THE threat of a recession looms large among policymakers when revising interest rates. The United States'experience in managing inflation offers a basis for this fear.
Its recession between 1981 and 1982 occurred when Paul Volcker, chairman of the US Federal Reserve between 1979 and 1987, forcefully increased interest rates up to 16.9 per cent.
These rates were to subdue mounting inflation that had peaked at 12.8 per cent by the end of 1980.
Today, the US is similarly aggressively jacking up the interest rate (the Fed raised it last month by 0.75 per cent) to counter inflation of around 9.0 per cent. More increases are anticipated. And already an economic slowdown is apparent.
Against this backdrop and a rosier Malaysian economic growth of five per cent, Bank Negara Malaysia (BNM) raised the benchmark interest rate to 2.25 per cent last week.
The latest increase comes on the heels of a similar rise in May. BNM is confident that economic vigour will mitigate any deleterious impact. There is some justification for this hope. At close to three per cent, our inflation rate is nowhere like those of the West.
And as economic recovery gains in momentum, more rate increases can be expected. This portends the death of ultra-low interest rates, which had served to bolster the economy during the pandemic.
We can gather four implications of the recent interest-rate hikes for the economy.
FIRST, they would check the 7.0 per cent erosion in the value of the ringgit against the US dollar over the past year. Foreign-capital outflows in search of better returns and safer havens in the West are among the reasons for such a fall.
SECOND, while it indirectly makes our exports more competitive, the ringgit depreciation also results in pricier imports. About two-thirds of Malaysia's raw-material needs are imported. Imported inflation can put pressure on domestic price levels.
BNM will be challenged again to increase interest rates if inflation figures continue to disappoint and cause the ringgit to depreciate further. Such was the case with the Russian rouble.
The rouble had collapsed following the imposition of sanctions over Russia's invasion of Ukraine. Inflation rocketed to 12 per cent. The Russian central bank raised interest rates to reduce demand. The rate increases have since stabilised the rouble and lowered inflation.
THIRD, depending on the extent, interest rate increases have a tendency to reduce business investments. They could cause the weakest firms to contract or even go bust, thereby constricting supplies of consumer goods.
Consumer credit, too, will be pricier. That may reduce consumption. Coupled with the excess-supply capacity in the
economy, the increased interest rates should control inflation and steady the cost of living.
FOURTH, higher interest rates also raise the cost of financing loans and mortgages obtained on variable-interest terms. The bulk of the lower segment of the population relies on such borrowings.
Servicing those loans might now prove more difficult. BNM estimates that it will annually cost about RM1,000 more to service a loan of RM300,000. The envisaged economic growth with its attendant wage and job increases should compensate for this additional burden.
BNM's fundamental purpose is to maintain price stability. Its anti-inflation credentials thus far are intact.
As the economic upturn gains traction, BNM need not worry about each ringgit depreciation and every inflationary spike.
Thailand's central bank, for example, has done little to curtail swelling inflation lest it derails the nation's nascent economic recovery.
However, if inflation expectations escalate, and inflation becomes more sensitive to a weaker ringgit, BNM will be forced to act.
With the current rate well below the pre-pandemic rate of three per cent, there is ample room to increase interest rates further. It is not easy to slay inflation.
With the interest rate hike, BNM could stay ahead of the inflation curve.
The writer is vice-chancellor of AIMST University