This article was first published as an op-ed in The Business Times on November 10, 2023.

The post-pandemic era has been very challenging for central bankers worldwide. With the return of high inflation in 2022 after two decades of calm and serenity, “higher for longer” has become a new theme as the US Federal Reserve vowed to fight inflation. This has sent the US dollar soaring and emerging-market (EM) currencies plunging.

Asian EMs, which were just coming out of a pandemic downturn, were caught between a rock and a hard place: tightening policy to contain inflation which could derail the nascent economic recovery, or maintaining an accommodative policy to support growth which could lead to accelerating inflation.

In addition, the region was faced with downside risks to growth from a potential downturn in the United States and Europe, as the Fed and the European Central Bank jacked up their policy rates to anchor inflation.

Bank Negara Malaysia (BNM) has not been as aggressive in raising the policy interest rate to fight inflation, with only a cumulative hike of 125 basis points between May 2022 and now. Yet, growth has been robust with relatively moderate inflation, as indicated in Asean+3 Macroeconomic Research Office’s 2023 Annual Consultation Report on Malaysia.

Like other small open economies, Malaysia was hit hard by high global commodity and food prices. At the same time, the ringgit has been kept broadly at par with other regional currencies despite relatively low interest rates.

How did the country manage to contain inflation without keeping monetary policy so tight as to stifle growth? The answer lies in a skillful mix of policy measures.

A well-coordinated use of monetary policy, fiscal policy, foreign exchange (FX) intervention, as well as macroprudential and capital flow management measures can help policymakers address several concurrent, and seemingly conflicting, macroeconomic goals without relying on a single tool such as monetary policy.

Malaysia, along with other countries in the region (such as Indonesia, the Philippines and Thailand), had decades of practical experience on the policy mix before it was conceptualized as the Integrated Policy Framework by the International Monetary Fund.

Both monetary and fiscal policies were coordinated to help contain inflationary pressure. The use of fiscal measures—broad-based fuel and electricity subsidies and price controls on food staples—has moderated inflationary pressures from the supply side, especially from rising global energy and food prices.

At the same time, the hike in policy interest rate helped dampen demand-pull inflation and stabilized inflation expectations. Given that the rate hike was gradual and measured, the momentum of the economic recovery was maintained.

The gradual approach in raising the policy interest rate resulted in widening interest rate differentials between Malaysia and the US, which put downward pressure on the ringgit vis-a-vis the dollar. As a tool to address excessive volatility in the ringgit, BNM used FX intervention through the purchase or sale of the US dollar, as reflected in changes in BNM’s international reserves.

A policy mix sounds great, but what’s the catch?

An effective and well-planned policy mix requires close coordination between the monetary and fiscal authorities and sufficient policy space and buffer. For instance, the total fiscal expenditure on fuel subsidy in 2022 amounted to RM50.8 billion (S$14.7 billion) or 2.8 per cent of Malaysia’s gross domestic product (GDP)—half of the fiscal deficit in 2022. Similarly, FX intervention, especially during periods of sustained downward pressure on the ringgit, contributed to a drawdown on international reserves.

Without sufficient fiscal space and reserve buffer, the use of fiscal policy and FX intervention could lead to undesirable consequences in terms of fiscal sustainability and external stability.

In the design of an appropriate policy mix, the nature of shocks and policies’ potential side effects need to be assessed. For instance, the sources of inflation could be demand-pull or cost-push, which need to be addressed by different tools.

For Malaysia, the broad-based increase in inflation in 2022 was driven by both the supply side—rising energy and food prices—as well as the demand side, which was pent-up spending induced by the economic reopening. As a result, both monetary and non-monetary measures were used, with policy rate hikes to dampen demand pressures and blanket subsidies, as well as price controls to curb increases in food and fuel prices.

Bearing in mind the side effects of subsidies on the fiscal position, the Budget for 2023 reflected a policy shift from fiscal expansion to consolidation with the aim to narrow the fiscal deficit to 3.2 per cent in 2025 from 5.6 per cent of GDP in 2022. The recently tabled Budget for 2024 is a resumption of the government’s commitment to ensure long-term fiscal sustainability.

Addressing short-term challenges should not be at the expense of long-term goals. While a policy mix can help address short-term inflation and growth concerns, long-term structural challenges call for structural reforms to enhance competitiveness.

The Malaysian authorities are encouraged to continue efforts to attract high-quality domestic and foreign direct investments, strengthen their workforce’s skills to boost Malaysia’s digital economy to be a new driver of development, improve the adequacy and coverage of social protection, and implement policies to incentivize the shift to a low-carbon economy.

The country’s New Industrial Master Plan 2030 and National Energy Transition Roadmap are welcome steps that reflect the government’s commitment to address structural issues and pave the way for economic transformation.