Why raise interest rates again?

 

As expected, Bank Negara Malaysia (BNM) raised the overnight policy rate (OPR) by another 0.25% to 2.5%, to the level last seen in March 2020. Commercial rates will follow quickly.

The fact that this was so widely expected is reassuring. Interest rate policy should be predictable so that people can anticipate changes and not be taken by surprise. However, we also need to understand why the rates are rising.

BNM has a mandate to promote monetary and financial stability which supports sustainable economic growth. This is a broader mandate than other central banks such as the Bank of England which is simply focused on an inflation target.

Price stability for BNM is broadly defined and there is no specific inflation target. In fact, at the moment, inflation in Malaysia is due to specific price increases in transportation, food and food-related businesses and a utilities price effect.

None of these are controlled by higher interest rates, they are being controlled by subsidies and price caps outside the scope of BNM policy. So the hikes in interest rates are not specifically focused on controlling inflation, although they can have a broad effect overall.

Economic growth has been stronger than many expected in the first half of the year and the current interest rate stance remains neutral and accommodative to sustain growth, given possible headwinds in the future.

BNM is also monitoring pain points on repayments and defaults to make sure that small rises in the OPR do not cause difficulties for borrowers when commercial rates rise in tandem.

As for exchange rates, BNM has made clear that the OPR is not used to chase the dollar. This is wholly correct and, despite calls to the contrary, BNM really cannot control the exchange rate systematically with interest rates or even market intervention.

So why raise interest rates in these circumstances? The reason is really in terms of normalisation of policy and financial stability.

When interest rates are very low for a long time, anyone who wants a loan will have already taken it. Low interest rates will not encourage more loans so they become ineffective.

In fact, we may get a liquidity trap where people will be reluctant to take cheap loans because they expect finance costs to rise in the future. So they will save money rather than spend it or borrow more. Again, low interest rates become ineffective.

Another problem is that due to cheap financing, many unviable loans are taken on and these can become toxic if interest rates rise quickly. This is not good for the loan mix in the long-term. So if interest rates rise and stabilise first, there will be fewer unviable loans. This better mix of debt helps to stabilise the financial system.

Raising rates now also provides some policy space in the future if the global economy slows and there is a need for monetary easing. If rates are kept too low then they cannot be cut further when needed because they are already ineffective.

So contrary to simple monetary policy in developed markets like the US, interest rate policy in Malaysia is more sophisticated and requires greater reflection and skill. It is not just about saying, “inflation is going up so hike interest rates to bring it down”.

BNM is very wise in making small changes slowly over time and avoiding big hikes at one go, as we see with the US Federal Reserve. If the situation stabilises this year, BNM can stop without having gone too far and allow the economy to settle down to face whatever might come next year. - FMT

The views expressed are those of the writer and do not necessarily reflect those of MMKtT.