Objective and Formulation of MP_TAR College 6July2010[1]

The Objective and Formulation of Monetary Policy in MalaysiaAnas Faizal Aning & Rubin Sivabalan Monetary Assessment & Strategy Department 6 July 2010 Auditorium, Bank Negara Malaysia 2.30-4.30pm

DISCLAIMER: Views expressed in this presentation are those of the author and do not necessarily represent those of BNM nor are they necessarily 1 Presentation to TAR College, July2010 endorsed by BNM.

Presentation outlineMonetary Policy and Macroeconomic objectivesThe importance of price stability

The role of monetary policy Monetary policy framework in Malaysia

Presentation to TAR College, July2010

2

What is the objective of policymakers?

The ultimate objective of all public policies is to improve the living standards (welfare) of its nation


3

What is the objective of policymakers?To improve the standard of living, one of the public policy objectives is to promote robust and sustainable economic growth

GDP (or GNI) is a crude proxy for measuring the standard of living, i.e.

Y = C + I + G + (X-M)


4

What is macroeconomic stability?INTERNAL BalanceInflation is low and predictable Fiscal policy is stable and sustainable

EXTERNAL BalanceBOP situation is perceived as viable Real ER is competitive and predictable

Stanley Fischer (1993)


5

How does price stability contribute to sustainable growth?

Facilitates decision-making

Promote efficient allocation of resources Price stability Reduces distortionary effects on the tax system Prices remain an effective signal for demand & supply Better conditions for growth

Reduces the cost of hedging


6

Other costs of Inflation : What you inevitably face when prices increaseThe erosion of value of money & living standards Redistribute income from savers to borrowers if real interest rate is negative Shoe leather and menu costs Inflation unnecessarily pushes households into higher tax brackets Inflation encourages households to invest for speculative purposes Higher domestic inflation relative to abroad, leads to loss of international competitiveness. Uncertainty of future prices may discourage investment and saving. High inflation may lead to shortages of goods if consumers begin hoarding out of concern that prices will increase in the future.


7

Inflation increases the cost of livingCost of Breakfast (1956 - 2005)300

Nasi Lemak250 200Sen

Teh Tarik

7% per year

90

15070 150

100 503 30 40 40 50 45

60 55 90 75 60 20 30 15

120

10

0

5

56-60

61-65

66-70

71-75

76-80

81-85

86-90

91-95

96-00

01-05.


8

Inflation reduces real purchasing power


9

Higher inflation associated with lower growthReal GDP vs. Inflation

Beyond a certain threshold (kink), inflation is really harmful to growth Kink; 1-3% for industrial countries, 7-11% for emerging marketsKhan and Senhadji (2001)


10

Structural policies for long-term objective, while counter-cyclical policies for medium-term sustainabilityMacroeconomic Policy Structural policies Types of Policies Purpose Desired Outcome Increase potential output

Industrial policy, Labour policy, Education policy, Banking policy

Productivity, Efficiency, Competitiveness, Flexibility

Counter-cyclical Monetary policy policies Fiscal policy

Contain risks of recessions (deflation) and high inflation

Stable prices with sustainable pace of economic growth


11

Monetary policy comprise of actions by a central bank to influence the availability and cost of money and credit to help promoting national economic goalsThe Federal Reserve Board


12

What is the objective of monetary policy?Hence, the role of monetary policy is to smooth out the short- to medium term cyclical fluctuations in the economy

GDP

Actual Potential output Time

Cansmooth out short-term fluctuationsInflation and wages

Cannot (directly)influence longrun potential growth of the economy

Time


13

Bank Negara Malaysia Act 20095. (1) The principle objects of the bank shall be to promote monetary stability and financial stability conducive to the sustainable growth of the Malaysian Economy

5.(2) The primary functions of the Bank are as follows:(a) to formulate and conduct monetary policy in Malaysia

