The State of the Nation: The conundrum of rising inflation and slowing growth

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MALAYSIA’S INFLATION, as measured by the Consumer Price Index, fell to 2.6% in September, the first time it has gone below the 3% level since the beginning of this year.

This, however, is not an indication of things to come. Instead, inflation will trend higher again from October onwards. The consensus view is that inflationary pressures will continue to build up in the Malaysian economy over the next two years.

The two key drivers are the Oct 2 hike in petrol and diesel prices and the implementation of the Goods and Services Tax (GST) in April 2015. In fact, the last time petrol and diesel prices were raised on Sept 3, 2013, inflation trended higher for most of 2014, that is until September when it cooled to 2.6%. It took almost a year for the full effects of the 2013 fuel price hike to wear off in the economy.  

The Ministry of Finance in its most recent Economic Report has forecast 2015 inflation at between 4% and 5%. Some economists, though, are less conservative, with a majority of them opining that the official CPI could peak beyond the higher end of the forecast. Urban inflation, for sure, will be significantly higher.

The Malaysian economy has not seen such a high inflationary environnment since the second half of 2008, when a drastic hike in petrol/diesel prices in June caused inflation to soar to 8.5% in July and August that year.

While the impact on inflation from fuel hikes is usually a one-off, this time around, the situation is compounded by GST. It is a double whammy, so to speak.

The problem becomes even more complex when rising inflation is accompanied by slowing growth. The worst-case scenario is when such a situation develops into stagflation — a period of sluggish growth and high inflation.

Is this a possiblity?

Most economists don’t think the economy is in any imminent danger of facing stagflation, but opine that rising inflation and growth slowdown will pose great challenges for policymakers. The conundrum is this: if Bank Negara Malaysia tightens monetary policy to curb inflation, growth will be impacted. If monetary policy remains loose, further inflationary pressure could build up.

Domestic headwinds

In recent weeks, more signs of a slowdown have emerged, affirming views that the domestic economy will post weaker growth from the second half of this year.

Last week, Malaysian Institute of Economic Research (MIER) said its Business Conditions Index and Consumer Sentiment Index both fell below the 100 threshold in the third quarter of this year, signalling a deterioration in prospects and sentiment. (A fall below 100 indicates that sentiment has turned negative.)

RHB Research notes in a report that reflecting the lower BCI are weaker manufacturing sales during the July-August period, which grew at just 3.3% year-on-year, compared with 5.7% in the second quarter and 12% in the first quarter of the year.

Manufacturing exports fell in tandem, growing at just 0.7% during the July-August period, down sharply from the 12.6% in the second quarter. RHB Research attributes this to weaker growth in China and the eurozone, as well as to a Japanese economy still struggling to gain traction despite the recent quantitative easing programmes.

Private investment, it notes, will likely moderate in the second half of 2014. Be that as it may, this slowdown will be mitigated to a certain extent by the ongoing projects under the Economic Transformation Programme (ETP), such as the MRT Line 1, and those announced in the 2015 budget, including the MRT Line 2 and LRT extensions.

Consumer spending is also showing signs of weakening.

MIER’s survey showed that consumers are likely to tone down their current and future finances, with the middle-income group worried about rising prices and their ability to weather GST.

Already, consumers have begun to feel the pain of the latest fuel price hikes — the trickle-down effect is being felt in food and transport especially. For example, some neighbourhood coffee joints were reported to have raised their prices by some 10% since fuel prices were raised on Oct 2.

The Real Estate and Housing Developers Association Malaysia has forecast that house prices will increase by 2.6% once GST is implemented.

It is largely expected that in the early part of 2015, the government will announce another round of subsidy cuts via a revamped subsidy scheme, where targeted groups (high income) will be subjected to market-driven prices.

Against such a backdrop, consumer spending will likely be hit and is forecast to grow around 5% in 2015 compared with 7% in 2014.

Global environment deteriorates

Since the second half of 2014, the global environment has deteriorated, and is fraught with downside risks. This is not good news for Malaysia and other export-dependent economies.

