THIS article will attempt to explain the justification for raising the overnight policy rate (OPR) and briefly illustrate the relationship between the OPR and inflation, and the unemployment rate.
Ultimately, this author argues that the unemployment rate, and not inflation, should be Malaysia’s primary policy focus in the immediate term.
Following the monetary policy committee’s (MPC) first post-lockdown rate hike last month, economists expect there will be at least one more hike in the second half of 2022.
From the growth perspective, everything seems to fall into place amid economic reopening, albeit not to everyone’s delight for various reasons.
The rationale for monetary policy normalisation is well justified.
Once post-lockdown growth signposts become solid, the historic-low OPR must go to avoid rapid overheating.
Besides, since other major central banks are becoming more hawkish over time, it is apt for Bank Negara to close the policy gap between Malaysia and advanced economies.
This is all in the name of macroeconomic stability.
Arguably, the most important rationale is to ensure that Malaysia’s monetary policy space remains intact to face another slowdown, should there be one in the immediate future.
The latest Bloomberg survey says the odds of a United States recession happening over the next 12 months is 30%.
If the US Federal Reserve is willing to risk a recession by killing demand through rate hikes, OPR hikes may be considered somewhat aggressive as well.
So if a higher OPR is a surety, what should come down?
Economic textbooks would say that inflation and interest rates have an inverse relationship, which is rightly so since the interest rate is the central bank’s primary tool to tame inflation.
Therefore, as interest rates rise, inflation falls.
When Brent crude oil peaked in July 2008, inflation shot up to 8.5%, but the OPR remained steady at 3.5%.
The OPR only started to decline starting November 2008 amid the anticipation of a sharp slowdown in global demand following the oil price crash. Notice that the high inflation rate here had failed to nudge the central bank to take an accommodative stance. Interestingly, as inflation started to decline, so did the OPR.
Today, inflation is creeping up amid supply chain shortages, high global oil prices and a weakening ringgit. Similar to what ensued during the 2008 global oil price shock, both inflation and the OPR are moving up in tandem, not otherwise. “What gives?” you might ask.
Answer: subsidies and petroleum tax revenue. Recently, Malaysian Finance Minister Tengku Datuk Seri Zafrul Abdul Aziz revealed that the government’s subsidies bill may reach RM71 billion in 2022 – twice the size spent in 2008.
Concurrently, it is also highly likely that Malaysia’s petroleum tax revenue will also go up in 2022 to approximately RM23.3 billion this year, if not higher. (Note: the government collected RM24.2 billion in 2008 and even more so in 2009, amounting to RM27.3 billion). Although many economies are experiencing decades-high inflation rates, we can expect inflation in Malaysia to remain relatively benign with the help of higher fiscal support.
It appears that the relationship between inflation and the OPR is weak in recent decades. Reiterating the author’s earlier question, which economic variable should fall when OPR starts to rise in the coming months?
Answer: the unemployment rate. The choice of the word “should” here denotes that the unemployment rate will likely correlate negatively as in recent trends of OPR movements. And more importantly, it must decline back to its pre-pandemic levels soon enough to avoid risking future economic growth.
To be clear, the inflation-unemployment rate correlation was stronger before the 1990s. The early 1980s global oil shock had caused Malaysia to suffer an acute macroeconomic imbalance, pushing the then government to undertake an austerity drive to contain record-high debt and fiscal deficit. The unemployment rate shot up and inflation came down. Following that, the government managed to keep the unemployment rate closer to the natural rate of unemployment for decades through various fiscal measures.
The COVID-19 pandemic-induced lockdowns had pushed the unemployment rate higher to a level unseen since the 1980s crisis. Household income in all income brackets dropped as its average declined by 10.3% in 2020 versus a year earlier.
It is a fact that recessions punish nominal household income and more so when the unemployment rate reaches record-highs. Hundreds of billions of ringgit have been spent to support the economy over the past eight quarters, yet the unemployment rate remains elevated at 4.1% as of March 2022. Having a bigger informal sector does not help and may in fact be even more arduous amid the economy’s low-cost/wage environment. Therefore, as the OPR is slated to increase further soon, the unemployment rate must fall quickly. Otherwise, more fiscal support is needed to aid such an anaemic labour market.
Furthermore, maintaining the socio-economic fabric is of utmost importance for a developing country with a relatively young workforce. Since younger workers are the ones who bear the brunt of unemployment the most, a low graduate-level pay may affect their earning capacity in years to come.
Recently, there was a news report about the gig economy, such as food deliveries, actually pays better than a typical graduate-level job. If younger workers prioritise take-home pay over working experience – which is highly likely – entering the formal job market can be challenging in the future. If things do not work as well as these younger workers expect them to, it will be laborious for the ruling coalition to justify government policies in the coming general elections.
The silver lining is that the unemployment rate is dependent on the performance of the services sector, which has been trending higher over the past three quarters. Since the services sector appears to be the biggest beneficiary of lower mobility restrictions, we can expect the unemployment rate to fall steadily. That said, the magnitude of such decline remains a concern.
To sum up, the OPR will go up in the coming months. Inflation is highly problematic, no doubt. But this author would argue that the government has adequate policy tools to limit prices from rising faster than they should. Prices will organically go up, but not at the same degree seen in other countries. Since Malaysia aims to maintain its competitive advantage against regional peers, it is our natural tendency to keep prices down, anyway.
On the other hand, unemployment is a messier problem and merits much closer attention. It would be unwise to reduce/rationalise subsidies if it brings down employers’ appetite to hire. Therefore, Malaysia’s policy focus in the immediate term should be about reducing the unemployment rate, bar none.