22.(1) In promoting monetary stability, the bank shall pursue a monetary policy which serves the interests of the country with the primary objective of maintaining price stability giving due regard to the developments in the economy.Presentation to TAR College, July2010 14

Operational Autonomy: Independence within the Government BNM enjoys significant degree of independence in its operations The independence mainly stem from the Governments confidence in BNMs ability to carry out its duties Minister of Finance Minister of Finance II

Deputy Minister of Finance 1

Deputy Minister of Finance 2

Secretary General of the Treasury

Bank Negara Malaysia

Treasury

Other agencies, e.g. Securities Commission, Inland Revenue Board, Khazanah Nasional Bhd15


Framework has evolved in line with the changing financial and economic environmentMonetary Targeting Interest Rate Targeting Interest Rate Targeting with Fixed ER Interest Rate Targeting with Floating ER

Narrow money M1 up to 1970s: Broad money M2 up to early 1980s M3 up to early 1990s

Mid-1990s to Sept 1998 Base Lending Rate (BLR) framework

Sept 1998 July 2005 ER pegged to the US$ at RM3.80/US$ BLR framework (BLR linked to Intervention Rate) Capital controls

July 2005 present New interest rate framework using the Overnight Policy Rate (OPR) to signal MP stance Gradual liberalisation of capital controls


16

BNMs current MP framework

Operating Target

Intermediate Target No specific intermediate target

Ultimate Objective Achieving sustainable growth with price stability

Instruments Direct borrowing & lending Issuance of BNM bills and notes OMO SRR Public sector deposits

Average Overnight Interbank Rate (AOIR) OPR is target of AOIR


17

The instrument that is under the control of BNM is the Overnight Policy Rate

Bank Negara Malaysia

CollateralCollaterals Money

Eligible Financial Institutions


18

The important link between the policy, wholesale and retail interest ratesSaversDeposi t rates

SaversDeposi t rates

Bank ALending rates

Inter-bank rates

Bank BLending rates

Borrowers

O P R

Borrowers

Bank Negara MalaysiaOPR = Overnight Policy RatePresentation to TAR College, July2010 19

Liquidity operations steers the operating target (avg o/n interbank rate) close to the policy rate (OPR)Average Overnight Interbank Rate%

4.0Ceiling rate (OPR +25bps) of the corridor for the OPR

3.6

3.2

Floor rate (OPR -25 bps) of the corridor for the OPR

OPR 25 bps: 26 Apr 06 2.8 OPR 25 bps: 22 Feb 06 2.4 OPR 30 bps: 30 Nov 05 2.0 OPR 75 bps: 21 Jan 09 OPR 50 bps: 24 Feb 09 1.6May-05 May-06 May-07 May-08 N ov-05 N ov-06 N ov-07 N ov-08 Mar-06 Mar-07 Mar-08 Sep-05 Sep-06 Sep-07 Sep-08 Mar-09 Jul-05 Jul-06 Jul-07 Jan-06 Jan-07 Jan-08 Jul-08 Jan-09

OPR 25 bps: 24 Nov 08


20

OPR and Overnight Interbank RatesOvernight IB OPR Floor Ceiling7.50 7.00BLR

BLR and ALRALR Weighted ALR OPR

4

5.0 4.5 4.0

3.56.50

3.5 3.0 2.5

3

OPR: 2.50 OIB: 2.466.00 5.50 5.00

2.5

2.0 1.5 1.0

24.50

0.5Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Mar-10

Mar-05

Mar-06

Mar-07

Mar-08

Mar-09

Sep-05

Sep-06

Sep-07

Sep-08

Sep-09

Mar-10

1.5

4.00

0.0


21

Central Bank role in influencing the price of short-term creditRetail market Wages & Profits

Borrowings & Deposits

Deposits

Central banks

Financial InstitutionsCollaterals

Households & Businesses

Economic activity & inflation

Borrowings

Consumption & Investment


22

What is monetary transmission mechanism?

