Given Malaysia's moderate inflation rate of 2.3 per cent, it was mildly surprising that Bank Negara Malaysia raised its benchmark interest rate to two per cent on May 11.

Many circumstances had forced Bank Negara to take this pre-emptive action.

FIRST, the United States, United Kingdom and the European Union have seen inflation spike to over eight per cent — a rate unseen for four decades.

This spike has been as much due to the pent-up consumer demand post-pandemic as to quantitative easing. 

Since the pandemic, these countries have pumped liquidity into their economies through printing (electronically) new money and buying government securities, private bonds and mortgage securities.

SECOND, the Russia-Ukraine war has resulted in a naval blockade that has thwarted Ukraine from exporting 25 million tonnes of grain.

Aggravating this situation is India's ban on wheat exports.

Droughts around the world and sanctions have pushed up global oil and commodity prices.

So much so, the G7 countries recently declared that we now suffer "one of the most severe food and energy crises in recent history".

THIRD, supply-chain disruptions following severe lockdowns in China and the resurgence of Covid-19 have also contributed to inflation.

Take Zimbabwe, for example.

At 152 per cent, its hyperinflation has prompted its government to instruct banks to stop lending in order to halt currency speculation and dampen consumer demand!

Tighter monetary policies now see the West tapering its bond-buying programme and increasing its interest rates.

Such moves will reduce the money supply.

Consequently, it will staunch consumer exuberance and dampen inflation.

The US, for example, raised its benchmark interest rate by 0.5 per cent early this month.

More 0.5 per cent increases are expected in the coming two months.

Such massive rises in interest rate by Western standards can negatively impact emerging markets' currencies.

Bank Negara would have reckoned, and rightly so, that if it did not act now, there would be capital outflows seeking better returns in advanced countries.

Such outflows, if unchecked, would depreciate the ringgit as demand for the currency falls.

Although ringgit depreciation would make exports more competitive, the impact would be transitory.

Imported inflation would raise the cost of their manufacture.

Hence, the interest rate rise is timely.

It is expected that Bank Negara would keep increasing its benchmark interest rate in tandem with such increases in the US.

Such a lock-step increase would stabilise the value of the ringgit as it stems capital outflows.

It should prevent the economy from going into a tailspin and descending into a recession.

This was what happened in the 1980s when the US, bent on curbing inflation, increased its interest rate to a phenomenal 20 per cent.

While interest rate represents a traditional tool to ensure price stability, pegging the ringgit to the dollar is a possible alternative.

A fixed exchange rate would prevent the rapid expansion of the domestic money supply which might otherwise fuel inflation.

But, a peg brings problems.

For example, in the 1990s, to maintain its currency's peg to the dollar, Argentina had to forfeit its policy independence.

It had to copy the monetary policies of the US, tightening them when the US did and vice versa.

Worse, pegs such as the yuan-US peg are usually fixed at a lower value than a freely floating rate.

While such a peg enhances the country's export competitiveness, it hurts imports.

A central bank may have to spend dollops of its foreign reserves to hold the peg should it be out of kilter with the natural rate, unless capital controls are in place.

Such was the case in 1998 when Malaysia pegged the ringgit to the dollar.

When they see that a peg is unsustainable, currency traders will try to break the peg.

This is what happened when Britain was forced out of the European Exchange Rate Mechanism (ERM) in 1992.

Britain could not support the pound from falling below the lower limit of the ERM.

The current managed float of the ringgit has kept the economy on an even keel.

It has controlled inflation well.

Fluctuations in the value of the ringgit are little cause for concern, as they mirror similar fluctuations in regional currencies.

So, it is best to maintain the status quo.

The writer is the AIMST University's Vice-Chancellor

https://www.nst.com.my/opinion/columnists/2022/05/796729/interest-rate-fights-inflation-better-currency-peg