Countdown to MPC Meeting

The consensus is leaning towards another 25bp OPR hike (excerpt):

Economists expect rate hike next week

PETALING JAYA: Although Malaysia’s year-on-year (yoy) export growth of 21.9% to RM52.3bil in May fell below market expectations, economists are still positive on an interest rate increase next week…

…Bank Negara raised its key rate by 25 basis points to 2.5% in May – a normalisation process after rate cuts during the global downturn.

AmResearch senior economist Manokaran Mottain told StarBizWeek that although the numbers showed slower-than-expected-growth, it was still at respectable rate…

…Thus, Manokaran said the interest rate hike next week would likely to go on.

“But after July 8, I think there will be a pause pending on the development then,” he said.

Standard Chartered Bank economist Alvin Liew was quoted by Reuters as saying despite the slower exports growth in April and May trade data, these two months of data still pointed to a decent second-quarter economic performance…

…“As our expectations for a healthy recovery in first half of this year remains intact, we reiterate our view that the central bank is likely to continue normalising interest rates further to suit current economic conditions.

“We expect Bank Negara to hike rates by another 25 basis points at its July 8 policy meeting and thereafter keep the overnight policy rate on hold at 2.75% for the rest of the year, which is the normal rate for the OPR in 2010, in our view,” he said.

Like any good economist, I’m in two minds (or two hands) on whether continued “normalisation” of interest rates is called for. With growth likely to slow and external demand likely to fall off, we’re still faced with a substantial output gap, i.e. there’s still unutilised capacity in the economy, which means there won’t be much pressure on consumer prices in the near term. The relative strength of the MYR also means less inflationary pressure from imported inflation.

So what’s the case for continuing to raise interest rates? BNM’s concerns will be centred, to their credit, on asset markets, which has not been a particular focus of central banks until this past financial crisis. But before getting into that, what other indicators would matter?

First, inflation is pretty tame, so raising interest rates effectively mean also a rise in real interest rates:

…which is what BNM is aiming for. By raising the cost of borrowing, BNM is hoping to limit a build up of leverage and consumption that would raise consumer and asset-price inflation. Consumption indicators are up this year, such as loans (log monthly changes):

…but not to any great extent. Housing loans are a fairly big chunk of the increase (defying the increases in interest rates: more on this later), but other loans for asset purchases aren’t too troubling (log monthly changes):

…and working capital loans are growing at least as fast.

Turning to the asset markets, the FBM-KLCI has almost fully recovered to its 2007-2008 peaks, and you could argue that at these levels, the stock market is overvalued:

…which is supported by the market’s historical PE-ratio:

Price has outrun earnings, and the market needs a period of consolidation (i.e. companies need to start registering profits, not prospective profits). But I’d note that the stock market was well into its current sideways trading phase before BNM started raising rates, so this isn’t an obvious immediate concern.

More solidly, house prices have started to pick up at the end of 2009 (log annual changes; 2000:100):

…but 3% per annum doesn’t exactly qualify us as an overheating property market. The only thing that stands out is prices of high-rises, which rose 8% in 4Q 2009, and apparently primarily in Penang. So what we’re looking at here is a potential limited market bubble confined to a small (but volatile) segment of property. Tightening monetary policy to keep a lid on this strikes me as using a hammer to swat a fly. The other aspect of this is that based on the limited data available to me, interest rates have a very limited impact on property sales – population and income growth matter much, much more.

In short, there doesn’t seem to be much of anything going on right now to justify a rapid increase in interest rates. What BNM is really doing is trying to peer through a half-obscured crystal ball and trying to head off potential asset price bubbles, but with the trade-off of slowing growth in the interest rate-sensitive parts of the economy despite an economic recovery that still isn’t fully settled.

I’ll leave this post with one further nugget – money velocity (read this post for fuller details) still hasn’t recovered to pre-crisis levels:

In fact, the rate of change in the velocity of monetary aggregates is still negative (log annual changes):

Juxtaposing this with money supply and economic growth suggests that far from being expansionary, monetary policy is in reality still too tight:

M3 adjusted for inflation and velocity is signalling a real interest rate level of nearly 10%, far above the approximately 1% difference between the OPR and CPI/Core inflation measures. So I don’t think an interest rate hike is fully justified right now.

On the other hand (you knew that was coming, right?) here’s an alternative viewpoint, from a highly respected economist who was one of the very few to foresee the financial crisis in the US:

Monetary Policy or Fiscal Policy

...Perhaps more worrisome is the view that the main problem is aggregate demand is too low. In response to ultra-low interest rates, the thinking goes, households will cut back on savings while firms will invest more, demand will revive, and the workers who have been laid off will be rehired.

But this recession is not a “usual” recession. It followed a period of ultra-low interest rates when interest sensitive segments of the economy got a tremendous boost. The United States had far too much productive capacity devoted to durable goods and houses, because consumers could obtain financing for them easily. With households recovering slowly from the overhang of debt resulting from the binge, and with lenders extremely risk averse, it is unrealistic to expect households to spend beyond their means again, and unwise to try to tempt them to do so...