The International Monetary Fund in early October revised world growth downwards to 3.8% in 2015, from its earlier forecast of 4%. The weaker outlook was based on risks posed by growing geopolitical tensions and expectations of a financial market correction because equities in some developed markets have reached “frothy” levels. “The downside risks to an equity price correction have increased, as valuations could be frothy,” the IMF said.

While growth in the eurozone and Japan is still sputtering, focus has turned to China, which posted its slowest growth in five years in the third quarter of this year.

Its gross domestic product (GDP) grew 7.3% year-on-year from 7.5% in the second quarter, dragged down by its ongoing structural reforms, the downturn in the housing market and a higher base effect from a year ago.

The Chinese government has taken some pump-priming steps to avoid a hard landing for its economy.

The only bright spot is the US, which is expected to expand by 2.2% in 2014 and 3.1% in 2015. Even so, some economists say a stronger growth in the US may not have much impact on economies in this region.

JP Morgan, in a recent report, opines that US growth recovery will bring more headwinds than tailwinds for Asean.

It explains that stronger US growth does not automatically lead to higher exports growth in Asean, as has been the case in the past. A reason is that despite the GDP expansion, there is still lacklustre tech demand and soft commodity prices will limit domestic demand for exports.

Exports account for some 43% of Asean GDP, of which 60% is made up of tech (20%) and commodities (40%). Of the 20% tech exports, some 70% go to the US, JP Morgan notes.

Stronger US growth means that the Federal Reserve Board will have room to raise rates. Some economists say this could happen in the second quarter of 2015 but is dependent on how well the US economy is progressing.

Rising rates in the US could muddy the visibility for Malaysia’s financial markets, given the possibility of an outflow of funds back to the US to chase higher yields.

In fact, since September, Malaysia has seen a steady outflow of equity portfolio funds. According to Alliance Research, Bursa Malaysia data indicates that foreign investors have been the net sellers with a net outflow of RM300 million during the first half of October. In September, the outflow was RM1.4 billion.

Commodity prices — both oil and non-oil — have remained soft amid weaker global economic growth. Crude oil prices, for example, have fallen 27% to around US$82 a barrel since the middle of 2014 and forecasts are for crude oil to stay below US$100 a barrel for some time to come, due to a supply overhang, caused to a certain extent by weaker global demand.

The slowdown in global growth will impact world trade. Already, global trade has stagnated in the first half of 2014, according to the World Trade Organisation (WTO). In September, it revised downwards world trade growth for 2014 to 3.1%, from a previous forecast of 4.7%. The 2015 forecast has also been downgraded to 4%, from 5.3%.    

This is not good news for Malaysia, a net oil exporter and whose export revenue is derived largely from crude oil and crude palm oil.

A problematic combination

The combination of rising inflation and slowing growth is every policymaker’s nightmare. Hence, going forward, how policymakers walk the tightrope balancing  inflation and growth will bear watching.

A view is that Bank Negara’s monetary policy stance will have to remain pro-growth, which means that interest rates are unlikely to rise significantly any time soon.

This may not be a good thing for the long term given the growing gap between nominal and real interest rates. As things stand now, Malaysian savers are already subjected to negative real rates, which means that they get negative returns from putting their money in the bank.

If inflation climbs to 5% and fixed deposit rates remain around 3.2%, the differential is 180 basis points — a situation that will have significant impact on consumer spending.

The silver lining is the argument that inflation is cost-pushed and once the impact from higher fuel prices and GST wears off, prices will start to cool down again.

Additionally, Malaysia’s growth will be cushioned by domestic demand, underpinned by the projects rolled out under the ETP. Economists generally expect GDP is to slow to around 4.5% to 5.5% in 2015 (from the 5.7% estimated for 2014).

Even so, the waters ahead are choppy, and we will have to be prepared for a rough ride.

This article first appeared in The Edge Malaysia Weekly, on October 27 - November 2, 2014.