Is Your Central Bank Going to be the Next to Tighten?

by Alaistair Chan, Moody’s Economy.com, 11 March 2010

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As their economies recover, Asian central banks are shifting monetary policy to less accommodative positions. Australia and Malaysia have so far been alone in the region in reducing the monetary stimulus, but others are set to follow. Interest rates are being raised from record lows, but policy is likely to remain accommodative until economic recoveries are judged sustainable, which may be beyond 2010.

On March 2, the Reserve Bank of Australia (RBA) raised its cash rate by another 25 basis points to 4%, its fourth move in the current tightening cycle. The RBA judged that growth was "close to trend" and inflation was "close to target", making it appropriate for interest rates to be "closer to average".

The target for the cash rate over the medium term (by the end of the year) has been taken by markets to be around 4.75%. This is on the low end of the 4.75% to 5.25% range typically considered neutral. As the RBA noted, overall funding costs for commercial banks remain higher than average, so the interest rates that households and businesses pay are already nearly normal.

Other countries are taking a more gradual path. In China, the government has set a lower 7.5 trillion yuan target for bank lending for 2010, while the People's Bank of China (PBOC) has raised the yields on bills it issues and raised commercial banks' capital reserve ratios twice. The Reserve Bank of India raised the cash reserve ratio for banks by 75 basis points to 5.75% in the beginning of March.

However, these steps by the PBoC and RBI are quantitative, in that they reduce the supply of funds. Neither central bank is ready for higher-impact measures such as raising interest rates.

Malaysia Tightens

On March 4, the RBA was joined by its counterpart in Malaysia. Bank Negara Malaysia (BNM) raised its key overnight rate to 2.25%, from the record low 2% in place since February 2009.

This move could mark a turning point to broader tightening in Asia. BNM said in its accompanying statement that the record low rate was to "avert a severe fundamental and economic downturn". These conditions no longer prevail. Malaysia's recovery so far is fairly broad based, with growth coming from private and public domestic demand, investment, and exports.

Another reason to lift the overnight rate was to avoid financial imbalances. This is a forward-looking move, as asset markets in Malaysia do not appear out of hand as yet. The Kuala Lumpur Composite rose over 60% in the period from mid-2006 to early 2008, and then lost it all by the end of 2008.

It has since recovered most of those losses, possibly helped by the easy funding conditions now in place. The property market is also recovering, as are prices of palm oil and other commodities, although none have returned to peak levels. Palm oil prices in ringgit terms are only at early 2007 levels.

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