Back to basics in monetary policy<\/p>\n
This is the first of two articles on monetary policy by
\nTubagus Feridhanusetyawan, senior economist and head of economic
\naffairs at the Centre for Strategic and International Studies
\n(CSIS) in Jakarta.<\/p>\n
JAKARTA (JP): Inflation will reach 11 percent year-on-year
\nthis May and recent trends suggest inflation will continue to
\nrise. Fuel and electricity prices are expected to increase by 30
\npercent and 20 percent respectively in the next few months to
\nmaintain the government's fiscal deficit at a sustainable level.<\/p>\n
The prices of transportation, utilities and other services
\nwill also increase very soon, and the pressure for higher
\ninflation is definitely on the rise. With prolonged political and
\neconomic uncertainty, the risk premium for all financial assets
\nis high and the capital inflow that could prevent the rupiah from
\ndepreciating is not likely to be forthcoming.<\/p>\n
In fact, Indonesia's net capital outflow is expected to
\ncontinue while exports are weakening, depleting foreign reserves.
\nThe demand for foreign currency remains high as a result of both
\nprecautionary actions and real underlying transactions such as
\ndebt repayments and trade financing activities.<\/p>\n
A prolonged depreciation of the rupiah and higher import
\nprices would create additional inflationary pressure. So without
\npolicy action we are facing double-digit inflation this year.<\/p>\n
Bank Indonesia (BI) has announced that it will tighten the
\nmoney supply and conduct some discretionary interventions in the
\ncurrency market if necessary.<\/p>\n
Due to increasing political uncertainty and rapidly growing
\nbase money in the beginning of the year when the rupiah was still
\nbelow Rp 10,000 per US dollar, the policy options seem simple:
\nincrease the interest rate really fast or let the rupiah fall to
\nthe 12,000 level. It is clear that interest rate rises have been
\nvery slow, the rupiah remains around Rp 11,000 to Rp 12,000 per
\nUS dollar and the clear trend of depreciation continues.<\/p>\n
The Bank Indonesia Certificate (SBI) rate is more than 16
\npercent now, and BI has acknowledged selling part of its foreign
\nreserves to support the rupiah, but none of this seems to be
\neffective.<\/p>\n
Prolonged uncertainty has made direct intervention in the
\nmarket ineffective and costly, and interest rate increases so far
\nseem to be too little too late. The deposit rates at major banks
\nare about 12.5 percent, while the unpublished negotiated rate for
\nlarge depositors could be as high as 14 percent to 15 percent.<\/p>\n
After correcting with the 20 percent tax on interest income,
\nand with more than 11 percent annual inflation this month, the
\nreal interest rate is close to zero or even negative. It is not
\nsurprising that people are converting their rupiah to US dollars
\non a daily basis, and with the absence of significant capital
\ninflow this conversion is financed by the depletion of foreign
\nreserves at BI.<\/p>\n
How tight is a tight policy?<\/p>\n
Some BI officials say the money policy is tight enough to
\ncontrol inflation, but loose enough to maintain the momentum of
\neconomic recovery. Academically speaking, this means that BI
\ncould fix the money supply and let the interest rate float, or
\nset the interest rate and let the money supply adjust -- but
\ndefinitely cannot do both at the same time.<\/p>\n
There is a clear negative relationship between money supply
\nand the interest rate, but there are several channels through
\nwhich money supply and interest rate equilibriums can affect
\ninflation. First, any excess supply of money leads to higher
\ninflation.<\/p>\n
But there is another channel, as a lower interest rate leads
\nto capital outflow, a weaker currency and then higher inflation.
