Malaysia's inflation is forecast to come under control, despite the central bank's prediction that it will reach a 10-year high in 2008.
Combined with a range of other factors, inflation could reach of 4.2% for 2008, the Bank Negara forecast, well above its 2.5%-3% target.
However, the central bank expects the annual rate to peak at 5% in June and to decrease steadily thereafter, falling to less than 3% in the third quarter - hence its calm interest rate outlook.
Year-on-year inflation hit 3% in April 2008, with food and beverage prices rising 5.7% in the same period.
Inflation is rising globally as the cost of oil, food and construction materials have soared, partly on the back of the growth of larger emerging markets like Malaysia's.
Nevertheless, this figure compares favourably against its neighbours. Indonesia's inflation is predicted by some analysts to top 12% in 2008, Indian inflation is riding a 13-year high of 11% and Thailand's rate was 7.8% in May.
The governor of Bank Negara, Zeti Akhtar Aziz, said on June 16 that raising interest rates might not be necessary if the institution's inflation forecast is correct. However, the bank will retain a vigilant stance and increase the base rate from the current 3.5% if necessary.
On June 5, the government raised petrol and diesel pump prices by 41% to $0.87 a litre, and by 63% to $0.80 a litre, respectively. The move is intended to shift fuel prices towards market levels, conserve hydrocarbon resources and reduce the growing deficit in the national budget.
Besides the direct effect of a rapid increase in staple fuels, the increases are likely to feed through into inflation indirectly though higher transport costs for goods.
Malaysian Prime Minister Abdullah Ahmad Badawi recently warned the World Economic Forum on East Asia of a 'real disaster' if governments ignored the consequences caused by price rises, particularly for the poor.
Considering these worldwide pressures and domestic fuel price rises, an annual inflation rate of 4.2% is perhaps not excessive. Conversely, with the central bank's policy rate at 3.5%, real interest rates could turn negative if spreads narrow, something the authorities will probably wish to avoid, due to the erosion of savings and given the enticement to borrow.
The rising inflation rate has caused the government to scale back some large infrastructure projects. For instance a planned high-speed rail link from Kuala Lumpur to Singapore and the construction of a bridge between Penang and Peninisula Malaysia have been put on hold. The change in plans has been blamed on inflation pushing up the price of construction materials and fuel.
The authorities' decision to re-evaluate these projects may be good news, as the investments due to be made could contribute to inflation through demand-pull on labour and construction costs.
Nonetheless, Zeti is confident that fiscal and monetary policy remains on the right track.
She asserted that the inflationary squeeze on the poor and sectors such as agriculture, at risk from the fuel price hike, can be alleviated. "Right now, we do not see any critical developments," she said. "The Government has the capacity to deal with both rising prices and how they impact certain target groups."
One of the reasons why Malaysia's inflation rate has remained below that of its neighbours is the policy of subsidising many staples, such as bread, flour and rice.
These subsidies remain in place. Yet over the medium to long term, the government could look to apply its market pricing logic to these commodities as well.
But for the time being, radical subsidy cuts - whatever the market rationale behind them - look politically impossible and economically risky, as they will feed through into higher inflation.
