Central Banks Are Rushing to Raise Rates – Malaysia next?

Recently, central bankers and investors elevated inflation to the top of the ‘worry’ list. Of not to be blamed in reacting too slowly, many regional central banks are rushing to raise the key benchmark rate arguably to fight inflation. So far, Philippines’, Indonesia’s and Thailand’s central banks have tightened monetary policy, in the context of each central bank’s inflation target. In fact, some claimed that the Bangko Sentral ng Pilipinas (BSP)’s greater than expected policy rate hike should be seen that the authority is serious about bringing inflation back to target in the medium term.

Grounding on that, together with inflationary threat, punters are expecting a 25bps hike in overnight policy rate (OPR) by Bank Negara this week – 25 July 2008. On 23 July 2008, market will get report on the June CPI, which more likely than not, will show inflation to accelerate beyond historical average rate on the fuel subsidy adjustment.

I doubt that BNM will deliver the expected hike, as the BNM once said that it has no immediate plan to raise policy rate if there is no evidence of the second round effects. It will be too premature to act.

Question – Is rate hike will be the solution that we are desperately searching for or there be other viable alternatives?

Under a cost-push scenario, interest rates hike will only worse the macro situation, and if not handle well, it exposes the economy to risk of stagflation. Debt servicing ability and business sentiment will be badly affected. Malaysia has one of the highest household debts to GDP ratio in this part of the world. Inflation expectation is unlikely to ease because price pressure is supply-side driven. Raising interest rates, at this point of time, is akin to rubbing salt to the wound!

If the objective is to ensure neutral or slight positive real interest rates, then the 25 or even 50 bps hike will not do the tricks. A rule of thumb is that for every 100 bps hike in interest rates, consumer spending will ease by 0.5-0.8 percentage points in the first year and 0.4-0.6 percentage points in the second year respectively.

Perhaps, there are more effective tricks that relying on interest rate management. Fiscal tools like reducing business costs and raising disposable income may be better options to current dilemma.

By allowing Ringgit to appreciate is another viable option, especially when the US dollar is on the depreciation path. It reduces imported inflation and strengthens purchasing power, hence promoting low and stable inflation expectations (see Mishkin Frederic, Monetary Policy Strategy, 2007, p 4). Impact to exports is likely to be minimal when the global demand remains weak.

As inflation heads higher, credibility to handle inflation is becoming more vital, and if the authority is not making the right use of right policy tools, we are likely to see greater impact of capital outflows and diminishing of wealth.