‘Monetary policy is to a large extent the management of expectations.’ - Lars E. O. Svensson
OVERVIEW
- We studied the monetary policy decision trend of the Bank Negara Malaysia (BNM) over the past decade and based on heuristic approach, the probability of a rate hike remains relatively low.
- Past BNM’s actions were deliberate yet decisive; hikes were incremental and consecutive, with little to no change for a considerable period afterwards.
- A 25 bps rate hike would most likely be followed with more hikes; may not provide the necessary remedy to the financial imbalance when the impact of GST drags economic growth in 2015.
- There are still other options; additional macroprudential measures, countercyclical regulations to manage imbalances apart from adjusting interest rates.
- There’s greater weight on output growth over price stability; potential price pressures are supply driven whilst past decision to hike rates was largely to combat expansion in domestic demand.
- Social consideration; ease the burden of borrowers, specifically those in the lower to middle income amidst rising cost of living.
Nudge and hints. Thanks to the constant nudge by the media, economists and market experts following the betterthan-expected 1Q14 GDP growth of 6.2% YoY, the guessing game is up a notch and swaying towards the view that Monetary Policy Committee (MPC) would hike interest rates at its next meeting on 10th of July. This was in fact encouraged by BNM’s last MPC statement in early May, which somewhat gave a rare but relatively strong hint on the need to “adjust the degree of monetary accommodation if there is any indication that risks arising from the accumulation of both monetary and financial imbalances would jeopardise Malaysia’s growth prospects.”
Mindset change. Prior to the release of the 1Q14 GDP data, only a handful of economists that contributed to the consensus survey compiled by both the media and independent research agencies called for a higher possibility of a rate hike, as early as the next MPC meeting in July. The view of a higher probability of a rate hike in July now seems to have won many converts leaving a minority expecting a possible rate hike only in the later part of 2H14 and even fewer saying no hike at all for this year.
Different viewpoint. Alternatively, it would be easier to jump on the bandwagon as the rationale for a rate hike appears to be somewhat straight forward: to combat inflationary pressure, reduce debt-fueled consumption, maintain a positive real rate of return. In short, to achieve the proverbial “balance growth” objectives of higher growth, stable prices and full employment. Invariably, this also requires the assumption that the economic outlook remains sanguine for the next six to twelve months, supported by steady exports and strong domestic demand. However, the current macro and market environment is constantly changing and becoming more perplexing than it used to be. This reflects our current neutral viewpoint of BNM’s monetary policy. In addition to the conventional methods, we also focus on the heuristic approach to determine the possible direction of BNM’s interest rate policy based on its decision behavior pattern and trend of managing market expectations.
MPC Decision Trend Analysis
Decision pattern. BNM Governor Tan Sri Dr. Zeti Akhtar Aziz recently highlighted on the optimal policy to be implemented in order to anticipate and pre-empt any financial and economic imbalances. In this regard, we think it’s essential to examine BNM’s policy decisions as well as its effort to manage market expectations since the MPC meeting began in May 2004 up till its last meeting in early May this year. This would help identify certain patterns of BNM’s decision behavior that may help market participants devise useful heuristics on the direction of interest rates.
Minimal changes. After studying the monetary policy decision trend of the BNM over the past decade, we found that its tendency towards rate adjustment is very conservative and deliberate. Since the first MPC meeting on 26th of May 2004 until the most recent one on the 8th of May 2014, or a total of 67 meetings, BNM adjusted the OPR by only a total of 10 times – seven rate hikes and three cuts (Table 1). In its ten years, the only time the committee decided to cut the OPR was at the height of the global financial recession. It was done within the span of less than four months from November 2008 till February 2009. The three successive rate cut started with a 25 basis points (bps) reduction on 24th of November 2008, from 3.50% to 3.25%. This was followed by an unscheduled meeting decision on 21st of January 2009 to slash the OPR by an unprecedented 75 bps, to 2.50% and within a month in February by another 50 bps to its lowest at 2.00%.
