Author: Hafiz Noor Shams

Malaysian central bankers have become victims of a running joke lately: if you are divided between maintaining a low unemployment rate and containing inflation, pray and do nothing.

On Friday last week, Bank Negara made known its decision to maintain the Overnight Policy Rate at 3.5% even as the local real interest rate is negative.

The recently published monetary policy statement is too hilarious for me to read quietly. It reminds me of what US President Harry Truman once famously said: “Give me a one-handed economist… All my economists say, ‘On the one hand… on the other’.” For sure, Truman would not find a one-handed economist on Jalan Dato’ Onn either.

The statement opens with a pessimistic tone by making references to the wage-price spiral and persistent inflation. It is all doom and gloom but then Bank Negara vows to take the “appropriate monetary policy response” to “maintain medium-term price stability and ensure that the high inflation does not undermine the longer growth prospects of the Malaysian economy.”

After comforting the public that the bank is prepared to do whatever is necessary to fight inflation, the bank says “while both the risks to higher inflation and the risks to slower growth have increased, the immediate concern is to avoid a fundamental economic slowdown that would involve higher unemployment”.

The statement ends with “based on this assessment, the Monetary Policy Committee has decided to keep the Overnight Policy Rate unchanged at 3.50%.”

Smooth.

To be fair, however, the bank did indicate that projected slower economic growth is expected to keep inflation in check. The statement also seems to suggest, or at least I interpret it as such, that the inflation rate we are experiencing is likely only a one-time spike.

The fact that there are lags between wages and prices would discourage a wage-price spiral, further providing the case that this high rate of inflation is unsustainable. All those control mechanisms over prices, though lamentable, do a good job at delaying the catch-up game between wages and prices. In other words, it helps keep inflation tamer than what it could have been.

I think the possibility that this is a one-time hike in inflation is important in understanding why the bank did not increase the OPR last week.

Ben Benarke in a speech last year said: “”¦With inflation expectations well anchored, a one-time increase in energy prices should not lead to a permanent increase in inflation but only to a change in relative prices.”

This is probably what is happening at the moment, fuelling the rationale for Bank Negara to maintain the OPR.

But how confident are we that this is merely a one-off hike?

Well, the 7.7% inflation rate is mainly due to the June 5 hike in local retail fuel prices. It is fair to assume, especially with all the control regimes the state has put in place, that if there is another hike in inflation rate, it would probably be caused by another hike in retail fuel prices.

Within that context, world crude oil prices at the moment have taken a dive and the fall is nothing less dramatic. From close to US$150 per barrel, a record even in real price, it now hovers below US$125 per barrel.

Now, the jury may still be out but the demand curve has to contract sooner or later as market participants adapt to a new reality which calls for less reliance on fossil fuel. Just as how the 1970s taught us about our amazing versatility in solving crises, there is little reason for us to embrace the Malthusian logic now and throw in the towel.

If indeed the demand curve has shifted, then Bank Negara has all the more reason to expect that the current high rate of inflation is temporary in nature despite the expressed concern about persistent inflation. And the bank did indicate how temporary is temporary in the statement: by mid-2009, we should be able to party on and laugh all this off.

Perhaps more importantly, the government has little reason to increase prices at the pump if prices stabilize at the current level. With current global crude oil prices being so favorable to the state’s coffers, there has been talk within the Barisan Nasional government about reducing local retail fuel prices.

Apart from politically undercutting the Pakatan Rakyat, reduction of prices has the potential to bring down the inflation rate without the need to raise interest rate, thus providing the bank some room to do something about the unemployment rate.

But damn, negative real interest rate!

A version of this article was first published in The Malaysian Insider.

It is fashionable these days to reminisce about the days when a penny could buy a fancy candy. I have no recollection of such times and I strongly suspect they are but a myth, especially when the not so old retell a story that should only be in the vague memory of the dead. I cannot help but roll my eyes whenever a conversation which touches on once-upon-a-time-a-penny-could-buy-a-fancy-candy slowly turns into a lament against inflation. Talk of inflation in the public sphere almost always takes a pessimistic tone but the inflation that we suffer is really misunderstood possibly due the lag that exists while wages and prices chase each other.

It is typical for many modern economies to see a rise in the general level of prices over time since the 1970s. There were some cases of deflation but we mostly live in an inflationary world. In Malaysia where inflation has been around for the longest time, many in the public complain about how inflation reduces  individual purchasing power.

What many do not realize is that the general rise of price levels is as much as about the general rise of wage levels. As both factors try to catch up with each other, inflation really matters little in the long run.

Due to this, it really does not matter if a penny could buy a fancy candy in a time long forgotten but not now. We can still afford to consume that candy anyway. In fact, it is very likely that with all the real improvements we have seen in our standards of living, we can afford to buy more candies than we ever could when candy was priced at only a penny.

But however many candies we can afford nowadays, what makes inflation hurt in the short run is the lag between price increases and upward adjustments to wages. This lag is usually associated with a phenomenon known as price stickiness: individuals and entities take time to change prices. Sometimes, the act of changing prices itself incurs cost and further forces prices and wages to be inflexible.

For instance, one transportation company that I am familiar with took two weeks to revise its prices upwards after the June 5 price hike. Why two weeks? Internal approvals, negotiations with customers, costing modeling, simulation, etc. The company was adversely affected by the lag but after that, higher fuel expenditure is met with higher service prices while the service level remains the same.

This is the actual meaning of inflation. It is not about erosion of a person’s real purchasing power per se but rather, it is about erosion of purchasing power of a unit of a currency.

It is important to note that the phenomenon does not exclusively happen to businesses. Individuals too undergo the same path. In the long run, the wages and prices tend to approximately equalize each other. And just like what happened to the transportation company, it is the lag of wages vis-à-vis prices that hurts individuals. Inflation adversely affect real wages by depressing temporarily, until nominal wages catch up with higher level of nominal prices.

So, how do we reduce the pain?

There are a number of things but my favorite revolves around management of expectation.

The idea is that if individuals or entities successfully anticipate a rise in prices, wages would quickly match the other. That would come close to eliminating any lag that might exist otherwise.

To do that, wages have to be defined in real terms, i.e. having wages adjusted to inflation. In employment contracts especially, an escalator clause is a must if preservation of real wages is a goal. At the moment, too many people out there have their wages defined in nominal terms, i.e. unadjusted to inflation. For businesses, well, they could just increase their prices and pay their own wages.

If we manage to considerably eliminate this lag, then perhaps it would finally dawn on many that inflation really does not matter as much as many make it out to. More importantly, the story of a penny candy would finally be buried and forgotten.

A version of this article was first published in The Malaysian Insider.