As what the market have been expecting Bank Negara Malaysia (BNM) raised the Overnight Policy Rate (OPR) by 25 basis points (bps). The decision implies a major shift towards a more aggressive stance by BNM to pre-empt any fallout from destabilizing financial imbalances. Though no strong hint this time around on heightened risk of financial misalignment, based on previous trend there could be another rate hike of 25bps by year end. But the probability of this happening is relatively low for now as the adverse impact on consumption spending will net off the positive gain in dealing with financial imbalances. Plus the implementation of GST in April next year may be a strong reason for BNM to remain accommodative and refrain from aggravating the downside effect on growth.

· The BNM Monetary Policy Committee (MPC) has decided to raise the Overnight Policy Rate by 25 basis points (bps) to 3.25%, its first adjustment since May 2011. The floor and ceiling rates is correspondently raised to 3.00% and 3.50% respectively. In a statement, BNM said the decision was largely based on firmer growth prospects and the fact that inflation remains above its long-run average. Referring it to the “normalisation of monetary conditions” the decision also aims “to mitigate the risk of broader economic and financial imbalances that could undermine the growth prospects of the Malaysian economy.”

· Overall BNM seemed sanguine on the global growth outlook. It sees the global economy to be improving substantially despite a weak start to the year, backed by improved economic conditions in the developed countries, mainly the USA as well as support from domestic growth within developing Asia. Financial markets have also stabilized in light of optimistic indicators moving forward. As such, this has provided positive repercussions to the Malaysian economy, which BNM believes is more than capable of withstanding an increase in the interest rates, regardless of the somewhat tepid aggregate demand.

- Based on our study on BNM’s monetary decision behavior, we conclude that it has somewhat begun to deviate from its more conservative decision pattern. We reckon that it has all to do with the shift in the way that central banks worldwide approach in dealing with impending risk of financial imbalances and asset bubble. In spite of the seemingly absence of financial froth and convincing signs of demand pull inflationary trend, BNM has surprisingly begun to adopt measures that is pre-emptive in nature. Not that it has been less pre-emptive in the past but the timing and manner of which it is done is less deliberate and more advanced.

- It started with the macro-prudential measures introduced in October last year, mainly to deal with property speculation. It was intended to put the lid on rising real estate value that has increasingly made urban and to some extent suburban dwellings beyond the reach of many middle and lower income citizens. The fact that this time it chooses a blunt tool in the form of raising the OPR makes it more surprising considering its impact goes far and wide. This may have an adverse impact on the economy as well as the financial market.

- Of concern is the possibility of another rate hike in not the too distant future. This is premise on historical trend whereby the total seven rate hike BNM had made since the MPC began most of the time it will follow through with another rate hike either at the next MPC meeting or within a period of three to six months. While a 25bps may not have much of an impact as 50bps, only then, would the rates be truly effective in nipping any ‘risk of broader economic and financial imbalances’ in the bud. But this will all depend on how strong the economy is in the 2H14 and whether inflationary trend would increasingly shift towards demand pull. However, we believe that there could be a trade off in the form of a weaker consumption spending which could weigh down on the economy

- As we project the economy to expand by 5.5% this year the growth trajectory would most likely be weaker in the 2H14 as we have already estimate that the economy to exceed 5.5% in the 1H14 judging by strong exports and sustainable domestic spending along with the low base effect. But then again, growth for the whole of this year could also exceed 5.5% if the global demand momentum spills over into 2H14. We feel that Malaysia’s domestic economy hasn’t quite recovered from the effects of fiscal consolidation. Though exports related sectors remains robust and infrastructure expansion under the ETP continues to support growth, private sector investment spending and expansion is still trying to gain traction.

- Similarly inflation still remains above its long-term average and we estimate it to average around 3.3% for the whole of 2014 from 2.1% in 2013. Consumer prices are expected to remain elevated on the back of cost-push factors due to fiscal consolidation and higher imported inflation as the US dollar is expected to strengthen putting a damper on ringgit upside.

- Having said that, the probability of another rate hike is relatively low for now. However, given the new pattern of behaviour of opting prevention over cure there could still be some element of surprise in BNM’s bag of tricks. For instance, instead of adjusting rates it can also choose to introduce more macroprudential measures. Another reason that we think BNM would stop at its track would be the concern of the adverse impact on the economy following the implementation of the Goods and Services Tax (GST) beginning 1st April next year. A slowdown in GDP growth is expected for at least six months before its impact normalizes.

- With regard to the impact on the ringgit, we expect the USDMYR exchange rate to remain volatile in the short to medium, hovering around 3.15-3.25. Fundamentally, the ringgit is well supported backed by the prospect of strong GDP growth, a widening current account surplus and a relatively large savings-investment gap. Given that the US dollar would gain strength ahead of the expected Fed rate hike somewhere in 2015, we maintain our USDMYR year-end forecast at 3.21 (Average: 3.25).

- In other parts of the world, the Bank of England (BOE) has opted to retain its interest rates at 0.5%, despite earlier hints of a rate hike by BOE Governor Carney, indicative that even though economic indicators in the UK has improved exponentially of late, they still choose the err on the cautious side, less acting too fast too soon resulting in a backslide. Just across the channel, Europe has recently had to act the other way in terms of monetary policy and had cut rates to an all time low of 0.15% from 0.25%, in hopes to maneuver the region away from the threat of deflation. Alongside imposing a negative deposit rate and stimulus measures, ECB’s president, Mario Draghi hopes that it will encourage more investment by businesses though many believe that another form of stimulus is possibility, especially when unemployment rates in the region remains a staggering 11.6%, with countries like Spain suffering with over a quarter (25.1%) of its labour force unemployed. Economic activity in the region is showing signs of weakening, if the PMI for the private sector (fell to 52.8 in June from 53.5) is of any indication.

- Across the Atlantic, the Fed continues with the QE tapering and is expected to end in October this year. The question now remains on when Fed Fund Rates will start to increase. From what we can gather about Janet Yellen, who still remains cautious on the trajectory of economic recovery in the US, we’ll most likely only see a hike in the later part of 2015. Despite diminishing unemployment rates, increased business hiring, and improved production, labour force participation rate is still a 30-year low and there’s been an increase in risk-taking within their financial and property markets as a result of the accommodative policies in the recent years.

- In Asia, the Bank of Korea (BoK) shares similar worries to that of the ECB, concerned that inflation is not picking up as hoped, only rising by 1.7%, far below the BoK’s target range of 2.5% - 3.5%. They have left rates at 2.50% for the 14h consecutive month and lowered their GDP forecast to 3.8% form 4.0%. The BoJ is also expected to it’s monetary policy steady and maintain its stimulus measures, in hopes to achieve their 2.0% inflation target (currently at 3.4% - a 32 year high) and mitigate the downside effects of the sales tax hike in April this year.

Source: Kenanga