This is a very short respond to oyster cove, whom asked about the problem of inflation in Malaysia two posts ago. As with other general concerns on inflation in Malaysia, it is often masked implicitly, and sometimes explicitly, with an accusatory tone towards the government. Understandable I guess, but it is useful to know the limit of what the State could and could not do when it comes to the current scenario.

Inflation - Supply Shocks

The problem of inflation currently is global, not local. It is not due to the doings of the State, say like in Zimbabwe. If anything, Malaysians have been shielded too long from these pressures, particularly on fuel prices due to populist measures. The inflationary pressures are external, and in some sense, transient (I am referring to inflation, not the prices - i.e., the increase in prices, and not the levels of price), and does not come from within.

Conventional monetary tools to handle supply-shocks are mostly ineffective, and the appropriateness of using monetary means to overcome supply-origin inflationary pressures is often questioned. Interest rate is a very blunt tool. We currently have a delicate problem, careless wielding of the tool might result in more damage than actually solving the problem.

So what can the State do? I can think of two things:

1) Do not make the matter worse - by succumbing to populist policies such as fiscally unsustainable subsidies, price and wage controls and other measures which are popular but economically disastrous.

2) Prevent secondary inflationary pressure - there is little the central bank can do for supply shock inflation, but there is a potential problem of spiralling prices due to the first round impact of the supply shock. Firms might increase prices irresponsibly beyond the first round increase in cost, leading to further increase in prices and wages and so on. The classic price-wage spiral situation, plus the embedding of inflation expectation which would be much worse than the current problem now. I talked about this from a different angle not too long ago. Interest rate can help to stop this demand-induced pressure, if executed appropriately.

Exchange Rate - Appreciation?

There is of course, the issue of why don't we just allow the exchange rate to appreciate to control the inflation problem? Well, the problem is a little more subtle. I can think of two issues:

1) Allowing exchange rate to appreciate implies that the ringgit is undervalued to begin with. Which could be or could not be true - which is difficult to assess. For example, undervalued relative to? Vis-a-vis major currencies? Major trading partners? Major trading competitors? Propensity of more short-term inflows than outflows?

Anyway, the thing is, the ringgit has been appreciating over the past few years - not in a straight line manner, but appreciating nonetheless. Very recently however, as in since the beginning of this year, the ringgit is not appreciating as fast as other relevant currencies. And I do not think it is due to constant interventions from the central bank - the evidence doesn't corroborate this view. I believe the current relative weakness of the ringgit has got to do with the relatively bad economic prospects of the country compared to other economies (on top of the already bad overall global situations). And I am talking about political uncertainties. Definitely not inviting money into the country, and investments being driven on hold. This naturally limits the upward tendency of the ringgit.

So, if the ringgit is not held down artificially, then you can't really 'allow' it to appreciate. And to artifically appreciate the ringgit is not entirely sustainable or cheap too.

2) Exchange rate movements have many repercussions, many conflicting in nature. For one, it affects trade and external sector-oriented investments. Malaysia's exports and imports are about 250% of GDP, and exchange rate is the 'price' of our trade. Overvalued exchange rate can be bad for our exports, as well as investments in the sector. This adverse impact is significantly more damaging than the relatively transient inflation problem, as the impact is long-term in nature. When the country's dominant sector is affected, it will drag the economy down. There is a whole lot more to say on this, but I will stop here - the point is, manipulating the exchange rate can be wrought with many unintended consequences.

So there goes - my short say on the issue. I guess the main point is that it is not something policy-makers can handle easily, and I can't see how they are intentionally making the situation worse than it is.

The politicians, on the other hand, are making things worse, with power struggle and petty controversies. I wish some of them would just grow up and govern. Really do not want to tell my kids that we are the generation that messed up the country.

Read more interesting thoughts from Elanor at Cambridge blog’s Arrested Development here