Never Reason From A Price Change: Inflation Edition

The quote comes from Scott Sumner, and I’m not using it in the original sense (identifying causality in a supply-demand equilibrium), but there’s a certain truth to it when applied to monetary policy.

There’s a lot of speculation in the market right now that Bank Negara will cut interest rates in the next two meetings of the MPC, largely because (1) political pressure and (2) the coming drop in inflation. I think (1) is nonsense (I see no evidence of it, nor have I heard anything), and (2) is mistaken.

This post is about point 2.

What we’re going to see over the next few months is inflation dropping sharply, as measured by the growth rate of the CPI – assuming oil prices stay the same (not a given), CPI inflation could drop to as low as 1%. The speculation is that, because “inflation” is low, that gives room for BNM to cut the OPR and support GDP growth this year.

My problem with this mindset is that, just as “inflation” was high across the first quarter of this year and much of last year, “inflation” for the rest of this year will be low due to the base effect – it’s a purely mechanical artifact from the year-on-year growth calculation of the CPI. For the same reason, I’m expecting to see the inflation average for 2017 to be abnormally high. Again, it’s going to be largely due to the base effect, not any substantial change in the path of the price level.

In the presence of structural breaks such as the introduction of GST, year-on-year growth calculations will give a higly distorted view of price level changes. In other words, even with an unchanged path of increase, changes in tax regimes – and we had a few last year, not just GST – will shift the price level up (or down), without changing the path of inflation.

On that basis, don’t expect a change in monetary policy just because CPI inflation is low.

Another reason to be wary of this rate cut speculation is that, as an open economy, inflation in Malaysia doesn’t really signal anything about demand or supply pressures in the economy. Changes in domestic economic activity can leak out, and changes in global economic activity can leak in. When the pace of economic activity is high, excess demand could manifest itself not in terms of price increases, but in terms of higher imports instead. Conversely, low inflation might not signal deficient domestic demand, as this could be due to supply side factors instead.

From a policy perspective, we need to be more holistic – the output gap, unemployment, and retained imports are probably as important indicators for monetary policy direction as inflation is, and none of those are currently definitively signaling a rate cut.

If you have to look at inflation, I’d concentrate more on DOS new core inflation measure and on month-on-month growth rates, as y-o-y CPI is being driven too much by structural breaks and gyrations in global oil prices. Unlike the CPI, Core CPI has not seen anything like the same variation, and once we get past the GST base effect in April, I don’t see it dropping much below 2.0%.