Gradual and reversal averse. While the BNM decision to cut rates came at an extraordinary time, to deal with external shocks, its decision to raise interest rates was largely to combat rising inflationary threat derived from expansion in domestic demand. Another salient feature BNM adopts when raising interest rates was that it adjusts rates in small increments, of 25 bps each time. Whilst BNM’s increments in their policy rates are small, it also makes several of them consecutively. This tendency is called “reversal aversion”. Looking at past trends, the probability of BNM to raise interest rates not long after it starts its tightening mode is more than 90%, meaning that its likelihood to raise another 25 bps in its subsequent meetings or within 3-6 months is relatively high. A total of 50bps rate hike within six months may seem to be too much too soon as it could raise cost of funds and adversely impact large infrastructure projects.
The outlier. In comparison to other major central banks in the region as well as those of the advance economies (refer Table 1), BNM’s rate decision pattern can be regarded as the most conservative. The average number of adjustments made by other major central banks in the region is around 29 times in the span of 10 years, almost triple that of BNM’s. Being extra cautious and preferring to consider alternative policy options could have largely contributed to BNM’s less aggressive yet effective decision bahaviour. Being less prone to adjust rate when its regional peers does it more liberally with higher frequency, does not mean BNM is doing it the wrong way.
Accolades and awards received by BNM governor Dr Zeti since she chaired the first MPC meeting has proven this otherwise. The Global Finance magazine accorded her “Grade A” among the heads of central banks for 10 years in a row, and even named her one of the world's best central bank chief in 2010.
Other tricks in the bag. In spite of the hints and signals that BNM has given to “adjust the level of monetary accommodation” it still has the option of introducing additional macroprudential measures or countercyclical bank capital regulation to prevent and manage the build-up of financial imbalances apart from adjusting interest rates. If it still bent on adjusting the policy rate then the probability of any rate adjustment to be made anytime soon remains relatively low partly because that BNM adopts gradualism and reversal aversion in charting the direction of its interest rate policy. Let say BNM starts with a 25 bps rate increase for the purpose of anchoring to market expectations of inflation in the medium- and long-term it would only create a bigger expectation of another rate hike. Doing too much too soon may not provide the necessary remedy to the financial imbalance when in a matter of less than a year the impact of GST would likely drag economic growth down for at least an additional six months.
Decision Trends and Triggers
Aiming for growth and stability. BNM formulates its monetary policy mainly to accomplish three objectives – to achieve price stability, to increase output and to smooth the interest rate. Besides, looking at its past policy action there is enough research and academic literature to support the view that BNM puts greater weight on output growth over price stability. Furthermore, a strict inflation-targeting framework is not a good policy option to be practiced in Malaysia, as it produces high volatility to other macroeconomic variables.
2nd round effects? Nonetheless, the balance of risks to the inflation outlook continued to lean toward the upside, suggesting narrower policy headroom going forward. We project the CPI to increase by 3.3% in 2014 up from 2.1% last year. Potential price pressures are still mostly coming from the supply side, notably another possible fuel price hike and higher food prices resulting from an expected El Niño episode in the 2H14. These factors highlight the continued risk of second-round effects, which however are not yet evident. In addition to that, the likelihood of a continued strong liquidity growth from potentially large portfolio inflows following ECB’s decision to cut interest rates last week is still seen as posing a risk to future inflation. The downside risks to inflation are seen to emanate from the potential growth slowdown in key emerging markets namely China and the risk of deflation in advanced economies especially in the eurozone.
No hurry. Meanwhile, calls for immediate rate hike could also partly attributed to the fact that the ringgit have been on a weakening bias since early this year thus reducing its purchasing power parity and weakened terms of trade. Both affects the headline inflation and cost of living. We still believe that the current policy stance is in line with the need to support growth of the Malaysian economy, especially with enhanced economic and financial risks on the external front. The ringgit has also been relatively stable and steadier off late, vis-à-vis the US dollar. The value of the ringgit is more favourable now, at around 3.23 from year’s low of 3.35 in late January this year. Hence, we believe there is no immediacy to move interest rate aggressively. This is also in line with the need to cautiously manage the ringgit in view of China’s engineered yuan devaluation which could trigger much wider competitive currency devaluation in the region.
