Fatal Flaws Inflation Interest Rates And The Ringgit

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There is an intricate, convoluted, but eventually logical relationship between inflation, interest rates and the exchange rate which if misunderstood or if adherence to a particular school of thought is too strict can result in some fatal flaws in economic decision-making.
When prominent economist Milton Friedman said “inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output”, he provided a tool for fighting inflation - controlling money supply.
In other words, he was saying that inflation was caused by too much money chasing too few goods. His prescription was to raise the cost of money, in other words increase interest rates by controlling money supply. Those advocating these views were called monetarists.
This has been used by central banks across the world, particularly the US Federal Reserve to fight inflation. But that does not mean that it is the only way to control inflation - the circumstances have to be right.
Friedman’s thoughts displaced those of the arguably more famous economist, John Maynard Keynes, whose thinking dominated economics until the 1970s when Friedman’s monetarism gradually began to dominate.
Keynesians believed in government intervention at appropriate times to keep the economy on an even keel and to stimulate demand when there are signs that the economy is slacking off. In other words, the government should spend when the economy is weak.
They had their day when the US government at the time of the world financial crisis in 2007-8 injected huge amounts of money to save the economy from collapse. This was counter to the prescription of the International Monetary Fund during the 1997-98 Asian financial crisis for tighter money which needlessly prolonged the crisis.
Keynes said, “By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.
“If, however, a government refrains from regulation and allows matters to take their course, essential commodities soon attain a level of price out of the reach of all but the rich, the worthlessness of the money becomes apparent, and the fraud upon the public can be concealed no longer.”
The problem is economic policymakers often think in silos. They are either monetarists who think in terms of controlling money supply to solve problems or Keynesians who favour government intervention from time to time to ease it in the right direction.
Active intervention
A lot of my own economic education comes from observing policy decisions of our own finance ministry and the central bank, Bank Negara Malaysia, over the years. Their reports are often a fount of great wisdom and temperance when it comes to broad policy-making.
It is to their credit that Malaysia’s inflation problem has been largely well-controlled over the years, with active intervention by the government to keep prices low at the right times. More recently, this ability to do so has come under pressure by political meddling.
I attribute their competence in terms of inflation management to their pragmatic management of policies, with no one belonging exclusively to either the monetarist or Keynesian school of thought. They did what was pragmatic and what is likely to work.
For instance, does tightening monetary policy work in every instance of inflation? No, it does not. Friedman’s solution only works if inflation is caused by excessive demand in the first place - too much money chasing too few goods. In that case, you temper demand by increasing interest rates to fight what economists call “demand pull” inflation.
But what if inflation is simply caused by an increase in the cost of inputs such as the price of oil or wheat or milk, or all of them together. In a globalised economy no single country - not even the US - can control these prices by control of demand.
So when you choke off money to fight the problem of rising costs or “cost-push” inflation, you may be exacerbating an already bad situation, sinking the economy into recession prematurely. You need interventions to fight these. There may be a need to free supply bottlenecks to see if profiteering is happening and to insulate the poor by direct or indirect subsidies.
This part of governing cannot be ignored and is a vital part of the efforts to keep inflation down without actually killing the economy and needlessly burdening the people in the process. The US, spooked by the highest inflation rates in 40 years, faces the threat of putting the brakes on economic recovery ahead of time.
But can it mean that even as the US is increasing interest rates to control its inflation running at over 8% that we can keep our interest rates down? Not likely because our interest rates, although higher than in the US, have also been historically low.
Bank Negara’s overnight policy rate is currently 2.25% compared to the Fed’s 1.5-1.75% but the Fed is expected to increase rates further this month. Our inflation rate is low - still around 2% compared to the US’ over 8%, so we have some leeway.
Also, as interest rate differentials between Malaysia and the US decrease, Malaysia may become less attractive as a destination for funds. The fund outflows can therefore cause currency weakness of the ringgit in the short term, and accounts for the general strength of the US dollar now against most other currencies. And a lower exchange rate causes inflation too.
Best weapon
Malaysia needs to recognise these dynamics and be a bit more relaxed about tightening monetary policy now as inflation is still low. But it needs to look at the increasing food prices and keep some subsidies in place to moderate the impact of rising oil and food prices from affecting the broad economy.
In the past, Malaysia stuck to no particular school for fighting inflation but instead looked to another commodity - often scarce at the best of times - common sense. This meant using the right tool for the right effect. That’s the best weapon in the fight against inflation. But sometimes you can’t fight it, when you just have to roll with the punches. Knowing when is important too.
PM Ismail Sabri Yaakob’s strident call for a jihad against inflation is the wrong one to make - it implies that inflation is a deliberate action initiated by others to derail our economic progress, which it is not. Simply energising the people will help, he would have us believe. But it won’t.
What it requires is highly nuanced economic policy-making which takes a combined stance - a judicious eye on subsidies to keep prices down, the need to smoothen the exchange rate movements as US interest rates rise faster than domestic rates, to take into account short-term fund flows as interest rate differentials narrow, and to take small measured steps to higher interest rates, amongst others.
The last needs to be carefully monitored to ensure it does not derail the nascent economic recovery post the pandemic effects.
Politicians, including the PM, can play their part by honestly and effectively dealing with economic problems using the remaining strengths of the civil service and Bank Negara instead of using every economic threat to make xenophobic statements which help no one, least of all, us.
That will help improve overall international confidence in the economy and our ability to manage it and bring some strength to the currency where a poor perception of the country is no doubt one of the contributions to a weakening ringgit.
No, Friedman, inflation is not just a monetary phenomenon - thankfully our policymakers knew that a long time ago - Mkini
P GUNASEGARAM, a former editor at online and print news publications, and head of equity research, is an independent writer and analyst.
The views expressed here are those of the author/contributor and do not necessarily represent the views of MMKtT.

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