CENTRAL banks all over the world have been hiking interest rates to keep up with the inflation.

Malaysia has seen three overnight policy rate (OPR) hikes, the most recent by 25 basis points to 2.5% on September 8.

Bank Negara Malaysia raised the OPR to 2.25% from 2% in July, after hiking it from 1.75% in May.

Malaysia’s headline inflation rose for four consecutive months, reaching 4.4% in July, with food inflation hitting a record high of 6.9%.

Economists expect the central bank to raise the OPR two more times to reduce the inflation rate to the pre-pandemic level of 3% by the first half of 2023.

The Malaysian Insight spoke to economist Sunway University Business School’s economics professor Dr Yeah Kim Leng, Dr Yeah Kim Leng, who explained the theory of interest rate hikes to curb inflation. 
 
Q: Why is BNM raising interest rates? 

YEAH: The key reason is monetary policy is done independently, based on domestic conditions, price stability and other considerations affecting growth

Malaysia and other countries are now facing rising inflationary pressure. The key reason here (raising the interest rate) is you want to control inflation from rising too rapidly.

Inflation worldwide has been skyrocketing due to rising prices of goods and services due to the Covid-19 pandemic as well as unexpected demand and shock caused by supply chain disruption

And now we have the Russia-Ukraine war and the sanctions levelled against Russia (also driving inflation up). 

The slowdown in China with its intermittent lockdowns also means that the supply chain is affected. 

They produce a sizeable chunk of global trade; as a result, these shortages have resulted in rising price pressures.

How does raising the interest rate bring down inflation?

Higher interest rates are meant to ensure that we don’t face inflation expectations. Inflation expectations are simply the rate at which people—consumers, businesses, investors—expect prices to rise in the future.

Rising inflation expectations will lead to businesses increasing their price.

The objective is to ensure that inflation expectations are not unanchored so that people don’t lose confidence that the economy is stable.

But there is a fine line between raising interest rates to curb inflation and over-tightening that will lead to adverse consequences.   

How does it affect the public?

Reduced demand means businesses will not be able to set higher prices as they may not be able to achieve sales targets.

That’s why we want to curb demand, so that prices are not raised indiscriminately.

What are the risks of higher interest rates?

To achieve the optimal rate in terms of interest rates, Malaysia will have to look at the current financial conditions.

This means determining whether the rates are too high for people to take out loans. 

As long as the rates are not too high until it is unaffordable, where people won’t be able to pay or service loans and you see a sharp cut back in borrowing to expand capacity it is still all right.

That is a risk faced by the US, where the Federal Reserve has raised interest rates to to a 15-year high as it fights to rein in soaring prices.

If the rates are raised too high, from accommodativeness it becomes over tightening that deter consumers from spending and borrowing because of the high cost and slowing demand. 

This is where the fine line is. In the case of Malaysia, if we look back at pre-pandemic, the rates hovered at 3.25% and 3.5%.

It is still accommodative and reasonably low for consumers to borrow and spend while also allowing investors to take loans to expand and invest.

When Malaysia raised its interest rates, it slowed down the depreciation of the ringgit as it narrowed the gap between the local currency and the dollar.

Our foreign currency debt is 2.5% while 95% of our debt is denominated in ringgit, so there is no risk of defaulting. – September 30, 2022.