\nWhether targeting the interest rate or the money supply works
\nbetter in controlling inflation is actually an empirical
\nquestion.<\/p>\n
Therefore the increase in administered prices, such as for
\nfuel and electricity, will not necessarily lead to higher
\ninflation if BI can keep the money growth low enough, or the
\ninterest rate high enough. For a fixed supply of money, any
\nincrease in money demand will lead to higher interest rate,
\nlarger capital inflow and a stronger rupiah, and therefore
\ninflationary pressure will not be permanent.<\/p>\n
But what is the appropriate target for money growth during the
\nperiod of high inflationary pressure this year? During the boom
\ndays of the early 1990s, BI could maintain single digit inflation
\nby letting the base money grow at about 20 percent, and the
\ninterest rate at about 15 percent, because the rupiah was strong
\nand imported inflation was low due to massive capital inflow.
\nAny excess supply of money was basically absorbed by the rapid
\neconomic growth and by the conversion to foreign currencies.<\/p>\n
The current situation is totally different. Economic growth is
\nexpected to slow to between 3 percent and 3.5 percent this year,
\nthe capital account is showing a net outflow rather than inflow
\nand imported inflation is high due to rapid rupiah depreciation,
\nso it will be impossible to achieve single digit inflation by
\nmaintaining the base money growth at 20 percent.<\/p>\n
Based on a simple rule of thumb, with 3.5 percent economic
\ngrowth, BI should maintain less than 12.5 percent base money
\ngrowth to keep inflation below 9 percent. In fact, a pure
\nmonetarist would argue that the targeted inflation rate of 9
\npercent could only be achieved by maintaining base money growth
\nat 9 percent.<\/p>\n
The growth of base money has been more than 17 percent
\nyear-on-year since May last year, even though the one month SBI
\nrate has increased from about 11 percent to more than 16 percent
\nover the last 12 months. If we were consistent with the base
\nmoney targets set in the letter of intent signed with the
\nInternational Monetary Fund last year, the base money should be
\nbelow Rp 100 trillion now.<\/p>\n
But the base money has been well above Rp 100 trillion since
\nthe end of November 2000, which means that the monetary policy
\nhas not been tight enough. By looking at the experience of the
\nlast two years, the base money target in the letter of intent
\nitself has been growing, and it remains unclear who is to blame,
\nthe IMF or Bank Indonesia, for the increasing target.<\/p>\n
One thing is clear now: The interest rate has to go up, faster
\nand higher, or the level of the base money target has to be
\nreduced. The period of high interest rate does not have to be
\nlong, and the rate could then decline when the inflationary
\npressure ceases. In fact, the period of high interest rate in
\n1998 and early 1999 was relatively short before inflation could
\nbe contained.<\/p>\n
But not everyone is happy with the higher interest rate, of
\ncourse. Some commercial banks might be in trouble if the interest
\nrate goes up further to about 20 percent or more. Some
\nrecapitalized banks that have large amounts of fixed-rate
\ngovernment bonds are in trouble because of the growing negative
\ninterest-rate spread.<\/p>\n
Higher interest rates could also lead to higher levels of
\nnonperforming loans and lower capital adequacy ratios. So the
\nbankers are nervous about higher interest rates. Higher interest
\nrates and the possibility of a second banking recapitalization
\nwould also lead to a higher fiscal deficit, so the government
\ncould also be in trouble.<\/p>\n
The private sector would definitely complain about any
\nincrease in interest rates, even though they should only be
\nconcerned about the real interest rate -- which is actually close
\nto zero or even negative.<\/p>\n
Are capital controls an alternative?<\/p>\n
An argument against higher interest rates also comes from the
\nnotion that the movement of the exchange rate seems to be less
\nsensitive to the movement of money supply when there is so much
\nuncertainty. During normal times, higher interest rates and a
\ntighter money supply would attract more capital inflow leading to
\na stronger rupiah. But when there is so much political and social
\nuncertainty, the increase in the interest rate has to be very
\nhigh to attract significant capital inflow.<\/p>\n
One can show here that the movement of the exchange rate, at
\nleast in the very short run, is a function of political news
\nrather than economic fundamentals. Both precautionary and
\nunderlying demands for foreign currency remain high despite high
\ndomestic interest rates.<\/p>",
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