The process in which economic agents react to MP actions undertaken and how their subsequent actions affect the economy in terms of aggregate demand as well as the price level


23

Monetary policy transmission mechanismMP works with long and variable lagsInterest rate channelWholesale rates, retail rates

MP actions

Credit channel

Domesti c Demand C+I +G Net External Demand X-M

DomesticAggregate inflationary Demand pressureChanges in the output gap

OPR

INFLATION

Asset price channelHouse prices, stock prices

Expectation channelMkt expectn of int rate, yields

Exchange rate channelExchange rates

Import prices

1 yearPresentation to TAR College, July2010

6 months to year 6 months 11year24

When BNM wants to Stimulate the EconomyEconomic Growth Below Potential

Interest Rates

Inflation Very Low

O P R

Loans

Economic Activity & inflation

Balancing growth and inflation

MP actions

Financial sector

Household & businesses25


Monetary policy decision-making process at Bank NegaraSurveillance and Research Work by Staff Monetary Policy Working Group Technical Discussions on recent economic, monetary and financial developments in the global and domestic economy Technical discussions on research and analysis

Monetary Policy Committee Members: Governor, Deputy Governors, Assistant Governors Discussions on recent economic, monetary and financial developments in the global and domestic economy Discussion on policy relevant research and other topical issues Deliberation on monetary policy stance Drafting of the Monetary Policy Statement


26

Illustration of MTM when Malaysia increased OPR in 2005


27

Illustration of MTM when Malaysia increased OPR in 2005

OPR hike

OPR hike

OPR hike


28

What happens during crisis times?Can conventional monetary policy help? In a crisis situation, interest rate cuts are not sufficient Complementary measures are introduced to reach specific sectors of the economy Unconventional measures, such as quantitative easing, if monetary transmission is not wellfunctioning QE is a last policy option QE is an attempt to restore or bypass weakened key transmission channels.


29

Can MP prevent financial imbalances?

Savers

Risk of financial imbalances in maintaining policy rate for too low and too long

Borrowers

Search for higher yields Disincentive to save Shift into higher risk investments Build-up of asset prices

Encourage excessive risk-taking behaviour Unhealthy build-up in leverages Undue exposure to interest rate risk

MP is effective as a pre-emptive toolPresentation to TAR College, July2010 30

Recognizing limits of MPSubstantial time lags in transmitting monetary impulses to final objectives Limited knowledge of the monetary transmission mechanism (MTM) MP is a blunt instrument Ineffective against supply shocks Ineffective when asset prices are spiraling


31

Constraints in the conduct of monetary policy in a small open economyMonetary Policy Independence

Free Capital Flows

Exchange Rate Stability

Global capital flows are distorting financial markets in ways that make it difficult to judge the appropriate stance of monetary policy


32

Greater emphasis on enhancing communicationsSustainable growth with price stability

Influence behaviors of economic agents & economic activity in the desired direction

Enhance predictability of interest rates Align financial market players' expectations about the future course of MP more closely with BNMs own plans & projections Anchor economic agents' long-term expectations of low inflation

Press Releases Press Releases on MPC on MPC Decisions Decisions

Advance Schedule of Advance Schedule of MPC Meetings and MPC Meetings and Announcements Announcements

Outlook Chapter Outlook Chapter in Annual in Annual Report Report

Governors Governors speeches & speeches & interviews interviews33


Communication: Monetary Policy Statement

Decision Regular assessment of outlook and economic conditions Rationale for decision


34

Recap and summaryPrimary objective of MP is to maintain price stability with sustainable economic growth There is a need to recognise the limit of MP Transmission mechanism of MP works with long and variable lags Surveillance and research are key to MP decision making Financial stability is an important precondition for the effectiveness of monetary policy Policy decisions need to be considered in a holistic mannerPresentation to TAR College, July2010 35

End of Presentation


36

Documents

Objective and Formulation of MP_TAR College 6July2010[1]