...Put differently, the productive capacity of the economy has shrunk. Resources have to be reallocated into new sectors so that any recovery is robust, and not simply a resumption of the old unsustainable binge. The United States economy has to find new pathways for growth. And this will not necessarily be facilitated by ultra-low interest rates.

What many people forget is that interest rates are also a price, and shape not only the level of economic activity but also the allocation of resources and the relative wealth of buyers and sellers of financial savings. A sustained period of ultra-low interest rates will favor the segments of the economy that took us into the crisis – housing, durable goods like cars, and finance. And it will encourage households to borrow and spend rather than save. With policies focused on reviving the patterns of behavior that proved so costly the last time around, it is ironic that President Obama wants the rest of the world to change and spend more to displace the United States as spender of first resort, even while the United States is unwilling to make any changes itself.

Put differently, aggregate demand is indeed insufficient to restore the economy to old patterns of production. But that production was absorbed only through an unsustainable debt-fueled, asset-price-boom-supported consumer binge. And even if we think U.S. consumers have become excessively cautious (it is hard to see a savings rate of 5 percent as excessive caution, except in relation to the extravagant past), moving them back down the same path seems unwise.

More important, the United States also has a problem of distorted supply. Prices in the economy should reflect the past misallocation of resources and move resources away from areas like housing and finance. A lot of people have to be retrained for the jobs that will be created in the future, not left lamenting for the jobs they had in the past. A Fed that keeps real interest rates at a sustained negative level will stand in the way of the needed reallocation.

None of this is to say that the Fed should jack up interest rates quickly without adequate warning, or to extremely high levels. There are trade-offs here, between short-term growth and long-term misallocation of resources, between reducing risk aversion and inducing excessive risk taking, between reviving hard-hit sectors and encouraging repeated bad behavior. On balance though, if and when the jitters about Europe recede, it would be prudent for the Federal Reserve to start paving the way towards positive real interest rates.

Interesting, no?

April 2009 Monetary Policy Update

April's Monthly Statistical Bulletin released a couple of days back shows money supply growth still decelerating, except for M1 (log annual changes):



That actually worries me less than the fact that so is velocity (log annual changes):



Why be concerned over velocity? Because a fall in the velocity of money (the number of times money goes around within an economy) can amplify movements in the money supply. Falling velocity coupled with slower money growth makes monetary policy tighter than the money supply growth alone would indicate. Having said that, money supply growth is still supportive of economic growth right now:



Since adjusted M3 growth still exceeds the drop in GDP growth, we’re still looking at a loose monetary policy stance. Just be cautious when taking this chart at face value, because my methodology isn’t exactly rigorous here.

On the other hand interest rates, after the market absorbed the likely pace of government debt issuance after the tabling of the mini-budget, have settled down:



MGS spreads on the long end have continued to widen slightly but not by much, and current market data is showing a little pullback as well so I’m not overly worried about rising funding costs for the government just yet.

The banks are having a fine time though, with loan growth purring along and cost of funds very much in their favour. That part of the equation is a bit of a concern to me – the whole idea of loose monetary policy is to get credit flowing into the economy (which it is) and to lower borrowing costs (which is not). What should be cheaper funding for consumers and businesses is turning into a profit party for the banks, even bearing in mind potential losses from non-performing loans. NPLs in April have just registered the first uptick in over a year but it amounts to an increase of just RM150 million on a 6-month basis for the entire banking system, which is peanuts compared to the RM736.5 billion in outstanding loans.

In short, while BNM has cut bank funding costs to the lowest point I can remember, the margin between lending and funding is actually at the same level as it was when the economy was booming:



Never mind the increase in car financing costs – effectively the cost of every other loan is rising as well relative to what it could and should be. That makes a mockery of central bank policy, and I don’t see how this can be beneficial at all, unless it’s to boost the financial sector contribution to GDP at the expense of everyone else. Unfortunately, with the reforms under the Financial Sector Master Plan, there’s little that BNM can do about this, and we’ll just have to live with it.

Monetary Policy Update II

Since the interest rate front is showing little progress in loosening monetary policy, what can we glean from changes in monetary aggregates? Not a whole lot unfortunately. Here’s the situation up to March (log annual changes):



…and net of inflation:



Note that net M1 growth is essentially zero, while M3 growth is at just 3.6%. If you saw my post on Malaysia’s leading indicators, the forecast for GDP growth looks like it’ll hit negative 1% for 1Q 2009, which implies that money supply growth is still supportive of economic activity. This assessment ignores the possibility of the velocity of money (the rate at which money flows through the economy) falling however.

Back in March, I talked about the instability of money velocity and how it impacts monetary policy evaluation. Recall that the relationship between money and economic growth can be shown through the Fisher Identity:

Ln(ΔM) + Ln(ΔV) - Ln(ΔP) = Ln(ΔY)

Substituting the known numbers (including forecast rGDP) yields an expected velocity of -4.3%. My estimate of actual change in velocity in 1Q is about 2.0%, which means growth in M3 is higher than strictly required – thus we’re still looking at a loose monetary policy stance. This is with the proviso that both inflation and velocity are showing base effects – the levels for both have been dropping since the peak of the commodities boom in the middle of last year:



As a side note, I stumbled on this chart while preparing this post (monthly log changes in money velocity):



Money velocity has been considerably more volatile since abolishing the USD peg – in fact so have spreads and volatility of market interest rates. I’m speculating this has to do with portfolio flows, but certainly something for future investigation.

