Interest Rate, Inflation and The Ringgit

The incumbent Turkish Prime Minister described interest rates as the mother and father of all evils and many agreed with him, but unfortunately in the real world of finance, there is no such thing as a free lunch.?A layperson on the street isn’t keeping money in the bank if it doesn’t pay him any compensation.?Meanwhile wisdom tells us that interest rate comprises of compensation for deferred consumption, loss of purchasing power and taking credit risk.

There is also a very important reference rate that removes the credit risk from the interest rate, i.e. the Overnight Policy Rate (OPR).?This rate is determined by Bank Negara Malaysia (BNM) as the guardian of our monetary stability and it represents the interbank lending rate against excess funds held by banks with BNM.

OPR is a fundamental building block of many financial instruments and benchmark reference rates for home buyers or commercial loans in Malaysia.?Any changes in the OPR lead to changes in interest payments of loans, bond yields, derivatives, swap rates and the value of financial instruments.

It is also frequently used as a tool to tame inflation. Simply put, OPR is a crucial monetary tool that has an overwhelming influence on finance, economics and consumer spending behaviour.?Naturally, many aspects of the nation’s economy and the financial welfare of its people have to be considered by BNM before any tweaking of the policy rate can be undertaken.

That being said, the loss of consumption power is usually measured by changes in the Consumer Price Index (CPI) with the rate of increment of CPI used to measure headline inflation.?However, monetary policy setters prefer to use the core CPI as it serves as an indicator of the underlying trend of changes in price levels and that trend has been rising since last year, see Figure 1.?

It also shows that core inflation has exceeded the policy rate since early 2022, putting the country in negative real interest rate territory.?In real terms, this means ordinary savers are paying money to deposit in the bank instead of earning interest.?On the grand scale, banks have to pay to park their excess funds with BNM.?

In such an environment, conventional wisdom tells us it’s better to consume or invest than to hold money in hand to derive better value out of it rather than to let it erode. ?

...throwing kerosene into a burning house.

Keeping policy rates below the core inflation rate in an inflationary environment is also akin to throwing kerosene into a burning house.?The many paths to this debacle over time, usually lead to overbearing real and financial asset bubbles.?They usually burst with severe social and economic consequences that makes it paramount to keep the inflation djinn bottled up.

Turkey is an excellent example of a country in limbo caused by the uncontrolled inflation djinn fed by unrealistic low policy rates, resulting in an eye-watering inflation rate of 80%.?Its highest in 24 years, with the lira falling fivefold of its 2018 value against the US Dollar (USD) to 18.61 today.?

The financial markets believe that the Central Bank of the Republic of Turkey is no longer capable of making independent monetary decisions.?My heart goes out to the pensioners there, their purchasing power and quality of life must have suffered greatly.

In regard to our Malaysian Ringgit, it touched the low at 4.74 against the USD this week.?The mouth-gaping policy interest rate differentials with the USD are also encouraging money to leave and stay out of Malaysia.?The medium term performance of MYR is not impressive too in comparison to our neighbours as shown in Figure 2 below.??

US Dollar plays a dominant role...

Given the dominance of USD in global trade and finance, it is not surprising that the exchange rate pass-through is reflected in the prices of our goods and services, and the CPI whether headline or core. ?Let’s look at the price of diammonium phosphate (DAP), a common fertiliser that has tripled since 2020 (see Figure 3), leaving farmers with no alternative but to increase the price of fresh produce.?This pain is felt heavily by the middle and lower income groups as their purchasing power and standards of living deteriorate.?

On the corporate front, the low cost of money aided by the negative real interest rate is a sugar rush for cheap borrowings.?It encourages excessive risk taking by corporations and attracts off balance sheet risk on bank financials.?

The case for negative real rates is warranted in a deflationary environment as they cancel each other out.?But it's the opposite for Malaysia at the moment and we don’t need to invite chaos by having bloated pumped-up asset values.?

Our policy setters appear to be in a quandary.?On one hand, raising the policy rate may arrest the fall of the Ringgit, address inflation exacerbated by the exchange rate and encourage prudent spending, but on the other, it can make raising and servicing debts more expensive.?But this also means reducing excesses, no new taxes, living within our means and coming out stronger to face the future.

Many businesses will despise interest rate hikes, especially sectors high on debts or those so addicted to snowballing asset values to generate profits.?Yet, businesses must pay attention to the observed indications that the days of cheap credit are coming to an end globally and the need to prepare for it well.

Of course, prescriptions are bitter and hard to swallow, but they do provide cure or at the very least some relief, and some will make money out of it and some will pay for it.?Remember that cheap finance can be good politics, but politics can't claim to be economics.