Is Raising Interest Rate An Effective Tool To Fight Inflation?

Bank Negara Malaysia has raised the interest rate again, the third time this year, to counter inflation

First of all, please be reminded that economics, where we are discussing inflation here, is not a pure science but a social science subject. In pure science you can predict and be certain of the outcome. For example, two molecules of hydrogen and one molecule of oxygen make H2O or water. That’s pure science.

In form 1 science, we learnt that when we heat up zinc in hydrochloric acid, it will produce hydrogen and when we put a small fire at the furnace to burn the outgoing hydrogen, it will produce a pop sound. You can repeat the process 100 times and the results will be the same. This is pure science.

In social science, you are dealing with human beings. You can slap ten guys and the response from each of them might not be the same. You can even slap one guy a few times and the response might not be the same each time.

Theory

Economic theories and applications are often made based on two assumptions. First, economists assume that people are rational. Secondly, it is based on a term called “ceteris paribus”, which means on assumption that all other factors remain the same.

In reality we know that nothing remains the same and people are not rational, at least in the way they spend. We know that the cheapest places to buy things are at hypermarkets and the most expensive place to buy things are from 24-hour convenient stores and petrol kiosks. Yet, not everyone goes to the hypermarket to get their things and still a lot of people go to convenient stores and petrol kiosks for their daily needs.

How do you explain people with a salary of RM 3,000.00 a month who spends half of that to pay for car instalment? So do you think an increase in interest rates, which in turn will increase the expected monthly instalment for new car loans will slow car sales?

How do you explain a person with a monthly income of RM 2,000.00, yet buys a RM300 T-Shirt?

No wonder economists always screw up in making policies.

Inflation

Now, let us look at the question above. Is raising interest rate effective in fighting inflation? Well, sometimes it does and sometimes it doesn’t, depending on the cause of inflation.

At least 45 countries around the world have raised their respective interest rates and I can’t name one that has been successful so far and that includes USA, United Kingdom and a few European countries. Today, the European Central Bank is going to raise its interest rate, first time in 11 years and this time not only to curb inflation, but to strengthen Eurodollar that has depreciated sharply since economic sanction was imposed on Russia.  In my opinion, they will fail yet again.

Why? We go back to the two assumptions that economists like to use when making predictions. People are rational and “ceteris paribus”. 

We know that the reason Europe and USA were hit with inflation was due to the sanctions they impose on Russia. As a result, Russia was not able to supply oil & gas to the Europeans at a normal capacity. Since Europe depends about 40% of their supply from Russia, such situation leads to energy crisis in Europe. That leads to inflation.

Traders on the floor of the NYSE, April 14, 2022.
Source: NYSE

Do you think the European decision makers are rational in imposing the sanctions in the first place? Obviously not. Now the Russians are indirectly telling the European countries not to supply weapons and ammunitions to Ukraine or they will face the consequences of their gas supply being cut off completely.

How did the decision makers in Europe response to this? The German foreign minister said that “we are not going to budge to Russia’s demand” and suggest energy rationing instead, knowing very well that without Russian gas, not only will their citizens be frozen to death this coming winter, but their industries will be badly crippled. There are suggestions of going back to burning coal to power up their electricity plant, but that goes against their own policy of preserving the environment that they themselves have been championing.

The most rational thing to do is to stop supplying weapons and ammunition to Ukraine. Even today, in the 21st century, people and decision makers are not rational, how come economists who wrote those textbooks more than 100 years ago think people were rational then? 

Now, we look at our own backyard, Malaysia. As expected, BNM has raised the interest rate again, the third time this year to counter inflation. From the textbook theory, when interest rate is high, it means savings rate will be high. So, people are expected to save and not spend. That is true if the savings rate is higher than the inflation rate. If you get 2.5% return from saving one year from now and have to pay extra 5% for goods during the same period due to inflation, what will you do? Save or buy goods?

Secondly, from the textbook theory, when interest rate is high that will make it difficult for the industries to borrow and will then lead to a slower production of goods and eventually slower spending. Well, that theory might work 30 to 50 years ago when credit is scarce. Now, credit is in abundance. High interest rate or not, banks need to survive and will continue to offer loans, and companies need to survive and will continue to take up loans that are widely available.

What about the higher financing cost? That will be significant if the raise was from 4% to 7%. But an interest rate hike from 2% to 2.5% will have almost no impact on corporate future financing demand. Finance people who prepare business financial projection for projects to source for financing understand this very well.

For example, the current lending rate is 4%. Do you think any finance manager will use 4% as their input in their project cash-flow projection even if BNM is not raising interest rate? No. An experience finance manager will always put a buffer of at least 2% higher than existing interest rate in their financial projection model.  So, if that is so, do you think an increase of 0.5% or even 1% in borrowing cost will stop these companies from borrowing?

What about huge companies with huge projects with existing borrowings? The answer is since the early nineties, Malaysian companies engaged in large long term projects have turned to Private Debt Securities with fixed rate mechanism from capital market instead of floating rates term loans from commercial banks to finance their business. So whatever happens to interest rate will not affect them with long term fixed borrowing cost.

So, who will suffer? The SME’s and personal sector of course. Those SME’s with existing term loans as well as individuals with housing loan. 

For SME’s, its quite simple for them, they will pass back the cost to consumers. For consumers, sometimes they can pass back the cost to other consumers. How? I give you one example. A restaurant operator bought a RM1,000,000 house 2 years ago with an installment of RM 7,000 a month. Now that the monthly installment has increased to RM8,000 per month for example, what do you think the restaurant operator will do? Increase the price on his menu list of course!

So do you think raising interest rate will be able to counter inflation? The answer is obvious. But the next question is, if 45 countries failed to solve inflation problem through monetary policies why did our country’s Finance Minister adopted the same policy?

I have no answer for that, but my guess is he has to do something worth his salt and in doing so, aping other countries especially the west and following textbook is the safest approach because even if you are wrong, you can blame those theories isn’t it?

About the writer: Zam Yahaya was a Banking and Capital Market professional by training and a graduate in Accounting, Business & Islamic Finance and is a columnist with NMH. The points expressed in this article are that of the writer and do not necessarily represent the stand of NMH.

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