The Objective and Formulation of Monetary Policy

in Malaysia

Anas 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
Presentation to TAR College, July2010 1
endorsed by BNM.

Presentation outline

Monetary Policy and Macroeconomic objectives

The importance of price stability

The role of monetary policy

Monetary policy framework in Malaysia

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What is the objective of policymakers?

“The ultimate objective of all

public policies is to improve the
living standards (welfare) of its
nation”

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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)

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What is macroeconomic stability?

INTERNAL Balance EXTERNAL Balance

Inflation is low and BOP situation is

predictable perceived as viable

Fiscal policy is stable Real ER is

and sustainable competitive and
predictable

Stanley Fischer
(1993)

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How does price stability contribute to

sustainable growth?

Facilitates decision-making

Promote efficient allocation of

resources
Better
Price conditions for
Reduces distortionary effects growth
stability on the tax system

Prices remain an effective

signal for demand & supply

Reduces the cost of hedging

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 Other costs of Inflation :
What you inevitably face when prices increase

The 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.

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Inflation increases the cost of living

Cost of Breakfast (1956 - 2005)

300
7% per year
Nasi Lemak Teh Tarik
250

200

90
Sen

150
70 150

60 120
100
55
45 90
40 75
50 30
20 60
10 50
40
3 30
0 15
5
56-60 61-65 66-70 71-75 76-80 81-85 86-90 91-95 96-00 01-05.

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Inflation reduces real purchasing power

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Higher inflation associated with lower growth

Real GDP vs. Inflation

Beyond a certain
threshold (kink),
inflation is really
harmful to growth

Kink; 1-3% for
industrial
countries, 7-11%
for emerging
markets

Khan and Senhadji (2001)

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Structural policies for long-term objective, while
counter-cyclical policies for medium-term sustainability
Macroeconomic Types of Policies Purpose Desired
Policy Outcome

Structural Industrial policy, Productivity, Increase

policies Labour policy, Efficiency, potential output
Education policy, Competitiveness,
Banking policy Flexibility

Counter-cyclical Monetary policy Contain risks of Stable prices

policies Fiscal policy recessions with sustainable
(deflation) and high pace of
inflation economic growth

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“Monetary policy comprise of

actions by a central bank to
influence the availability and cost of
money and credit to help promoting
national economic goals”

The Federal Reserve Board

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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
Cannot
Potential (directly)
Can output influence long-
smooth out run potential
short-term growth of the
fluctuations Time economy

Inflation
and
wages
Time

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Bank Negara Malaysia Act 2009

5. (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.”

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 Operational Autonomy:
Independence ‘within’ the Government
• BNM enjoys significant degree of independence in its operations
• The independence mainly stem from the Government’s confidence in
BNM’s 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

Other agencies, e.g.

Bank Negara Securities Commission,
Treasury Inland Revenue Board,
Malaysia
Khazanah Nasional Bhd

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Framework has evolved in line with the changing

financial and economic environment

Interest Rate Interest Rate

Monetary Interest Rate
Targeting with Targeting with
Targeting Targeting
Fixed ER Floating ER

• Narrow • Mid-1990s to • Sept 1998 – • July 2005 -

money M1 up Sept 1998 July 2005 present
to 1970s:
• Base Lending • ER pegged to • New interest rate
• Broad money Rate (BLR) the US$ at framework using
M2 up to early framework RM3.80/US$ the Overnight
1980s Policy Rate
• BLR framework
(OPR) to signal
• M3 up to early (BLR linked to
MP stance
1990s Intervention
Rate) • Gradual
liberalisation of
• Capital controls
capital controls

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 BNM’s current MP framework

Ultimate
Objective
Intermediate
Target • Achieving
Operating sustainable
Target • No specific growth with
intermediate price stability
Instruments • Average target
Overnight
• Direct borrowing & Interbank Rate
lending (AOIR)
• Issuance of BNM • OPR is target of
bills and notes AOIR
• OMO
• SRR
• Public sector
deposits

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The instrument that is under the control of

BNM is the Overnight Policy Rate

Bank Negara
Malaysia

Collateral
Collaterals Money

Eligible Financial
Institutions

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

Inter-bank
Bank A rates Bank B

Lending Lending
rates rates
O
P
Borrowers R Borrowers

Bank Negara Malaysia

OPR = Overnight Policy Rate

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Liquidity operations steers the operating target (avg o/n

interbank rate) close to the policy rate (OPR)
Average Overnight Interbank Rate
%
4.0
Ceiling 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: 24 Nov 08
OPR ↑ 25 bps: 22 Feb 06
2.4
OPR ↑ 30 bps: 30 Nov 05
OPR ↓ 75 bps: 21 Jan 09
2.0

