Will the overnight policy rate be higher than before?

Did you KNOW Malaysia’s policy rate and statutory reserve requirement (SRR) ratio once trended in double-digits?

The current main interest rate framework, the overnight policy rate (OPR), never exceeds 3.5%.

Before 2004, the country’s interest rate framework was called the three-month intervention rate and reached 11% in February 1998, when the SRR was at 13.5%. The latter is only 2%.

Why are these figures important? For starters, people are generally nervous about the expected OPR hikes following aggressive tightening around the world, particularly in advanced economies.

A higher OPR will lead to higher borrowing costs and subsequently, a higher cost of living when wages cannot keep up with post-pandemic changes fast enough.

Second, the recent pace of OPR increases was the fastest in its history, with a cumulative 125 basis points (bps) over 14 months. When wages remain constant, every increase matters to borrowers with a fixed income stream.

Third, there are calls to use the OPR as a defensive tool against the weakening ringgit amid interest rate and bond yield differentials.

With the US Federal Reserve likely to hike again after the July 26 meeting, and with other major central banks keeping the door open to delivering more hikes in the near term, such a gap is widening.

Hence, prolonged pressure on the ringgit will continue. Some may even argue that Bank Negara should control foreign exchange volatility by mimicking the tightening approach of major central banks.

Many analysts assume that Malaysia’s terminal rate, or the neutral interest rate, is 3%. Previously, the OPR stood at 3% for a total of 170 months, but not consecutively, from November 2005 to December 2019.

OPR’s longest break at that rate was 38 months, from May 2011 to June 2014.

This does not mean that the terminal rate will always be at 3% because it depends on whether the economy can achieve price stability and sustainable economic growth. The constantly changing global economic landscape and crises influence the level of interest amid counter-cyclical financial measures.

For context, in the years before the Global Financial Crisis (GFC), the terminal rate was at 3.5% for 31 consecutive months from April 2006 to October 2008. Malaysia’s real gross domestic product (GDP) was good then amid a higher trade-to-GDP ratio.

It rested below 3% from the GFC to the Covid-19 crisis, during 64 months when the unemployment rate averaged around 3.25%.

In the post-pandemic until the next economic crisis, at any time, it can be argued that the OPR will be at 3% or less due to the tendency of interest rates to rest lower after a crisis in the middle of debt growth.

This phenomenon is not exclusive to Malaysia but also worldwide. But who knows? If Malaysia can sustain and push its average real growth rate above, say, between 5% to 6% in the current decade, the terminal rate could, in fact, be higher than 3%

Covid-19 has disrupted many things, including how economists measure and view the economy in the post-pandemic era. Instead of lower policy rates after the crisis, countries around the world are pushing rates higher and longer but, surprisingly, without the risk of stopping the economy.

OPR is likely to increase as growth is still commendable. For context, Bank Islam projects Malaysia’s economy to grow at 4.5% in 2023, 4.7% in 2024 and 5% in 2025.

The unemployment rate is trending lower, albeit sluggishly at 3.5% and this author believes the OPR could rise another 25 bps if Malaysia’s labor market continues to improve in the remaining months of the year amid the recovery of the tourism sector.

Having said that, since the unemployment rate is still trending higher than its long-term average of 3.25%, there is a high probability that the OPR will rest at 3% until the end of the year.

Furthermore, the government’s push to improve wages through policy intervention could push inflation higher despite disinflation from September 2022.

Malaysia’s average inflation since 1986 has been 2.49%, but it has been trending higher than its long-term average over the past twelve months.

With further implementation of the new minimum wage and, subsequently, the proposed introduction of a progressive wage model starting next year, inflation is likely to rise above its long-term average. Thus, a higher OPR may be required to meet Bank Negara’s mandate.

The real question is whether the OPR can be higher than its historical peak of 3.5% in the near term.

This author believes that such a scenario is unlikely due to the relatively small fiscal stimulus deployed by the Malaysian government during the pandemic compared to advanced economies.

It is quite clear that the high inflation phenomenon in advanced economies is a combo of demand and supply-side pressures.

Due to the fiscal measures caused by the pandemic, the household savings ratio rose to a historic high for the United States (17.5%), the United Kingdom (10.2%) and the eurozone (13.5%), according to the Organization for Economic Co-operation and Development. Co-operation and Development Data.

Coupled with robust post-pandemic labor market performance, supply chain constraints and high commodity prices, this is a perfect storm for high inflation in advanced economies; thus, high policy rates are needed to bring inflation back to the 2% target rate.

Interestingly, this author does not see a similar pattern in most of East Asia or Malaysia. Referring to Bank Negara data, the annual growth of saving deposits for individuals is shrinking from the post-Asian financial crisis average of 10.2% to 5.3% in the decade before the pandemic.

It was 4.23%, although the month-to-month trajectory was steep during the pandemic. Much of this excess savings began to fall sharply in May 2022. Depleting retirement savings exacerbated the moderating nature of growth in savings deposits.

Of course, other considerations may also influence OPR’s future trajectory. The arguments in this article have been greatly simplified to ease the understanding of a technical topic.

Based on these arguments alone, this author can safely conclude that the likelihood of Bank Negara replicating the trajectory of rate hikes in advanced economies is zero.

The pace of Bank Negara’s monetary policy conduct will continue to be “measured and gradual,” and future rate movements will only be so long as the central bank holds both, but flexible, mandated gospel.

Whether or not the OPR will breach its historical highs depends on the future performance of the Malaysian economy and to a lesser extent advanced economies, with or without ringgit defense.

Firdaos Rosli is the chief economist of Bank Islam (M) Bhd. The views expressed here are the writer’s own.

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