THE divergence in the monetary policy stance between emerging and advanced economies has caused the global economy to become more volatile as investors constantly recalibrate their investment decisions.

       As a small and open economy, Malaysia is not spared from this phenomenon.

       Malaysia’s Consumer and Producer Price Indices have been trending higher than their five-year averages for over a year now. It could have been much higher sans higher government spending.

       The situation is more acute in advanced economies.

       In the United States, inflation came in at 8.5% in March 2022.

       This is the highest level in four decades, prompting the Federal Open Market Committee to hike its funds rate by 50 basis points just days ago, the most aggressive increase in over two decades.

       Since inflation is trending higher than the level deemed comfortable by most central banks, shouldn’t this be a call for an immediate and/or aggressive rate hike to “kill” inflation at sight?

       On one hand, it is a “yes” by textbook definition as a way to tame inflation expectations.

       But on the other hand, it is a “no, not yet”, since textbooks have never explained the underlying driver of inflation we face today – distortions amid a global shutdown.

       Inflation drivers come in many shapes and forms, but the common ones are cost-push and demand-pull inflation.

       The Covid-19 outbreak brought changes to our way of living, with strict mobility restrictions and restrictive physical contact.

       Consequently, both demand and supply collapsed, and overall prices trended lower, prompting central banks to cut down interest rates to historic lows.

       The advent of vaccines in late 2020 enabled mobility restrictions to ease, and massive fiscal boosts had helped elevate demand, as seen in the advanced economies.

       Real interest rate – nominal interest rate minus the inflation rate – turned negative for longer to encourage even higher borrowing levels when demand recovery remains weak. For countries at risk of a sovereign rating downgrade, a negative real interest rate is not particularly useful in increasing spending and investment.

       The pandemic, in a way, should change how central banks deploy their policy tools to achieve mandate(s). In advanced economies, inflation is mainly driven by demand-pull inflation. High vaccination rates prompted governments to ease mobility restrictions early and allowed demand to recover more strongly than supply, causing prices to spike. Major central banks have now started to hike interest rates following the end of their quantitative easing policy to firefight inflation which has risen above the typical 2% inflation target. As a result, recessions are brief in advanced economies not only due to speedier economic reopening but also a bigger fiscal stimulus size to finance lockdowns.

       Meanwhile, emerging markets suffer from longer recessions as they do not have the necessary ingredients to speed up economic recovery. To illustrate, the Malaysian economy is taking about three quarters longer to recover than it had during the 2008/2009 Global Financial Crisis. Private consumption is also taking much longer to recover, while real investment is still nowhere near recovery as of 4Q2021.

       For Malaysia, inflation is high because supply is low and not because demand has recovered to its pre-pandemic levels. For the goods sector, it is more lucrative for manufacturers to boost exports to cater to external demand amid a speedier economic recovery in advanced economies. Manufacturers cannot easily switch their target markets anyway, so the supply shortfall in the domestic market is understandable. Supply bottlenecks amid varying degrees of lockdowns around the region further exacerbate the problem.

       Unemployment remains elevated as the sector’s recovery is highly dependent on mobility restrictions. If economic reopening is slow, so will the demand-side recovery. Prolonged lockdowns have also caused workers to venture out to seek new job opportunities to make ends meet or to acquire more rewarding skills, or in some cases, to leave the job market altogether. As such, high inflation is primarily due to prolonged supply-related disruptions and not demand recovery as seen in advanced economies.

       But then, one would argue that inflation is inflation no matter what causes it to occur in the first place. If developed economies’ approach to tame high inflation is by hiking interest rates, should Malaysia and other emerging economies follow suit? Yes, but at least not prematurely.

       The difference in the nature of economic recovery is causing a divergence in the monetary policy stance between emerging and advanced economies. Macroeconomic indicators have become more volatile as investors constantly recalibrate their investment decisions.

       The ongoing geopolitical tensions amid the Russia-Ukraine military conflict add further stress to the situation. Therefore, we should anticipate some macroeconomic volatilities as Bank Negara Malaysia (BNM) is unlikely to act as decisive or aggressive as the Fed until demand recovery becomes solid.

       As the Malaysian economy reopens progressively, we should expect such divergence to narrow in due time. Until then, fiscal policy should do most of the heavy lifting to combat high inflation while at the same time give ample time for BNM to assess the situation and respond prudently.

       Since most salary earners view inflation as a form of regressive consumption tax, it is perfectly natural for the laypeople to view it as a negative phenomenon. The fear of inflation is a knee-jerk reaction as we are concerned about the effects of rising prices on our (fixed) incomes, purchasing power, savings, welfare and the country’s overall macroeconomic performance.

       All in all, we believe that the government’s fiscal push to encourage speedier demand recovery is the right move. The pace is much slower than we hoped, but overall recovery is better late than never.