Written by Carmelo Ferlito
Published in The Edge on 3rd of February 2020
Bank Negara Malaysia recently reduced the Overnight Policy Rate (OPR) by 25 basis points to 2.75%, the lowest level since 2011. With this measure BNM hopes to improve the growth trajectory.
While a growing number of economists is sceptical in recognizing the eventual stimulus role played by cuts in interest rate, and some of them believe that such measure is key in generating boom and bust cycles, the first question I wish to pose here is: are we trusting monetary policy too much? Indeed, if it would perfectly work like described by textbooks – lower the rate to stimulate the economy and raise it to cool down prices – monetary policy would be too an easy tool, and we would not experience economic crises. In fact, central banks action is based on past information (and information always evolves), while it takes time for it to produce effects (and the bigger the time lag the bigger the evolution of the context).
The point I think is important to understand is that monetary policy is a signal more than an objective fact. By lowering the interest rate, the central bank wishes to communicate that more financial resources are made available for investment (or that borrowing money is cheaper). However, as economists such as Hayek, Lachmann and Lavoie have taught us, economic reality is not shaped merely by facts; what counts more is the way in which economic agents interpret the signals generated by objective facts. Prices, in example, are objective figures, but purchasing decisions are taken by consumers according to how those figures are interpreted by them.
The objective fact here is the interest rate cut. One potential interpretation indeed is that more financial resources are available – or that “money is cheaper” – and this would eventually call for more investment (which may be also malinvestment). However, this is not the only possible interpretation. Market players may think that the central bank is worried about the present status of the economy and therefore they may become even more conservative and hold back. In a nutshell: the economy is made by billions of individual actions linked by signal interpretations; in such a system, nothing is automatic, the result of an action is open-ended by nature.
The second point I wish to raise is strictly linked with the first one. The underlying question is still the same: do we trust monetary policy too much? When we believe that interest rate is the main driver for investment, we are disregarding the basic fact that entrepreneurial decisions instead are mainly driven by profit expectations. It is enough to look at the mix results produced by QEs in Europe: if businesspeople do not expect a bright future, no matter how low the interest rate is, they simply do not invest.
In the context of Malaysia, in example, a clearer political framework could play a bigger role in stimulating economic activity than expansionary monetary policies. It would be important for the new government to have a clearer political economy agenda, in order for investors to have a better idea of what to expect for the future, to know in which contest their entrepreneurial and investment activities would unfold. In fact, if profit expectations are the main driver for investment, a general climate of uncertainty makes more difficult to form that positive profit expectations, negatively affecting the business mood.
A clearer political scenario may thus produce better effects than monetary policy. In fact, while cutting the interest rate directly affects the quantity of money, stimulating the economy by virtually “creating” resources, risking to overinflate the economic system, a higher degree of certainty at institutional level is “neutral” – it does not affect economic variables but simply creates a better and safer environment for entrepreneurial actions.