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Saturday 2 January 2010

Interest rates: The only way is up

Interest rates: The only way is up
By CECILIA KOK

IT has been a year of “free money”. Well, almost, especially so in developed countries such as the United States and Japan, where interest rates have sunk to near zero levels over the past one year.

In most other countries, including Malaysia, interest rates are nowhere near zero, but they have been hovering at their historical lows. So, in general, money in these countries has been generally “cheaper” than ever as well.

Now, let’s think of interest rates as the price of money and liquidity as the lifeblood of the economy.

From the time governments worldwide began slashing interest rates towards the end of 2008 and early 2009, they have essentially opened the tap for cheap money to flood the economy. They call it a loose monetary policy, and the strategy is to encourage businesses to borrow more to boost investments and households to save less and consume more to help bring life back to an economy seen then to be at risk of sliding down into an unprecedented, deep and prolonged recession.

To a certain extent, the strategy of a loose monetary policy has worked pretty well for most economies. But of course, the strategy wouldn’t have worked as effectively if not for the massive government spending on public projects and various other incentive programmes to stimulate their economies.

Rising stakes

But the stakes are rising, as the global economy gradually returns to a growth path.

For one, the low interest rates are seen to be fuelling the emergence of new asset bubbles, particularly in Asian economies such as China, Hong Kong, South Korea and Singapore, where property and equity prices have surged beyond what their fundamentals would justify.

There is also money chasing commodities, such as gold and crude oil, as investors seek to invest in assets that promise higher returns. And that has resulted in the prices of major commodities rising sharply.

The other concern pertains to the rise of inflationary pressure. The general price level of goods and services could accelerate as total demand in an economy continues to grow with the improving economy or as the rise of commodity and raw material prices continue to push up costs.

While the consensus view is that inflation is still a subdued risk for most economies at this stage, the next few months can present a different story. Already, the United Nations Food and Agriculture Organisation warned that global food prices had bounced back to a 14-month high last November. This could be just one of the signs of rising inflation risk.

The risk of inflation cannot be left unchecked, as it could result in the value of money being significantly eroded, and hence, the purchasing power of consumers diminished. So, amid the rising risk of new asset bubbles and inflation in a more stabilised and improved economy this year, the next sensible move expected of policymakers is to turn off the tap of super-cheap money by raising interest rates before their economies get overheated with other problems.

So far, Australia has been leading the world in raising interest rates. Since October last year, the country’s central bank has raised its benchmark interest rates three times by 25 basis points each to the present level of 3.75%. Local economists are now saying that the next meeting of policymakers at the Reserve Bank of Australia in February could result in a fourth consecutive rise in interest rates.

Most policymakers in other countries, including Malaysia, are still assessing the appropriate time to raise rates by weighing the risks of tightening too soon with remaining loose for too long.

Malaysia’s Monetary Policy Committee (MPC) at Bank Negara will meet at the end of this month to determine the level of the country’s benchmark interest rate, that is, the overnight policy rate (OPR), for the next two months. No change in the OPR is expected out this first meeting of the year.

In general, the MPC meets six times each year to decide on the direction of the OPR based on its outlook of the local economy and inflation expectations for the country. It is noteworthy that while one of the key priorities of the central bank is to ensure general price stability, policymakers do not actually have a targeted rate of inflation to determine the movement of the country’s key interest rates, unlike some other leading economies such as Britain, which has an inflation target of 2%.

The reason for this is that Bank Negara wants to be flexible in terms of providing ample support for economic activities in the country to expand.

One thing is clear at this moment – the pace of Malaysia’s economic recovery is already gaining momentum. Key economic indicators such as industrial output and trade have been showing consistent improvements over the past few months, and the country’s economy is seen to have broken out of recession in the fourth quarter of last year.

(For the first quarter of last year, Malaysia’s gross domestic product, or GDP, contracted 6.9%. The subsequent two quarters also saw a contraction respectively of 3.9% and 1.2%.)

But gauging the risks of rising inflation causing price instability is tougher as various factors come into play. Economists are cautious over the rising pressure of commodity prices as well as the Government’s restructuring of its subsidy schemes this year as part of its economic transformation plans.

Thus far the signal that Bank Negara has been sending out is that the current monetary policy stance is appropriate for the country, as it still believes the risk of inflation this year is modest. And while policymakers have not hinted at any rate change as yet, most private economists hold the view that the OPR is most likely to be maintained at 2% only until the middle of the year before the rate rise sets in in the latter part of the year.

Exactly when and at what rate, that’s anyone’s guess. But when the inevitable happens, the cost of obtaining credit will no longer be that cheap, although the incentive to save money in private banks will improve. For instance, mortgage and hire-purchase rates would rise, and so would savings rates as the fixed deposit rates.

And the uptrend of interest rates could also slow the rise of equity prices – which could be a good thing to prevent equity prices from overshooting beyond their fundamentals.

Certainly, the change in interest rates has a broader implication on the economy as a whole, but as in any case, if any change is necessary, a gradual one is vital to prevent any shock from happening.

1 comment:

  1. True, money has been generally 'cheaper' than ever!

    ReplyDelete