Thursday, March 10, 2011

MPC Preview

Not many of my peers are expecting an increase in the Official Policy Rate (OPR) coming from tomorrow’s Monetary Policy Committee meeting at Bank Negara, and frankly neither am I:

Economists expect Bank Negara to hold key interest rate steady

PETALING JAYA: With the slower pace of economic growth this year compared with 2010, economists do not anticipate any interest rate hike in Bank Negara's monetary policy committee meeting on Friday.

However, they believe that there is a 50:50 chance that there could be a 1% hike in the statutory reserve requirement (SRR).

MIDF Research chief economist Anthony Dass said Bank Negara was likely to hold the overnight policy rate (OPR) at 2.75% for the time being, deeming it too early to be raised.

“We think it's too early to raise interest rates. However, Bank Negara may look at other administrative measures to maintain inflation, such as raising the SRR,” he told StarBiz yesterday. “There is a 50:50 chance of that going up, perhaps by 1% (to 2%).”

But I think on balance the odds are rising that there will be a 25bp hike at the next meeting or two – I consider an increase in the SRR as a given.

The key thing to look at here isn’t inflation – as pointed out this is largely coming from rising costs, not higher demand. In theory, there shouldn’t be a BNM policy response to supply-side price shocks, since there’s no policy traction on the causes of these shocks (civil war in Libya, weather patterns and structural changes for food commodities).

But Malaysia’s case is slightly different – we’re both a consumer and a producer of commodities. Higher commodity prices might push up inflation, but it also causes aggregate nominal incomes to rise from better terms of trade, even if those incomes aren’t distributed evenly (i.e. commodity companies and their employees benefit relative to everyone else).

So there’s also an upside risk to financial sector liquidity as higher trade receipts are repatriated back into the domestic financial system. And this is something BNM will have to respond to, even if it means risking economic growth. Take away the crisis months from July 2008 to June 2009, and monthly loan growth is averaging around 1% since 2007, or about double the growth rate in the half decade previous to that. In other words, we’ve got more than enough money sloshing around the system already, with more expected to come in in the months to come.

So something fundamental has changed, or to be more precise, the structural relationship between interest rates and economic activity has changed. On that basis, for any given level of economic activity, we’re probably looking at a fundamentally higher rate of interest that the economy can support without the level of output decreasing (for the technical types out there, the Phillips curve might have permanently shifted up). Central to my view here is the growth acceleration recorded in the last quarter of 2010, and January’s outsized increases in the money supply and loan growth.

Which means that the MPC might now be lagging changes in the economy, rather than ahead of it like they were in late 2009. The language of tomorrow’s press release will make interesting reading.

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