Comment: Damned if you do, and damned if you don’t

This article first appeared in Wealth, The Edge Malaysia Weekly, on July 25, 2022 - July 31, 2022.
Comment: Damned if you do, and damned if you don’t
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At the start of the year, a prevalent view was that monetary policy error in managing inflation was a key risk for the global economy in 2022. This prediction may be coming to bear; in the second half of this year, signs are emerging that the delicate balancing act of ensuring economic growth and taming inflation at the same time is turning out to be a major uphill battle.

In the US, the series of aggressive interest rate hikes since the start of the year by the Federal Reserve to keep inflation at bay has sparked concern that it could tip the world’s largest economy into a recession. In June, US inflation hit 9.1%, a 40-year high.

Elsewhere in the world, most central banks have also continued to tighten monetary policy, in realisation that inflation is no longer transitory, as was first thought.

For sure, Malaysia’s inflation rate, as measured by the Consumer Price Index (CPI), has stayed below 3% so far this year, at 2.8% in May and 2.3% in April. But the thing to note is that the CPI has been on an uptrend since January. What is worrying is that core inflation (which strips out food and fuel) has risen significantly, standing at 5.2% in May.

The challenge before Bank Negara Malaysia is this: What options does it have if inflation continues to rise in the coming months? While raising interest rates is obviously the “go-to” solution, the impact could have an adverse, ricocheting effect on the economy. And herein lies the quandary.

Rising interest rates and high inflation pose a double whammy for the pocket of the man in the street. For one, Malaysia’s household debt was very high at 89% of gross domestic product (GDP) at end-2021. More importantly, a large portion of this household debt is held by the B40 (bottom 40% income group) and M40 (middle 40%).

Raising the overnight policy rate (OPR), which leads to higher lending rates, will increase the debt servicing burden of these two groups, which make up the majority of households. Add to this equation rising prices, especially of necessities such as food and transport, which will further erode purchasing power and the value of the ringgit. The domino effect will result in weaker economic growth, indeed maybe even a recession.

But can Bank Negara afford to not raise the OPR after the July hike? This is the question. Already, the July hike has raised some discontent; it will certainly not be a popular move, given the high indebtedness of households.

Yet, if we look at the aggressive hikes by the Fed, it is a matter of time before the Fed funds rate, or FFR (now at 1.75%), overtakes the OPR, which stands at 2.25% today. Bank Negara’s next monetary policy committee (MPC) meeting is in September while the Fed next meets at end-July. If the US raises the FFR by another 75 basis points (bps) to 2.5% (as widely anticipated), it will be higher than the OPR.

The interest rate differentials have implications on fund inflows and outflows, and hence the ringgit’s exchange rate. In recent months, our markets have begun to see higher portfolio outflows, pressuring the local currency downwards to trend at about RM4.40 against the US dollar currently.

The Fed will meet at end-July and in September, November and December. Bank Negara’s MPC is scheduled to meet in September and November only and the projection is for the OPR to go up another 25bps to end the year at 2.5%.

All eyes will be on the Fed and whether it will start to slow down rate hikes in anticipation of inflation peaking by the third or fourth quarter of the year. Expectations, though, are that the US will raise the FFR to around 3% to 3.5% by year end.

Investments will go where there are higher returns. If the differential in favour of countries with higher rates continues to widen, we can expect to see an increase in portfolio fund outflows, which will weaken the ringgit further. A fallout from this would be higher imported inflation.

Note that the 25bps hike in the OPR to 2.25% in early July had little impact on the ringgit; in fact, it weakened further. One of the reasons is that foreign investors, in anticipation of further FFR hikes, are liquidating their ringgit asset holdings to seek higher returns in US dollar assets, hence the view that the US dollar will stay stronger for longer.

An argument is that given inflation is below 3%, the urgency to raise the benchmark rate is less, and therefore will not impact economic growth significantly. However, if rates are kept low, in all likelihood, the economy will have to bear the brunt of a weaker ringgit and rising inflation, possibly even stagflation.

How long can interest rates stay low amid rising inflation? And can the economy withstand a weaker ringgit without repercussions?

An error in policy decision may well affect financial markets and economic growth. It is not easy being in the shoes of the central bank, even more so as the 15th general election may be just around the corner.