The State of the Nation: Subdued inflation and weaker growth could prompt another rate cut

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This article first appeared in Corporate, The Edge Malaysia Weekly, on August 29 - September 4, 2016.


THE Consumer Price Index (CPI) tapered off for the fifth consecutive month to 1.1% year on year (y-o-y) in July (see chart 1), lower than the consensus forecast of a 1.2% and 1.6% increase in June. The subdued inflation in July gives Bank Negara Malaysia more room for further monetary easing later this year to support growth.

As inflation eases to its slowest in 16 months in July, and gross domestic product (GDP) growth slowed to 4% in 2Q2016 — the lower end of Bank Negara’s forecast of 4% to 4.5% (see chart 2) — economists expect the central bank to cut the overnight policy rate (OPR) by a further 25 basis points (bps) to 2.75%, either in September or November.

To put things in perspective, the situation with easing inflation and disinflationary pressures is not unique to Malaysia. “In this region, Singapore went deeper into deflation during the month while Thailand flirted with stagnant prices as inflation fell to 0.1%. Inflation in Indonesia declined to 3.2% from 3.5% in June. Generally, the same observation has been made in other parts of the world — China, the US and the European Union ... recorded lower inflation by 10bps, 20bps and 20bps respectively,” MIDF Research says.

“We maintain our expectation of one more OPR cut in September this year by 25bps. With the inflation rate near 1%, a level not seen in 16 months, we believe this would give ample room for Bank Negara to ease further. Besides, there are signs of more deterioration in domestic demand as reflected by lower prices of housing rental and food away from home. The cut by the central bank will help to provide a floor to the domestic economy to maintain growth above 4% in the quarter,” the research house adds.

UOB Malaysia, HSBC Global Research and Nomura Global Economics echoed this view that there will be further monetary easing this year.

“Benign inflation against a weaker growth environment puts another policy rate cut on the radar, though we think more probable at the Nov 23 meeting. The remaining two policy meetings for this year fall on Sept 7 and Nov 23. Given that there could be more growth stimulus measures announced when Budget 2017 is tabled in October, Bank Negara may stand pat on rates in September before evaluating the need for further easing in November after the US election, which is viewed as a key event risk,” writes UOB Malaysia economist Julia Goh in a recent note.

Earlier, at the July 13 Monetary Policy Committee meeting when Bank Negara surprised markets with a 25bps cut in the OPR, it revised downward its inflation projection for 2016 to 2% to 3% from 2.5% to 3.5%, but expects inflation to remain stable in 2017. The central bank attributed the soft inflationary outlook to fading impact from the Goods and Services Tax (GST), implemented in April 2015, lower oil and commodity prices and low imported inflationary pressure arising from subdued global inflation.


Economists divided on a further OPR cut

However, not everyone expects Bank Negara to ease further in the months ahead. DBS Group Research, Kenanga Research and JF Apex Securities expect the central bank to keep OPR steady at 3%, even as lower-than-expected inflation contributed to the recent surprise rate cut.

“Headline CPI inflation will likely average about 1.5% in the second half of the year and register 2.1% for the full year, before trending gradually higher to 2.4% in 2017. That essentially means that the central bank may be on hold for the time being and prefer to gauge economic conditions in the coming months before its next move,” DBS Group Research says.

This view is shared by JF Apex Securities, which reckons that the costs for food and beverage-related products will rise further amid the 30% increase in the wholesale price of refined sugar effective Aug 1. Meanwhile, it maintains its view that the central bank will keep the OPR at 3% in 2016 and does not foresee any further rate cut in 2H2016 unless the global economy continues to weaken.

“We see the Bank Negara decision to cut the OPR by 25bps in July as having a limited impact on domestic inflation for the year, considering the transmission lag of monetary policy impact and weak consumer sentiment. We revise our full-year inflation forecast to 2.1% y-o-y from 2.3%, as we continue to see uncertainties in domestic growth prospects and consumer spending behaviour,” writes Kenanga Research in an Aug 25 note.