Exports surprise. Another factor that may have triggered BNM’s hawkish tone is the surprisingly good export data and the expectation that it may sustain its uptrend into 2H14. Combined with a lower-base effect and a weaker ringgit along with steady improvement in the US and eurozone economy, it resulted in exports surging to a 47-month high of 18.9% YoY in April. This means that the economic performance in the 2Q14 could again surprise us on the upside, as it did in the 1Q14 when GDP jumped by 6.2% when consensus where looking at around 5.0%. This could also suggest that growth in the 1H14 could be much faster than 2H14, going by the upper end of the official GDP forecast of 5.5% (KIB projection: 5.5%) for the whole of 2014. This is on the assumption that the growth trajectory of domestic demand stays the same and exports starts to taper due to the higher base. That being said, it may not yet be a compelling reason to raise interest rates as the economic growth may start to taper from 2H14 and well into 2015.
External guide. Since Malaysia is a small, trade-dependent and resource-based economy with a high degree of foreign presence in both the real and financial sectors, it is imperative to closely monitor the global economy. Hence, we need a forward-looking indicator that may trigger a shift in BNM monetary policy decision when global demand changes. For this purpose, we analysed the relationship between the OPR and the J.P. Morgan/Markit global manufacturing Purchasing Managers Index (PMI)TM ,which also serves as a extended proxy to Malaysia’s export-oriented sector. In the span of ten years since the MPC began, we see a trend whereby BNM would shift towards tightening mode when the index of global manufacturing PMI breached and remains above 54.0 and start to loosen its policy rate when it dipped below 40.0.
Not high enough. The latest global manufacturing PMI index showed that it reached 52.2 in May, up from April’s six month low of 51.9. Assuming the current trajectory continues its gradual steady climb on the back of improvement in the global economy and the absence of external supply shocks, it may take at least another three to six months before the index breaches 54.0, the level BNM feels comfortable enough to raise the OPR.
Other Factors
Social consideration. To achieve macroeconomic stabilization, the choice of the optimal monetary policy regime is a very important policy issue and a tough one to determine. There are cases in which a central bank gives priority to economic growth at the cost of inflation. Though we have made our case for monetary policy to remain status quo, there are still other reasons that the MPC should consider before giving its final say. It may not be surprising that apart from macro considerations, it could also extend its thoughts and concerns to the general plight of the main component of economic growth – the people. In this respect, the committee’s decision may perhaps take into consideration the need to ease the burden of borrowers, specifically those in the lower to middle income amidst rising cost of living. The ongoing subsidy rationalization and the impending implementation of GST in less than ten months from now would contribute to rising prices and reduction in disposable income. History has shown that the implementation of GST would have a debilitating impact on consumer spending, and eventually the overall economic growth, for at least the first six months after it is implemented. In the event of a supply shock, macroprudential measures combined with a strong response to inflation by the central bank policy tend to yield the lowest welfare losses.
Reducing credit growth risk. On account of continued commitment to reduce household debt, credit growth would remain somewhat subdued this year. Total credit growth has slowed to 10.0% YoY in April from 11.0% in January. The pace remains sedate as macroprudential measures continue to reign in household debt and speculation in the property market. Loans to the household sector moderated slightly to 11.6% in April from 11.7% previously. Meanwhile, inflationary pressures continues to curb spending, especially the household and consumer sectors but should begin to alleviate in the later part of the year when prices start to normalize as consumers begin to spend more before the implementation of the GST. This may take off some pressure from BNM to raise interest rates this year. In the event of a credit shock, countercyclical bank capital regulation is more effective than monetary policy in promoting financial, price and overall macroeconomic stability.
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