OPR ↓ 50 bps: 24 Feb 09

1.6
May-05

May-06

May-07

May-08
N ov-05

Mar-06

N ov-06

Mar-07

N ov-07

Mar-08

N ov-08

Mar-09
Jul-05
Sep-05

Jan-06

Jul-06
Sep-06

Jan-07

Jul-07
Sep-07

Jan-08

Jul-08
Sep-08

Jan-09

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 OPR and Overnight Interbank Rates BLR and ALR

Overnight IB OPR Floor Ceiling BLR ALR Weighted ALR OPR

4 7.50 5.0
4.5
7.00
3.5 4.0
6.50 3.5
OPR: 2.50
3 3.0
OIB: 2.46 6.00
2.5
5.50
2.5 2.0

5.00 1.5
2 1.0
4.50
0.5
1.5 4.00
Mar-05
0.0

Mar-06

Mar-07

Mar-08

Mar-09

Mar-10
Sep-05

Sep-06

Sep-07

Sep-08

Sep-09
Mar-05

Mar-06

Mar-07

Mar-08

Mar-09

Mar-10
Sep-05

Sep-06

Sep-07

Sep-08

Sep-09

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Central Bank role in influencing the “price of

short-term credit”

Retail market
Borrowings & Deposits Wages & Profits
Deposits
Economic
Central Financial Households &
activity &
banks Institutions Businesses
inflation
Collaterals Borrowings Consumption &
Investment

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 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

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Monetary policy transmission mechanism

MP works with long and variable lags

Interest rate channel

Wholesale rates, retail rates

Domesti
c
Credit channel
MP Demand
C+I +G Domestic
actions
Aggregate inflationary
OPR Demand
INFLATION
Asset price channel pressure
House prices, stock prices
Net Changes in the
External output gap

Demand
Expectation channel X-M
Mkt expectn of int rate, yields

Exchange rate channel

Exchange rates Import prices

1 year 66 months
months –to11year
year

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 When BNM wants to Stimulate the Economy

Economic
Growth Interest
Below
Rates
Potential

O
P
Inflation R Loans
Economic
Activity &
Very Low inflation

Balancing growth MP actions Financial sector Household &

and inflation businesses

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Monetary policy decision-making process at

Bank Negara
Monetary Policy Monetary Policy
Surveillance Working Group Committee
and Research
• Technical Discussions on • Members: Governor, Deputy
Work by Staff recent economic, monetary Governors, Assistant
and financial Governors
developments in the global • Discussions on recent
and domestic economy economic, monetary and
• Technical discussions on financial developments in the
research and analysis global and domestic
economy
• Discussion on policy relevant
research and other topical
issues
• Deliberation on monetary
policy stance
• Drafting of the Monetary
Policy Statement

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Illustration of MTM when Malaysia
increased OPR in 2005

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Illustration of MTM when Malaysia

increased OPR in 2005

OPR OPR
OPR hike hike
hike

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 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 well-
functioning

QE is a last policy option

QE is an attempt to restore or bypass weakened
key transmission channels.

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Can MP prevent financial imbalances?

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

• Search for higher yields

• Encourage excessive
• Disincentive to save risk-taking behaviour
• Shift into higher risk • Unhealthy build-up in
investments leverages
• Build-up of asset prices • Undue exposure to
interest rate risk

MP is effective as a pre-emptive tool

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Recognizing limits of MP

Substantial 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

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Constraints in the conduct of monetary

policy in a small open economy

Monetary
Policy
Independence
Global capital flows are
distorting financial
markets in ways that
make it difficult to judge
Free Exchange the appropriate stance of
Capital Rate monetary policy
Flows Stability

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 Greater emphasis on enhancing communications
Sustainable 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 BNM’s own plans & projections
• Anchor economic agents' long-term expectations of low inflation

Press
Press Releases
Releases Advance
Advance Schedule
Schedule of
of Outlook
Outlook Chapter
Chapter Governor’s
Governor’s
on
on MPC
MPC MPC
MPC Meetings
Meetings and
and in
in Annual
Annual speeches
speeches & &
Decisions
Decisions Announcements
Announcements Report
Report interviews
interviews

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Communication: Monetary Policy Statement

Decision

Regular assessment
of outlook and
economic conditions

Rationale
for decision

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Recap and summary

Primary 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 pre-

condition for the effectiveness of monetary
policy

Policy decisions need to be considered in a

holistic manner
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End of Presentation

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