Tuesday, February 2, 2010

"Normal" Interest Rates?

My posts for the next couple of months might be briefer than usual - work getting in the way (plus it's Super Bowl week!)

Madam Governor's comments here, and research houses reactions here.

What's "normal"? It's difficult to say, since the use of the Official Policy Rate (OPR) as the policy instrument is relatively new in historic terms. In the 1980s, BNM experimented with money base targeting (as was the fashion at the time). When that failed, it became a combination of exchange rate and interest rate targeting to manage changes in the price level and output. The reason for this was that Malaysian interest rates were not really market determined until the mid-1990s, although the exchange rate target was retained until the 1997 crisis. After that of course, we had the peg with the USD, which allowed for a transition to pure interest rate targeting, which is what we have now.

So really in examining BNM's history with interest rate targets, we're really looking at the last ten years, and very specifically the last five i.e. since the Ringgit was floated in July 2005. That's not a whole lot of history to look at in terms of determining what BNM considers "normal" as we're not even through a single business cycle during that time span. Looking at the short term interbank rates (which is what the OPR is designed to influence) isn't very illuminating:

The last time the OPR was raised, it took nearly a year to move up 1%, so the expectations of a gradual 50bp-75bp move up this year looks about right, which would take the OPR to 2.75%. Whether BNM will go the whole hog and match the 3.50% last seen in 2006-2008 is a another matter, and would depend on the path of the economy.

My guess is that economic activity will be much stronger than expected this year, and the first 25bp hike may very well come in the next Monetary Policy Meeting this March, as the results from 4Q2009 GDP will already in the books by the end of this month, and there will be two months worth of industrial output and trade available to gauge economic strength this year. Mind you, Chinese New Year will put a dent in February's output, so that may be a consideration as well.

A more satisfyingly statistical approach would be to try and determine if BNM is following some form of Taylor Rule; but as I said earlier, we don't have a lot of data to work from (10 years - about 40 quarters; with two different sets of exchange rate policies to factor in; and one tightening cycle and one loosening cycle; is definitely not enough).

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