Tuesday, August 26, 2008

On inflation and interest rates

Inflation hit 8.5% in July 2008. Oil prices have dropped in the early part of August to about USD118 per barrel. Since then, the government has reduced petrol prices from RM2.70 per litre to RM2.55 per litre.

Yesterday, Bank Negara decided not to increase the overnight policy rate (OPR) from its current rate of 3.5%.

As a result the Ringgit fell to a 9-month low against the USD.

The Bank Negara Governor is quoted as saying that the decision to maintain the OPR stems from Bank Negara's desire to avoid a fundamental downturn in economic activity.

Chicken vs egg scenario
In effect, Bank Negara is saying that it's either high interest rates with economic slowdown OR low interest rates with economic growth. Is that really how it works?

What about the depreciation of the Ringgit? This is caused by leaving the OPR at 3.5%. While cheap Ringgit valuations favour exporters, the exporters are only one aspect of the complex Malaysian economy. What about the goods and services that Malaysia has to import?

What about imported inflation?
Doesn't a cheaper Ringgit make imported goods and services more expensive? Isn't that imported inflation? Won't that have a dampening effect on economic growth?

Is the Bank Negara truly independent?
Judging by the defensiveness of the Governor in responding to questions about her resignation (she denied it) and Bank Negara's independence (she said she's worked with 4 Finance Ministers and none of them ever gave a directive on interest rates ... ever!) - one's curiosity is even more piqued by the answers and responses given.

To avoid being caught in the bark of words, we have to look at the action...or, inaction on raising the OPR.

While Malaysia has always prided itself with the Robert Frost verse, the road less travelled (which this blogger may have alerted some personages to in 1998), the reticence of Bank Negara on raising interest rates is questionable. Just take a look at the way in which Vietnam is unravelling. By the way, Vietnam started to unwind due largely to the catalytic effect of their failure to raise interest rates which, in turn, led to the devaluation of the Dong which, in turn triggered a prolonged round of inflation which, is now causing their economic miracle to sputter.

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