This article first appeared in The Edge Malaysia Weekly on December 26, 2022 - January 1, 2023

A global rate hike cycle throughout 2022 to tame surging inflation is expected to continue at least into the first half of 2023. The rise in prices globally was caused by Covid-19 disruptions to supply chains, followed by pent-up demand in goods and services as restrictions eased and made worse by the Russian-Ukraine war.

In the US, inflation soared to a four-decade high of 9.1% in June on higher prices in energy, food and housing. In the UK, it was reported that the average bill for motorists to fill up their petrol tanks rose almost 50% in June from a year ago.

Central banks the world over applied the antidote of monetary tightening and warned that the era of low interest rates and mode-rate inflation has come to an end.

Calling inflation “transitory” initially, The US Federal Reserve (Fed) had no choice but to engage in its most aggressive round of interest rate hikes in 40 years, lifting the federal funds rate to 4.25%-4.5% — the highest in 15 years — after the first rate hike since 2018 in March this year.

Based on the US Open Market Committee’s “dot plot” of individual members’ expectations, the terminal rate is projected at 5.1%. In other words, there will be rate hikes by another three to four times next year. Fed chairman Jerome Powell was quoted as saying that it was important to “keep up the fight against inflation” so that the expectation of higher prices does not become entrenched.

In Europe, amid fears over recession risk and despite saying inflation has peaked, the Bank of England (BoE) increased its base rates by 0.5% to 3.5% this month — the ninth hike in 2022. Higher interest rates mean that borrowers have to bear higher costs, raising concerns over their ability to repay mortgages. The BoE has warned that half of UK homeowners will be hit by higher costs next year.

For corporations that are highly geared, they have to brace for higher interest payments that will raise the cost of doing business, which will affect their profitability. Already, higher interest rates have caused risk aversion among investors, evidenced by the correction in stocks, cryptocurrencies and other risk assets.

Some say that the transition to a high interest rate environment was played out in the UK gilt crisis two months ago. The sharp rise in the yields of long-dated UK government bonds in reaction to then prime minister Liz Truss’ mini budget forced pension funds to de-leverage as the value of their assets fell.

Just last week, the Bank of Japan (BoJ), which was under pressure to exit from ultra-low interest rates to address the country’s core consumer inflation that hit a fresh four-decade high, tweaked its yield control and allowed long-term interest rates to rise more. The move surprised markets and is seen as a prelude to a further withdrawal of its massive stimulus programme.

At home, Bank Negara Malaysia this year increased the key interest rates by 100 basis points (bps) in total to 2.75% from the record low of 1.75%, with the first 25bps hike done in May. In its last monetary policy statement in November, the central bank noted that headline and core inflation are expected to remain elevated amid both demand and cost pressures, as well as any changes to domestic policy measures.

“The extent of upward pressure to inflation will remain partly contained by existing price controls, subsidies and the remaining spare capacity in the economy. The balance of risk to the inflation outlook in 2023 is tilted to the upside and continues to be subject to domestic policy measures on subsidies, as well as global commodity price developments arising mainly from the ongoing military conflict in Ukraine and prolonged supply-related disruptions,” Bank Negara explained.

All in all, what’s the direction for the monetary policy in 2023? So far, central banks have been willing to sacrifice growth for price stability. Is the global tightening cycle going too far to tame inflation, given that persistent hikes could hurt economic growth?

The aggressive monetary tightening is set to become a contributing factor to a weaker global economic outlook, with the International Monetary Fund (IMF) lowering the global growth forecast to 2.7% from 2.9% for 2023 versus 3.2% in 2022.

Dr Yeah Kim Leng, professor of economics at Sunway University, sees a gradual increase in the overnight policy rate (OPR) towards 3.25%, given that inflationary pressures remain elevated amid the continued strengthening of the domestic economy.

“The advanced economies are also facing a similar situation. US Fed rate hikes will continue, although at a less aggressive pace, reflected by the recent 50bps increase from 75bps previously. The aim is to bring down inflation to 2%.”

Nonetheless, Yeah says rate cuts could happen in 2H2023 in anticipation of the worsening of global conditions.

“Malaysia’s economic growth is likely to exceed 6.5%-7% this year, and the growth momentum may continue in 1H2023 before global headwinds slow down the economy.

“We cannot rule out a global recession effect spilling over to Malaysia. In the event of a slowdown and weakening of global demand, inflation will fall. As what we experienced during the pandemic in 2020, oil prices fell sharply. So, if there is a global recession, that will give space for rate cuts,” he tells The Edge.

The new unity government has expressed an intention to implement targeted subsidies, which may see some pass-through to consumer prices. Yeah is of the view the impact on inflation will be manageable, as long as the subsidy rationalisation is carried out on a gradual basis.

Malaysia’s inflation, measured by the consumer price index (CPI), rose 4% in November, attributed mainly to food inflation. The CPI has been consistently growing at least 4% for the fifth month since July. Bank Negara expects core inflation to average closer to the upper end of the 2%-3% forecast range in 2022.

While higher borrowing costs could help cool overheating market demand, it risks dampening economic growth. Hence, Yeah stresses, “The key challenge is to ensure no termination to multi-year projects. Our financial system continues to be robust with credit flows and that’s the key to averting recession or downturn. As long as banks continue to lend, then consumers and businesses will be able to maintain their spending.”

UOB Global Economics and Markets Research maintained the expectation that the US economy will fall into a shallow recession by a 0.5% full-year contraction, as well as a higher unemployment rate of 4.5% in 2023. This is due to the combination of elevated inflation, global growth slowdown with a European recession, and more importantly, the impact from the aggressive central bank rate hikes.

“We are pricing in the US recession to happen in 1H2023 as we project the Fed to reach its terminal rate of 5% by 1Q2023, and stay on a prolonged pause for the rest of the year until 1Q2024,” the research house said.

Although global inflation is believed to have peaked in 4Q2022, PublicInvest Research expects it to remain elevated longer than expected, in tandem with the IMF’s expectation of a decline to 6.5% in 2023, from 8.8% this year. In the US, headline inflation remains high at 7.1% in November compared with the Fed’s 2% target.

As such, the research house believes the Fed may still need to tighten monetary policies in order to manage inflation, notwithstanding the potential for a substantial downturn in US economic activity in 2023, particularly in the private consumption sector.

Hong Leong Investment Bank (HLIB) Research also forecast the OPR to reach 3.25% next year, after two hikes of 25bps each in January and March. It expects inflation to average slightly lower at 3.1% in 2023 versus 3.4% in 2022, as base effect dissipates.

“However, the 3.1% expansion estimate still remains elevated and sits above pre-pandemic levels, propped up by both demand and cost pressures alongside anticipated changes to domestic policy measures.”

HLIB noted that the latest purchasing managers’ index indicators are starting to signal economic contraction gathering pace in some of the largest world economies, including the US, the UK and the European Union.

The research unit has forecast that Malaysia’s economic growth will moderate to 4% in 2023 from an expected 8.2% in 2022, as the base effects and initial boost from pent-up demand wane.

“Our projection sits at the lower end of the government’s official target of 4%-5% as we expect growth to also be weighed down by further tightening of global monetary policies and its resulting weaker global growth environment, higher risk aversion in financial markets and geopolitical tensions,” it explained.

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