As I mentioned in the previous post, the monetary policy stance is unambiguously loose, but not to the degree I would like to see it. One way to support or disprove my opinion (and it is just an opinion), is to evaluate monetary policy based on some form of Taylor Rule which provides a consistent approach to interest rate policy setting. Does BNM follow a Taylor Rule? Given the shift to the OPR as the policy instrument, this is more than a possibility – again an area for future investigation.

Despite my misgivings regarding the cost of credit, bank lending growth is actually fairly solid (annual log changes in total loans):



…and based on plenty of resources:



Unfortunately, direction of lending is a bit of a mixed bag (log annual changes):








Loan growth to the financial sector at nearly 20% per annum doesn’t strike me as a terribly healthy development. I like this one though:



That’s right – 81.2% annual growth in March 2009. The runup appears to have started in October – no guesses as to why.

Evaluating the monetary policy stance: back of the envelope calculations

How do we judge whether monetary policy is tight or loose? The central bank has two general ways to impact the supply of money. First is through the price of money i.e. the interest rate. If r is higher than inflation, than the 'real' rate of interest is positive and is the rate at which economic agents base their decisions. The higher the real rate of interest is, the tighter monetary policy could be said to be. When the real price of money is high, the cost of borrowing for investment and consumption is high, and economic activity slows. The converse is true - monetary policy is loose when r is below inflation, and borrowing becomes cheap.

Incidentally, that's why deflation is a dangerous phenomenon - you can get a high real rate of interest even if the nominal r is zero.

The other way to judge the monetary policy stance is to examine the rate of increase in the money supply. Fast money supply growth accommodates faster economic growth but also signals higher future inflation. You can in theory slow down economic growth even with a low real interest rate, by restricting the supply of money. The relationship between money and the economy is described by the Quantity Theory of Money, which takes the form of the following accounting identity:

M x V = P x Y

Which states that money (M) multiplied by velocity (V: the number of times money circulates in the economy), is identical to real output (Y) multiplied by the price level (P). If we transform both sides to natural logs and take first derivatives, and move the price term to the left:

Ln(ΔM) + Ln(ΔV) - Ln(ΔP) = Ln(ΔY)

This states that the rate of increase in (M) less inflation should equal the growth rate of real output if we take velocity as a constant. When this identity doesn’t hold, one of the other variables will need change to bring the identity into balance again. Thus if (ΔM) is greater than (ΔY) + (ΔP), then we would expect inflation to increase if the economy is at full employment, or both output and inflation to rise when the economy has some slack - such as during a recession.

This is the current situation in Malaysia now (log changes in M3 less log changes in CPI, compared to log changes in interpolated, seasonally adjusted monthly rGDP, all relative to the same month in the previous year):



The charts show money supply growth was probably excessive in 2007, but got closer to neutral in 2008. Compare that with this comparison between the overnight interbank rate against CPI inflation:



(Correction:) The policy instruments appear to contradict each other in both 2007 (interest rates indicating tight money, money supply loose) and 2008 (interest rates very far below the rate of inflation, while money supply more neutral). One way to explain the discrepancy in the observable policy stance is if we go back to the original equation just now – what if velocity is NOT a constant? Then:

V = (Y x P)/M

which can be proxied by nominal GDP (real output multiplied by the price level) divided by money. One would expect velocity to (slightly) vary positively with economic activity – higher consumption and investment means money changes hands quicker. Conversely, when economic activity contracts, people and businesses become more cautious and cut spending, which reduces the circulation speed of money. Solving the equation for M3, we get:



We have a better than 10% variation in the velocity of M3 in 2008, although I'd be cautious in taking the level of velocity at face value due to the interpolation I've done on the GDP data. Nevertheless, looking at M3 adjusted for velocity and inflation relative to rGDP is instructive:



The interest rate and money supply variables are better matched in terms of their policy stance, though at this point in time monetary policy is far more expansionary than implied by the real interest rate. At this stage, I'd expect both velocity and inflation to continue dropping, which may cancel each other out as far as impacting output. This further implies that expansion of the monetary base would be more effective in boosting output, and would be non-inflationary given a reduction in velocity. It also implies that should the situation reverse, BNM has to react much more quickly in reining in monetary growth to head off a resumption in inflation.

Update:
Technical notes:

1. Real GDP is arrived at by deflating the value of nominal GDP with the GDP deflator, which is not equivalent to inflation as measured by the CPI. The main difference between the two price series is that the GDP deflator also takes into account export price inflation, which is not relevant in a domestic context except in terms of measuring output - by definition, exports are not consumed in the domestic economy.
2. The interpolation I did on GDP data is very rough and ready, but since I'm using it mainly to contrast the difference between two policy instruments, I hope everybody will give me a pass on that one.