Base money must remain steady to curb inflation<\/p>\n
Ross H. McLeod, Canberra<\/p>\n
The inflation data released by the Central Bureau of
\nStatistics (BPS) at the beginning of this month have caught
\neverybody by surprise. The reported inflation rate through
\nOctober was almost 18 percent, far in excess of forecasts.<\/p>\n
In September, it had been just over 9 percent. The drastic
\nincrease in fuel prices at the beginning of October is seen as
\nthe main culprit, although the increasing demand for consumer
\ngoods in anticipation of the end of the Muslim fasting month has
\nalso been mentioned.<\/p>\n
The reported inflation rate is so high as to cause some
\nskepticism regarding its accuracy. In particular, prices in the
\ntransport sub-component are reported to have risen by as much as
\n68 percent in the year to October, and this seems implausible,
\nfor two reasons.<\/p>\n
First, it is difficult for transport service providers to push
\ntheir prices up fully to cover big increases in their costs in
\nthe very short run, partly because of decision making inertia and
\npartly because consumers are likely to resist. Yet the BPS
\nwebsite suggests that its sample of transport service prices for
\nOctober was collected in only the first 10 days of the month.<\/p>\n
Second, although average fuel prices have risen by a little
\nless than 200 percent (29 percent in March and 126 percent in
\nOctober), fuel is said to constitute only about 20 percent of
\noverall transport costs (the major costs being that of the
\ncapital and labor employed).<\/p>\n
On this basis transport costs should be expected to rise
\neventually by about 40 percent at most. When the consumer price
\nindex is split into its major components and particular sub-
\ncomponents, we can see that the biggest contributor to the 18
\npercent inflation figure is fuel-related items (transport, and
\nthe fuel, electricity and water subcomponent of the housing cost
\nindex), at 8.3 percent.<\/p>\n
But food items (including processed food, beverages and
\ntobacco products) contributed almost as much, at 7.1 percent. In
\nother words, the two fuel price hikes account directly for a
\nlittle less than half of inflation overall, while food items,
\nwhose prices have been rising increasingly rapidly for several
\nmonths, account for almost as much.<\/p>\n
This raises a question about the underlying causes of
\ninflation, which is important when we come to consider the
\nappropriate policy response. In the absence of shocks to the
\neconomy such as the recent big increase in fuel prices, inflation
\nis the result of poor monetary policy. Specifically, if the
\ncentral bank allows the money supply to grow more rapidly than
\nthe public's demand for money, the value of money falls -- that
\nis, the average price of goods and services rises.<\/p>\n
In this case, it is entirely appropriate to tighten up
\nmonetary policy. But if inflation is simply the temporary
\nconsequence of a sudden increase in the price of a particular
\ncommodity such as fuel, it is not necessary to tighten monetary
\npolicy because a return to low inflation will occur automatically.<\/p>\n
With large increases in fuel prices raising the average level
\nof prices, the demand for money on the part of the public
\nincreases: people need more cash to fill their tanks, for
\nexample. In the absence of any accommodating increase in the
\nsupply of money, this will put downward pressure on all of the
\nother (non-fuel) prices, especially of goods and services that
\nhave relatively low fuel inputs.<\/p>\n
Production of these items will tend to contract, since more of
\nthe national income is now having to be spent on fuel. In other
\nwords, although a short-term spike in the average price level was
\ninevitable as a result of the huge fuel price increases, high
\ninflation would not be sustained over time because other prices
\nwould move in the opposite direction.<\/p>\n
If, however, the central bank decides to tighten monetary
\npolicy, ignoring the market mechanism that will come into play
\nautomatically, this will have an economy-wide contractionary
\nimpact on top of the negative impact of the fuel price increases,
\nresulting in a quite unnecessary slowdown in growth.<\/p>\n
Having said all this, it is necessary to return to the
\nobservation that food prices were already increasing at an
\naccelerating rate before the fuel price increases were
\nintroduced. Inflation overall had risen from 7.4 percent in May
\nto 9.1 percent in September. Bank Indonesia (BI) recognized
\nbelatedly that its monetary policy had been too loose, and began
\nedging interest rates up from about April. The problem, however,
\nis that it does not really have any clear idea as to how far it
\nshould go.<\/p>\n
Although interest rate increases in recent months suggest
\nmonetary tightening, the reality is otherwise. The supply of
\ncurrency-- money created by the central bank -- has actually been
\ngrowing quite rapidly. By June its growth rate had fallen to less
\nthan 10 percent p.a., but this was not able to be maintained. By
\nSeptember it was growing as rapidly as 16 percent p.a. At this
\nrate, inflation of the order of 10 percent is pretty much
\ninevitable. It is hardly surprising, then, that inflation has
\nbeen on an upward trend.<\/p>\n
BI reacted immediately to the announcement of the October
\ninflation rate by increasing its interest rate to 12.5 percent,
\nfollowing a series of increases in the last few months. But is
\nthis the appropriate setting for monetary policy now? The honest
\nanswer to that is that nobody knows.<\/p>\n
Some months back the central bank opted for using interest
\nrates as its instrument of monetary policy, despite having
\nvirtually no idea what interest rate will be compatible with low
\ninflation. Indeed, this has been a problem for some years now.<\/p>\n
Although BI pretended for the last several years to be using
\nthe money growth rate as its instrument of policy, its own data
\nshow clearly that it has always been far more concerned to
\ncontrol interest rates than money growth.<\/p>\n
The consequences of this unfortunate policy choice become more
\nand more obvious with every passing month.<\/p>\n
Decades of data on money and inflation, for both Indonesia and
\nits neighbors, show clearly that the way to keep inflation under
\ncontrol is to keep the rate of growth of base money slow and
\nsteady, and to be prepared to let interest rates move around in
\norder to achieve this. It is time for BI to acknowledge this
\nreality.<\/p>\n
The writer is the Editor of the Bulletin of Indonesian
\nEconomic Studies.<\/p>",
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