After two years of record-low interest rates and ultra-cheap credit in response to the Covid-19 pandemic, the global monetary policy stance saw a complete change in direction this year. In the face of surging global inflation, most policymakers had to choose between supporting economic activity in the post-lockdown era and maintaining price stability amid global supply shocks. Notably in the US, monetary policy had to be tightened aggressively, given price pressures from both the demand and supply sides. The sudden withdrawal of monetary policy support in the US and around the world raised considerable anxiety about potential financial market instability and an acute economic slowdown.
Malaysia, fortunately, has not been pressed into such a precarious position, given the relatively manageable inflation so far this year. Nonetheless, lessons can be drawn from the policy decisions made by other central banks, particularly the US Federal Reserve.
For starters, let’s look at how the US arrived at its current position and why the need to resort to such extreme measures.
It can be argued that soaring inflation in the US is in large part due to its economy “overheating” as monetary policy had stayed too accommodative for too long. The US has had a head start in its economic recovery compared with the rest of the world, given its early access, rapid rollout and coverage of Covid-19 vaccines among its population. The swift economic reopening led to a rapid closing of the negative output gap and quick employment recovery.
The strong economic rebound fuelled upward price pressure as the US inflation rate jumped to 7.1% in December 2021 from 1.4% in January 2021. However, the rate hike trigger was not pulled until March 2022, as the consensus leading up to that point was that the inflationary pressure faced was likely transitory, caused by supply-demand mismatch and bottlenecks.
This call proved to be costly in hindsight as prices stayed high while inflationary expectations became increasingly anchored in the US. The US inflation rate continued its climb to 8.6% in March before reaching a high of 9.0% in June, further compounded by the cost-push pressure from the Russia-Ukraine war. To stamp out inflation, the Fed enacted large and rapid interest rate hikes, knowing it would come at the cost of economic growth. It was arguably the lesser of two evils, as the cost of economic losses is typically short term in nature and can often be recovered quickly. In contrast, inflation is more difficult to reverse, and the negative impact can be felt over a longer period.
Knowing this, Malaysia needs to be mindful of keeping interest rates too low amid the current robust recovery in consumption spending. While domestic inflation has been relatively manageable and overwhelmingly cost-push driven due to global supply dynamics, the risk of demand-pull pressure making a sudden appearance should not be underestimated. Malaysian regulators seem intensely aware of our economic recovery strength, yet cognisant of the risks of raising rates too late. This could have partially fuelled the decision to increase the overnight policy rate (OPR) over the last three consecutive monetary policy meetings, each by 25 basis points. This will also pre-emptively stamp out any potential demand-pull inflation pressure and help avoid a scenario where Malaysia has to institute large and potentially destabilising rate hikes.
A common argument today against monetary policy tightening for the man on the street is that the higher cost of debt servicing creates undue cost pressures at a time when the general prices of goods are already rising. It is true that not raising rates now could provide immediate short-term gains for the economy. However, we risk losing sight of the longer-term costs should prices spiral uncontrollably upwards. The net cost to the economy would be even larger under that scenario.
Despite the strong headline economic statistics, it is understandable that recovery remains uneven. Some segments of the economy are still relying on cheap credit and low loan instalments to survive. Under that scenario, the more appropriate policy prescription is to extend targeted help to those who really need it, as monetary policy is a relatively blunt tool that cannot be relied upon to address specific issues.
Malaysia is in a fortunate position where we can afford to gradually normalise monetary policy. Moving ahead, more policy coordination is needed between monetary and fiscal policy to ensure the former is not overextended beyond its capability and role. A gradual normalisation of monetary policy is always preferred in maintaining the delicate balance of price and output stability.
Woon Khai Jhek is a senior economist and co-head of economic research at RAM Rating Services Bhd