In mid-September, the US Federal Reserve cut its benchmark interest rates by 50 basis points. This was the first rate cut by the Fed since 11 interest rate hikes over the course of 2022 and 2023 in an attempt to tame rising inflation in the US. As Fed Chairman Jerome Powell said in August, “The upside risks to inflation have diminished … and the downside risks to employment have increased.”
As a quick 101, central banks like the Fed hike interest rates when they believe that inflation is on the rise. These hikes in interest rate are meant to stabilise inflation by reducing the demand for money. Higher interest rates mean companies are less likely to borrow to fund their capital expenditure, while for individuals, it may mean that saving that money in a bank account is now preferable to spending it. The consequence of this is a fall in consumption and investment, which then helps to “cool” the economy, thereby lowering inflation. On the flipside, if the Fed wanted to “heat up” the economy — especially if they are concerned about unemployment figures — they then cut interest rates, which then has the opposite effect on consumption and investment.
This is what students learn in introductory macroeconomics (including in Ekonomi Asas at the SPM level) in textbooks all around the world. But this relationship between inflation and interest rates is built on a pretty critical assumption or premise — that ultimately, growth and inflation are correlated positively. As growth goes up from higher consumption or investment, so does inflation. And if consumption or investment falls, so does growth, and therefore inflation. As such, this mental model of monetary policy works primarily in situations where inflation is very much linked to economic growth.
But what if that is changing? We saw signs of this during inflationary pressures in the past two years, with many economists pointing out that those inflationary pressures resulted from supply-side issues, not demand-side issues. The economy wasn’t only overheating because people were investing more or consuming more (cash transfers from Covid aside).
It was also overheating because of pandemic lockdowns and the shuttering of supply chains which impacted the supply side of the economy too. Fewer things were being produced, supply chains were stuck, shipping was slower; the combination of these things all made goods and services more expensive. It is perhaps why the Fed rate hikes took so long to take effect — interest rate policies are most useful in addressing demand issues; they are less effective when dealing with supply-side issues.
Here is the bigger problem. Since the 1980s, the world has actually been on a general disinflationary trend. Following the Volcker hikes of the early 1980s, the US has had 40 years of essentially 2% inflation, which is the Fed target, amidst pretty reasonable interest rates. This structurally low inflation was due to several factors, including young global demographics which supported economic production, greater integration of production from globalisation which reduced costs via offshoring, China entering the World Trade Organization and becoming the world’s factory, the undermining of unions following Thatcherism and Reaganomics, and greater automatisation of production in both goods and services.
Today, all these trends have reversed. In many developed countries and even in developing Asian countries such as Malaysia and China, the demographic dividend is now shifting to a demographic tax with an ageing population. Global geopolitics is now seeing, in real time, supply chain reshoring and a potential bifurcation of production and technology which increases costs for everyone. There are also electoral shifts towards populism which necessitates massive fiscal spending, thereby also blunting the effects of tighter monetary policy. Climate change looms large as well, with more volatile weather patterns impacting agriculture, travel and economic activity, thereby increasing costs.
As such, when global structural changes from the 1980s to the 2010s kept inflation low, it was very possible to have growth be the most important correlator to inflation. But moving forward, it is likely that the relationship between inflation and growth will be far weaker. Massive global structural changes will now weigh more heavily on inflation, relative to growth. If this is the case, it’s not quite clear how effective classic monetary policy will be in managing inflation anymore. All this is to say that we should expect, in the years to come, a higher inflationary environment.
Now, we do know that people around the world are already feeling the pinch, Malaysia included. The cost of living of many basic necessities has increased, even with the tremendous amount of subsidies poured into the economy by the government. Subsidies on RON95 are almost single-handedly preventing escalating inflation in the country. But as we know, subsidy rationalisation is already on the horizon with diesel subsidies being removed earlier this year. Given government finances, unless they are willing to increase taxes significantly, it is just a matter of time before the RON95 subsidy removal comes on the table. And even if taxes are increased, the cost of living issues from structurally higher global inflation will still mean ever increasing pressures on everyday prices, beyond the control of the market or state.
It’s not a great outlook for an economy that has historically been dependent on firms whose competitive “moat” depends on a low-cost structure. On the one hand, things like raising the minimum wage or introducing a living wage are positive things from the perspective of everyday workers. But if so many of our firms compete based on cost, it’s not clear what the route to survivability of these firms will be unless they drastically transform their business models.
To manage rising prices, the government attempts various manners of price regulation. We know chicken prices were controlled last year with fresh chicken exports to Singapore also being banned. But think of the poultry farmers — they can only sell their products at a ceiling price that is set by the government while dealing with the fact that input costs such as the soy in their chicken feed had increased substantively. Subsidies for RON95 are probably the most famous of government price regulations; the textbook economic case to remove these subsidies is pretty clear-cut but it is also true that we don’t live in a textbook world. The real world, everywhere (not just Malaysia), operates not in an economy, but in a political economy.
However, there is a broader point to be made still. Ultimately, a higher cost of living eats into purchasing power. But purchasing power is made up of two components — income and costs. The bulk of the government’s focus has been on the cost side, managing costs via price controls and subsidies. In some sense, it is the “easier” problem to solve in the short term. But in reality, Malaysia’s main problem is not so much that costs are getting higher — this is true everywhere. Our main problem is that incomes are not rising as quickly and this is where the bulk of our attention should be.
Thus, it is not that Malaysia has a cost of living problem. Rather, it has a wages problem built on the basis of decades of an economy geared towards firms that compete based on being lowest-cost producers. No single firm has some divine right to existence. The focus of the nation — government, private sector, capital, labour — in a structurally higher inflationary global environment must be to transition existing firms towards competing on quality and innovation or build new firms that do.