Friday, July 25, 2008

High Prices, Interest Rate & Growth

This is unfortunately a long one.

High Prices

The global economic issue today is the high prices for real goods.

If we know what causes the high prices, then we know how to respond effectively; if not, we may end up doing a lot of things but with no effect on the high prices.

I have introduced the term "real goods" to distinguish it from "fiat money" pieces of paper issued by the central bank that has a value higher than the cost of printing the paper and have it authenticated.

Now, when we think of high prices, are we thinking in terms of "nominal" prices or "real" prices. At first brush, we are all looking at "nominal" prices, which are prices expressed in fiat money terms. E.g., the price of oil has rose from 25 US dollars per barrel in 2003 and 60 in early 2007 to 140 US dollars. The price of rice has tripled since the beginning of the year to 735 US dollars per metric ton. The price of wheat has gone up 180% from a year ago, and soya beans by 82%.

If we think in terms of "real" prices, it is quite obvious that among the "real goods" themselves, the relative prices of goods measured in terms of goods are relatively stable. If all the food and fuel prices doubled, then the relative prices remained unchanged.

If there is a disequilibrium in the commodities market, then that gap will be closed. If the increase in prices is due to higher demand relative to supply, then there is money to be made by increasing the supply. Now, if the higher prices for commodity do not lead to a margin in nominal terms, then there is no increase in demand and therefore any increase in supply will worsen the lot of the farmers. This is why, in today higher food price situation, farmers do not make money.

Where is the most lucratic business in the world today? The stock market and the real estate. Both markets feed on liquidity, and the markets are volatile because the real economies are weak around the world. The liquidity has generated activity which the real returns on those investments cannot justify, either in the stock market (p/e too high) or in the real estate (higher capital value but low rental or even high vacancy rate).

It can therefore be argued that the higher prices are caused by an excessive supply of fiat money printed by the central banks around the world. If this is the case, then the solution to high food and fuel prices is to cut the money supply.

Interest Rate

There is a certain stock of money supply in the market that is doing havoc to prices.

In simple crude terms, the central bank can just withdraw that a certain volume of that stock of money that it has issued. The central bank can ask the banks to place a higher amount of their deposits with the central bank and as a result withdraw it from the system.

In an economy with a fairly well-developed financial system, an increase in the interest rate will increase savings and deposits (which withdraws liquidity from the system) and the higher interest rate also slows down lending (which reduces the creation of liquidity by the banking system). A higher interest rate will also make bonds more attractive with which the central bank can lock up liquidity, if the bonds are long term.

Of course, the argument can be that the high food and fuel prices are not caused fundamentally by the local currency but rather by the excess US dollars. This is why the US Fed must act by raising its interest rates. But there is a consideration. Some of its excessive liquidity has already been destroyed by its banking bankruptcy as a result of the sub-prime problems. Bank collapse is a disastrious way of removing excess liquidity from the system but it gets the job done. The bank collapse in the US has ramifications for its investors which are the cash rich banks in Eurpoe and China. So, there has been a bit liquidity reduction in Europe and China as well.

It will be nice if the US raises its interest rate so that Malaysia can also follow. Then Malaysia does not need a central bank to look after its monetary policy. Malaysia can just copy whatever the US is doing.

The argument for an increase in the interest rate in Malaysia is this: since the higher prices come from imports, then it makes sense for the ringgit to strengthen so that imported inflation is reduced. A rise in the interest rate also has the effect of increasing savings and deposits, and slowing down the creation of money by banks through their lending. The banks in Malaysia should cut down on consumption lending through credit cards, car buying, and the buying of property when there is nobody to stay in them. In the meantime, banks are making excessive profits which the record shows will be followed by a banking disaster as non-performing loans pile up in the instance even of a slight credit slowdown. So the central bank is now riding a tiger.

A higher interest rate domestically without a rise in the US interest rate will also draw in excess liquidity, if currency speculators are of the view that the ringgit has strong and continue to strengthen. This will happen, and it will call on the skill and expertise of those in charge to deal with this excess liquidity. But there is no excuse. We see higher interest rates in the UK, the EU, Australia, New Zealand - in inflation-fearing economies.

The central bank talks about waiting to look at: (a) risks to the inflation outlook, whether it is going to increase; (b) the risk at moderation to the growth outlook; and (c) inflationary expectations.

Inflation Risks and Expectations

I think the inflation risks are over in the sense that once you pass the high base as a result of the 40% hike in fuel prices, it is unlikely that you are going to see headline inflation at more than 7.7%. By July 2009, we could see CPI inflation at 1% again - although by then your bowl of noodles could cost 6 ringgit (1% is still an increase no matter how small).

The argument for the recent 40% fuel price hike is to stave off the problem of expectations - the problem of the public thinking that the government will keep on raising fuel prices. The worse could be over for the global oil market, hopefully.


So the problem is really the speed of growth of the economy.

There is fear that the economy is already slowing down and that an increase in the interest rate will slow down the economy further. This may well be the case, but this could be good for the economy in the long run. At present, we have an easy money policy that encourages Tom, Dick and Harry to borrow and spend freely to buy consumer goods just to keep the retail sector afloat - more houses, more cars, more TVs, more fridges, more hifi, more washing machines.

But, structurally, the economy is in shambles. The relative prices are wrong. All the monopolies are asked to become profitable - and they are the GLCs which dominate the stock market index. When monopolies make money, it means that the rest of the economy is held to ransom by their greed to maximise their margins. All the utilities including Astro can raise their rates and send their bills to our house and we can do nothing but pay up, whether we like it or not.

The real private sector is cornered into disadvantage, so that for investments, reliance is made on foreign ones.

In other words, there is no real private sector to suffer the higher interest rates - only the poor consumers who are up to their noses with debts thanks to a low interest rate policy which is completely misleading. Low interest rate loans funded by expected windfall gains in the stock market or the property market is a dangerous economic gain.

Foreign investors are flushed with cash; they do not need loans from local banks.

Only the government needs to borrow, in order to perpetually priming the pump.

I wonder what will the to-be-formed Council of Economic Advisors promulgate.

I propose the following:
1. Raise interest rate so that the ringgit can strengthen and lower imported inflation;
2. Dismantle import duties to lower imported inflation;
3. Cut government spending, to reduce the crowding out;
4. Promote domestic investment, for Bumiputera and non-Bumiputera (if the government does not cut its spending, this will be reduced to arguments about transparency and how contracts are given out);
5. Promote the IT and creative industries as avenues for young graduates;
6. Reduce the role of the government to law and order and the protection of private property ownership (for people to keep the rewards of their own efforts).
7. Not allow the Council of Economic Advisors to be formed. The PM to give up post of Minister of Finance to "the one who would have to provide the intellectual leadership to the Council of Economic Advisors."


CT Choo said...

Guru, this is the best guide that I have read since the fuel price hike. The M'sian economy will be so much better managed and, in better health in due course, as and WHEN (not IF) your proposed polic prescriptions are followed.

etheorist said...

ct choo:

But I shall never dare hope.

We have to put up with simple minds who cannot go beyond the first order of differential, less the third order.

We shall continue to masterb..e on the blog.

Jeremiah said...

Your policy recommendations appear sound but your prediction of CPI at 1% by mid-09 is strange and off the mark, more like 3-4% in 2H 2009. If you are right, then BNM is justified in keeping rates at current levels.