Outside the central banks’ monetary tightening herd are Bank of Japan, which has been persistently sticking to negative interest rates despite growing concern about inflation
SINCE late 2021, central banks in advanced and emerging economies have aggressively hiked their interest rates to fight high and persistent inflation. Both headline and core inflation in many countries rose to the highest levels in decades.
The surge in inflation during the pandemic recovery was driven by key factors including supply disruptions, high energy and commodity as well as industrial materials prices following the persistent military conflict in Ukraine, and massive monetary and fiscal stimulus that fuelled consumer spending on housing, automobiles and durable goods.
The normalisation of interest rates since 2021 and continued into 2023, albeit smaller magnitude has led to a tightening of financial conditions globally; bond yields have risen higher; and also caused a sharp increase in longer-term interest rates.
The resulting borrowing cost increase has impacted existing businesses and households as well as new borrowers. As a result, global economic growth is expected to slow this year, estimated at 2.9% in 2023 from 3.4% in 2022.
There is divergent pace of interest rate normalisation or tightening between advanced and emerging markets.
The US Federal Reserve (Fed) is the most aggressive, followed by other major central banks such as Bank of Canada, the Swiss National Bank, the European central Bank and Bank of England to tame inflation.
Outside the central banks’ monetary tightening herd are Bank of Japan, which has been persistently sticking to negative interest rates despite growing concern about inflation; and also, the People’s Bank of China, which lowered lending rate amid concerned about the real estate stress.
Weighed by inflation pressures and capital flows volatility induced by the interest rate differentials, central banks in emerging markets have also embarked on interest rate normalisation suited to their domestic and price conditions, albeit gradually on a measured pace compared to the advanced economies given their relatively lower inflation level.
While both headline and core inflation have receded in some countries, both remain far too high.
Persistent strength in underlying inflation pressures were reinforced by firm consumer demand, underpinned by continued improvement or tight labour market conditions with labour shortages, which continued to drive wage gains in the private sector.
Therefore, central banks must still remain vigilant against potential cost-risk and demand pressures inflation and be resolute to ensure the interest rate is being raised to an appropriate level and relatively tight (less accommodative) as well as for a longer while to bring inflation down to manageable level.
Conundrum for central banks
The continued monetary tightening for taming inflation has put the central banks on narrowing tightrope without causing unnecessary stress on the banking sector and dragging down the economy.
The regional banks’ woes in the US highlighted investors’ concerned about the financial risks associated with higher interest rates and inflation.
At this point of writing, three regional banks have collapsed as interest rate and bond price volatility made their asset and liability mix unsustainable, causing depositors to flee regional lenders and fuelling fears that the crisis could engulf other mid-sized banks.
Uncertainty continues to pummel the banking industry, despite assurances from the financial regulators and bankers.
Higher interest rates (borrowing cost) make it costlier for businesses and consumers to borrow for capital investment and spending on durables like buying houses and automobiles.
Increased turbulence in the banking sector could make the already slowing US economy’s plan to escape a “soft landing” less likely. Credit flow into the economy will be affected as lending is likely to tighten further amid the regional banking crisis, creating a headwind for an otherwise decent economy.
It is pausing, not pivoting
The Fed has signalled that it may pause further increases after raising the Fed funds rate to between 5% and 5.25%, giving time to assess the fallout from recent bank failures, waiting on the resolution of a political standoff over the debt ceiling, and monitor the course of inflation.
The Fed is telegraphing the message that it may or may not tighten monetary policy further, guided by the evolving data and how events unfold; and said that “in determining the extent to which additional policy firming may be appropriate”, it will study how the economy, inflation and financial markets behave in the coming weeks and months.
While the Fed acknowledges that the financial stability policy is working well amid the banking stress, the fight to tame price pressures is far from over; and the process of tackling inflation has further to go.
The Federal Open Market Committee is of the view that it will take some time for inflation to come down to its longer run target of 2%. Hence, it would not be appropriate to cut rates any time soon.
While the Fed remains confident that the path to a “soft landing” for the US economy is not off the table, reducing inflation is likely to require softer demand and labour market conditions as well as moderating wages.
As the rate pause allows the full effects of the monetary tightening to work its way through the economy, we must not discount the possibility of additional rate hikes may be needed if the banking stress subsides and there’s no tangible evidence of a sustained decline in inflation.
Bank Negara has resumed interest rate normalisation, taking the overnight policy rate (OPR) to 3% in May after holding it steady at 2.75% for two consecutive monetary policy committee meetings.
The resumption of interest rate normalisation is in line with the forward guidance during Bank Negara’s previous engagements with market economists and analysts that the intermittent pauses do not signal the normalisation of interest rate is over.
In our view, the central bank wants a confirmation of data to see whether the economy is resilient enough to absorb the impact of previous rate hikes amid a slowing global economy.
Still-resilient gross domestic product growth of 5.6% year-on-year in first-quarter 2023 validates the accommodative monetary policy to support domestic demand amid slowing exports.
In our view, the 3% OPR is nearing the neutral level, an interest rate level that is appropriate and slightly accommodative after withdrawing the monetary stimulus to shallow the magnitude of economic contraction induced by the Covid-19 pandemic crisis. For those years (mid-2011 to 2019) prior to the pandemic, the OPR was between 3% and 3.25%.
Bank Negara continues to keep a wary stance against inflation as it assessed that the balance of risk to the inflation outlook is tilted to the upside, subjecting to any changes in domestic policy on subsidies and price controls, financial market developments as well as global commodity prices.
Of significance is core inflation that will remain at elevated levels amid firm demand conditions.
There’s no doubt that Bank Negara has a tough decision to make when raising interest rates to safeguard price stability as there are both pros and cons for doing so.
Households have grown accustomed to low interest rates. Those with high levels of debt relative to their incomes, particularly mortgage debt that are linked to floating-rate loans (about 50% of the total loan accounts in the household sector), will be affected.
Rising interest rates will discourage new borrowers from borrowing and spending while savers/depositors will benefit from higher interest income.
Bank Negara is also mandated to safeguard financial stability. Keeping interest rates low for a prolonged period induces financial imbalances by reducing risk aversion of banks and investors.
Low interest rates drive down the return on many investments, and prompted some investors to turn to riskier assets in search of better yield.
Overall, the normalisation of interest rate is not intended to cause a sharp pullback in economic growth; it is to ensure a sustainable economic growth that doesn’t generate price pressures.
Bank Negara needs to bite the bullet and hike policy rates gradually to keep inflation from rising unduly and higher inflation expectations to become entrenched.
Lee Heng Guie is Socio-Economic Research Centre executive director. The views expressed here are the writer’s own.
