This article first appeared in Forum, The Edge Malaysia Weekly on June 20, 2022 - June 26, 2022
Since the 1960s, there have been 11 times when the US Federal Reserve increased interest rates in a series of steps to cool down the economy. Out of these, seven eventually resulted in the US going into a recession.
During these 11 rounds of rate hikes, Malaysia felt the impact on at least eight occasions. The impact came a year after the US entered a recession.
The first to get hit was the ringgit, followed by the economy. Gross domestic product went into negative territory at least twice — in 1985 and 2009 — as a result of the US rate hikes. In other periods of Fed tightening, Malaysia generally experienced a slowdown in the economy.
There were two occasions when the country did not feel the impact of the tightening in the US. That was between the late 1980s and mid-1990s. The US ratcheted up interest rates twice, from March 1988 to April 1989 and between December 1993 and April 1995.
A former vice-chair of the Fed, Alan Blinder, described the December 1993 to April 1995 monetary tightening as the “perfect landing” for the US economy because there was minimal disruption to the country’s economy, and the rest of the world did not feel its impact.
In fact, between 1988 and 1996, Malaysia had its longest streak of high growth.
The local economy grew at an average of 9% or more, and even topped 10% in 1996. The stock market enjoyed a “super bull run” that ended with a crash in 1998. The bull run on the Main Board ended in December 1993 when the Fed started to tighten its monetary policy.
Sentiment on the Malaysian economy remained positive right through 1995, when rates were rising in the US because the economy was seeing high growth rates of more than 9%.
This kicked off the Second Board (now known as the ACE Market) bull run in the second half of 1996. The share prices of small-cap companies rose to dizzying heights. The run ended in mid-1997 as the Asian currency crisis unfolded.
The ringgit depreciated more than 80% from RM2.50 in the space of a year. At one point, it exceeded RM4.50 to the US dollar. The stock market crashed in 1998, and the Malaysian economy contracted by 7.4%. The recession affected companies as well as the pockets of ordinary people.
Income per capita dropped by almost 30% to US$3,263 in 1998 from US$4,638 in 1997. It was the biggest decline in the earnings of ordinary Malaysians during a recession. In the three other recessions experienced by the country since the 1960s, income per capita fell about 10% or less.
Last Wednesday, the Fed raised interest rates by another 75 basis points and pointed to more rate hikes to tame inflation, which is now at 8.6%. This is the third time rates have increased since March this year, pushing the Fed funds rate band to between 1.5% and 1.75%.
The markets rose the following day, latching on to comments by Fed chair Jerome Powell that the 75bps hike would not be “common” going forward. It fuelled hopes that the Fed was serious about battling inflation and would guide the economy to a soft landing.
But the odds are heavily stacked against the US economy achieving a soft landing. The view is that the Fed needs to raise the interest rate aggressively in the coming months and that it would tilt the US economy into a recession.
The naysayers, including Powell, dispelled the notion that the US would go into a recession. He said that unemployment was low, the economy had seen a strong rebound from the two pandemic years and inflation would come down when the supply chain kinks were rectified.
The markets are always six months ahead of the economic reality. Based on how the smart money is behaving, it appears that the US going into a recession is a more likely scenario. In fact, the economy contracted in the first quarter of this year compared with the preceding quarter.
The scepticism over the US economy is due to the element of inflation.
On the three occasions when the US went into a soft landing during a period of monetary tightening, inflation was tame. This time around, there is a supply shock. Inflation is caused by a global disruption in the supply chain due to the pandemic. Apart from the supply chain disruption, pressure to increase wages is building and productivity is not improving either because of restricted labour mobility.
There will be several more rate hikes and the rate can go up to 3.75%. Whether it is enough to tame inflation in the US is left to be seen.
When there is a slowdown or recession in the US, it impacts the rest of the world, including Malaysia. There is no escape.
Since the 1960s, Malaysia has had four recessions and all happened after a slowdown or a recession in the US.
The impact of the US using interest rates to tame inflation is the danger of a further weakening of the ringgit. Investors who borrowed in US dollars when the borrowing rates were almost 0% to put money elsewhere are unwinding their positions.
The ringgit is actually much more vulnerable than we think.
At RM4.40 to the US dollar, the local currency has room to depreciate, depending on how the US navigates its way through the highest inflation it has faced in 40 years.
Malaysia’s central bank cannot do much to stop the depreciation of the ringgit. It cannot raise interest rates aggressively because that would surely sink the country into a recession. In addition, Bank Negara Malaysia does not have the kind of reserves to defend the ringgit from further weakening.
What emerging economies such as Malaysia can hope for is that the Fed will be able to guide the economy to a soft landing.
But a soft landing is increasingly unlikely because inflation does not fade away. It ends with a recession or when people throw away their credit cards and stop spending on borrowed money.
Even if inflation is tamed, the rate hikes so far have caused upheavals in the financial markets and wealth destruction. This has led to a fall in asset prices, the closure of businesses and layoffs. The inevitable economic slowdown or recession is hard to evade.
M Shanmugam is a contributing editor at The Edge
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