outlook 2019 Report reveals that the exchange rate had the highest impact on CPI over the eight-year period. Essentially, a 1% change in the exchange rate would alter the overall CPI by 0.337%.

According to the report, the ringgit depreciation affects the CPI mainly through imported inflation, especially for food items, which cost some RM25 billion a year.

Thus, the exchange rate’s impact on CPI comes as no surprise given that the ringgit depreciated rapidly against the US dollar from the third quarter of 2014 to January 2017. Between August 27, 2014, and Jan 3, 2017, the local currency tumbled 42.83%, from 3.14 to 4.49 to the US dollar.

Meanwhile, indirect tax per capita in the form of the now repealed Goods and Services Tax, which was implemented in April 2015, has the least impact on CPI.

Even though it has often been blamed for the higher prices, analysis shows that for every 1% change in indirect tax per capita, the overall CPI changes by a mere 0.073%.

Other variables in the analysis include crude oil prices, which affect the overall CPI by 0.112% for every 1% change in price. The transport segment accounts for about 15% of the CPI weightage, and the Household Expenditure Survey (2016) reveals that energy accounts for 38.4% of total monthly household spending.

Between March 2012 and January 2016, Brent crude fluctuated dramatically between US$124.93 and US$30.80 per barrel.

Another variable that was taken into account in the report was the external debt-to-export ratio. The ratio provides an indicator of the economy’s capability to repay its external debts through export earnings.

The country’s external debt-to-export ratio increased from 7.7 times in 2010 to 11.3 times in 2018. Interestingly, findings from the analysis show that a 1% change in the ratio impacts the overall CPI by 0.094%.

Given how these factors play a part in shaping the overall CPI trend, the report concludes that it is crucial to implement policies to strengthen the nation’s economic fundamentals, promote renewable energy, improve public transport, facilitate high-value-added products and enhance the efficacy and efficiency of tax collection. “In addition, the Local Currency Settlement Framework, which promotes wider use of local currencies for trade and investment, could be explored further to mitigate the impact of exchange-rate volatility,” the report says.

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