Wednesday, November 28, 2012

BNM Watch: Is Zeti A Closet Market Monetarist?

Perhaps not operationally, but philosophically it sure sounds like it (excerpt):

Zeti: Malaysia wants steady growth, it is necessary to sustain and improve economy

KUALA LUMPUR: Malaysia wants to have steady growth that will allow it to sustain and improve its economic position, Bank Negara governor Tan Sri Dr Zeti Akhtar Aziz said.

She said the country did not want high growth in one year and a very low one the following year.

Zeti said this on the sideline of the 2nd International Shariah Research Academy for Islamic Finance (ISRA) Colloquium 2012 here. She was asked whether the country could sustain strong growth next year.

She said the domestic economy was still strong and resilient…

…Zeti added that Malaysia was in a good economic position from its initiatives and reforms over the last decade after the Asian financial crisis. Nevertheless, she said it would have to do much more to prepare for future disruptions that might be experienced by international financial markets and possible economic slowdown in different economies of the world.

Central bankers – and economists – sometimes (ok, often) speak in code, and some of the ramifications might pass over the head of the average man on the street.

To summarise 40 years of monetary policy evolution, central banks have shifted from effectively targeting money (either through the Bretton Woods system of fixed exchange rates, and the soft peg era that followed), to targeting inflation instead.

The rationale for this is quite simple – a low, stable rate of inflation empirically offers the best chance for stable full employment growth. The current orthodoxy is to use short term interbank rates to regulate the demand and supply of credit in the banking system, thus influencing aggregate demand and thus economic growth.

This approach has generally worked just fine, and in fact helped deliver what is sometimes termed the Great Moderation, an era of relatively low inflation and decent economic growth, sharply contrasting against the stagflation (high inflation, low real growth) of the 1970s.

The problem is that using short term interest rates to target inflation as an intermediate target for full employment growth (try saying that three times very fast), is getting much more complicated.

This is even after leaving aside the fact that the interest rate pass-through in developing economies from short term rates to long term rates – which are the ones that actually matter for credit supply and demand –  is universally poor due to underdeveloped financial markets [for the experts: I’m leaving out of this narrative all the other transmission channels such as portfolio and wealth effects, as well as exchange rates]. When policy rates are raised or lowered, countries with less developed financial systems will see less of an impact on actual consumer and business lending rates.

A couple of other problems come to mind – the impact of supply shocks on inflation, and the evolving nature of credit creation. China’s emergence as the world’s “factory” over the past decade has had a deflationary effect on prices of manufactured goods, while having an inflationary effect on food and prices of raw commodities such as oil.

So on the one hand, we have an artificially depressed inflation rate for physical goods that people use, and on the other hand we have much higher inflation in the more “volatile” consumables components of inflation. Yet most central banks strip out the volatile components when looking at inflation, the so-called core rate, as that offers a more stable picture of inflation.

But the main point here is that domestic inflation is being influenced by non-domestic factors, and offers less of a guide to the appropriate domestic monetary policy setting, with the corresponding risk of overreacting to movements in core or headline inflation rates and expectations.

The second problem is the evolving nature of credit – banks are increasingly being side-lined as the main intermediaries between savers/investors and borrowers. If you look at bank balance sheets over time, there’s been a gradual reduction in loans and advances and a corresponding increase in the holdings of securities relative to balance sheet size. It’s all still lending, except through different markets.

The key point here is that credit intermediation is no longer the main province of banks, but now also increasingly via securities firms. Banks are no longer the sole channel for capital funds, but now just one of many categories of investors. Policy rate frameworks designed around interbank rates are therefore increasingly less influential in determining credit conditions.

And then there’s shadow banking, with actual credit creation and destruction going on outside the formal banking system. But let’s not go there, or this post will never finish.

The upshot of all this is that inflation targeting has a number of unresolved problems. So if getting through to the intermediate target is problematical, why not skip to the end and target growth directly? And that’s where market monetarism comes in. The biggest advantage, even getting past the discussion above, is that monetary policy would be much more responsive to, and effective against, drops and spikes in output such as occurred during the Great Recession.

To get back to the beginning of this post, you can now see the significance of what the Governor has just said yesterday. To be honest, this isn’t really new – Tan Sri Zeti is, to put it mildly, less than enthusiastic about inflation targeting and not shy about saying so.

Bank Negara has over the years been (in)famously pragmatic in its approach to monetary policy, and don’t appear to follow any fixed policy rule at all, though they’ve conformed to the orthodoxy in terms of institutional arrangements (e.g. independence via the Central Banking Act, use of the interbank rate as the primary policy instrument).

Contrast that with the European Central Bank, who put inflation above everything else, including growth and jobs. To my mind, that is confusing the means to an end, with the end itself.

If in fact BNM is targeting growth directly – and it’ll be a growth range, given the lack of a domestic GDP futures market – that would put a very different spin on their past and future policy moves.


  1. The Horror!

    Are you suggesting that the domestic monetary policy transmission channel is broken? (It is especially sacrilegious to think that, given our employers :P)

    /end sarcasm


    Wouldn't it be easier to look through the lens of a cynical person (macroeconomist, perhaps) and say that the roles of the Central Bank and the Government in Malaysia are reversed?

    BNM being more longer-term growth-oriented; the Government being more short-termist and more interested in controlling immediate inflationary expectations.

    On another note, I always kinda pegged Zeti as a market monetarist anyway. The MPC statements are more focused on growth rather than the more abstract concept of money supply. I think in this day and age, practicality of policies trumps its theoretical underpinnings (and yes, somebody had better tell that to the ECB).

    1. I think I actually did a couple of posts on the transmission mechanism - interest rate pass-through has improved since the removal of the USD peg, but its still pretty poor relative to advanced economies. There's still an impact on output and jobs, which suggests that monetary policy is operating through more than just the credit channel.

      I have to agree a bit about the fiscal/monetary divide. There's certainly quite a bit of overlap in what they're doing.