“For now, we expect Bank Negara to keep the OPR at 3% for the remainder of the year. However, the low official core inflation could provide the central bank the flexibility to ease its monetary policy if needed. If the disinflationary trend continues unabated along with weaker growth prospects, it may give Bank Negara more room to cut interest rates,” it says.


Breaking down the CPI components

“A number of factors are keeping a lid on price pressures in Malaysia but transport costs have been the main drag, with the effects of the cuts in pump prices in March still lingering. Especially the transport component, the third largest after food and housing, reported a decline of 9.9% in the month (see table 1). Beyond that, the lapsing of the GST impact and a high base in the same period last year have continued to keeping a lid on inflation readings,” DBS Group Research says.

On the other hand, MIDF Research notes that there was a broad softening of inflation across different consumer items. “The largest constituent in the basket, that is food items, fell to 3.8% from 4.2% in June while non-food items were lower compared to last year by 0.2%,” it says.

“Despite a slight pickup in the pump price, that is RON95 at RM1.75 per litre from RM1.70 in June, it was still 18.6% lower than last year’s price of RM2.15. Hence, we see transport items are reflecting negative inflation on a y-o-y basis. Joining the lower price band was communications, where prices essentially stayed flat for six consecutive months.

“One of the major surprises in this month’s data is that food away from home declined by 0.4% on a month-on-month (m-o-m) basis. This has never occurred since the CPI was rebased to 2010 and could suggest a worsening of consumer finances, forcing people to cut their spending on eating out.

“Another glaring change during the month was that housing rental inflation dropped below 2% for the first time in 39 months. This happened as rents fell by 0.6% m-o-m, which has never occurred since the CPI was rebased. While we believe the excess in supply in fringe areas in the Klang Valley partly contributed, there is a high possibility that landlords have finally started to feel the pinch due to weaker demand in core areas as well,” it MIDF says.

Notably, inflation on alcoholic beverages and tobacco remained high at approximately 20% y-o-y, after expanding by about 22% in the previous two months. The double-digit growth in July is largely attributable to the raising of cigarette prices by tobacco companies as a result of an increase in excise duties.


Lower inflation expected in 2H2016

The lower-than-expected monthly inflation rate has prompted most economists to pare down their inflation rate forecasts for 2016. Economists generally expect headline inflation in 2H2016 to be lower compared with 1H, due to various factors such as the fading effect of the GST shock, an extension of the Price Control and Anti-Profiteering Act and the still pending decisions on “administered prices”.

“The Price Control and Anti-Profiteering Act, which does not allow retailers and traders to increase their net profit margins for goods and services, has been extended for another six months until December this year. The extension will help manage fears of higher costs passed on to consumers in the second half,” Goh says.

“There will be no change to electricity tariffs until year-end. The government also said there has been no final decision on further toll rate adjustments this year. Wholesale sugar prices were hiked in August but channel checks suggest minimal pass-through. From July, non-power gas tariffs were raised by 5.95% for Peninsular Malaysia, though there is no change for residential users, and labour costs rose 11% to 15% due to the increase in minimum wages,” she says.

Barring any unexpected shocks to oil prices, Goh is projecting headline inflation to average 1.7% to 1.9% in 2H2016 from 2.7% in 1H, bringing full-year headline inflation to 2.4% in 2016 and picking up to 2.5% in 2017.

Nonetheless, Maybank Investment Bank Research opines that pass-through of cost increases and price increases could be more prevalent in 2017. The research house also believes the 1.1% y-o-y inflation rate for July could well be the lowest monthly inflation rate in 2016 because inflation peaked at 3.3% in July last year.

In this respect, Kenanga Research concurs that inflation is likely to hit its trough in July and to trend higher in August and subsequent months, partly due to less disinflationary pressure in the transport sector.

“The popular RON95 petrol price was unchanged in August while it decreased by 10 sen in the corresponding month of last year. Furthermore, food price inflation is expected to remain high due to the upward trend in global food prices and the prolonged negative impact of El Niño weather conditions on food supply,” it says.