Careful policy mix is critical now<\/p>\n
Kahlil Rowter
\nJakarta<\/p>\n
Without doubt 2005 was a turbulent year. The rupiah and gross
\ndomestic product (GDP) growth fell substantially while inflation
\nand interest rates rose dramatically. Late policy responses
\ncaused the crisis to spread from microeconomic to macroeconomics.
\nTherefore policy adjustments caused a shock to the system. The
\nsituation has since stabilized, and confidence in economic
\nmanagement has resurfaced. It is now time to synchronize macro
\npolicies to allow for quick turnaround in inflation which will
\nprovide room for expansionary policies.<\/p>\n
What took place?<\/p>\n
The rise in international oil prices caused the initial shock
\nto the economy. Excess demand for U.S. dollar from Pertamina
\ncaused the Rupiah to slide. And exchange rate pass-through did
\nthe rest to raise domestic prices. Meanwhile, domestic fuel price
\nhike became unavoidable due to the huge cost of fuel subsidy.
\nHence domestic prices got another cost induced shock. With the
\nrise in inflation, the central bank started to tighten, resulting
\nin rising interest rates. Economic growth declined as demand fell
\non lowered purchasing power. To top these off, government
\nspending was delayed, causing an inadvertent fiscal induced
\ncontraction.<\/p>\n
Should we be surprised?<\/p>\n
Were these shocks a surprise and ensuing adjustments
\ninevitable?<\/p>\n
I argued in The Jakarta Post in October 2004 that the new
\ngovernment then had 70 days until the end of 2004 to work on the
\nbudget and adjust the crucial oil price assumption. It was not
\nuntil March that this to took place. By then fuel price hike
\nalready entered inflationary expectations.<\/p>\n
The March adjustment itself was deemed insufficient, causing
\nfurther rise in inflationary expectations which accumulated until
\nanother adjustment in October, this time to a more realistic
\nlevel. But with the buildup in expectations, massive hoarding
\nresulted in frequent \"disappearance\" of fuel especially kerosene
\nin many regions. Kerosene was the most lucrative to speculate on
\nas it had the highest potential percentage price rise.<\/p>\n
Oil shock, therefore, is not something unavoidable or even
\nsurprising. It has been long in the making. A more decisive move
\nand less public debate on the issue could have avoided most of
\nthe unnecessary predicament.<\/p>\n
A trouble which started rather small, one commodity in this
\ncase, but unresolved, became a macroeconomic issue. Questions
\nstarted surfacing on fiscal sustainability and snowballed onto
\ncredibility of the government overall economic program. And
\nrising inflation without a decisive early move from the central
\nbank also resulted in questions on monetary policy stance. So
\npeople voted with their wallet.<\/p>\n
They pulled money first from government bond based mutual
\nfunds, and then from the Rupiah. From another angle this can be
\nseen as shifting funds from the long end of the yield curve to
\nthe short, and switching currencies to a safer haven although
\nluckily most of this foreign currency deposits are still onshore.<\/p>\n
And now?<\/p>\n
Both the government and BI have now done the hard part in
\nshifting their key policy levers. It is unfortunate that policy
\nmakers must choose between price stabilization and economic
\nslowdown. Handling both only nullifies each other. Taming
\ninflation inevitably results in slower growth, while stimulating
\ngrowth entails flaring up inflationary pressure.<\/p>\n
With its stabilization mandate, BI is doing its part in
\nsoaking up liquidity and hiking key interest rates. The
\ngovernment raised fuel prices and put back its fiscal deficit in
\nline within a prudent range.<\/p>\n
But these stabilization measures are very expensive. In an
\ninter-temporal sense, the economy is paying for its past
\nindulgences. But most people discount the future (and the past)
\nmore than the present; hence the pain now is severe. Only a
\nsufficiently large promised future gain can overcome this. But
\npromising too much now actually defeats the stabilization
\npolicies.<\/p>\n
Take the case of inflation. Raising interest rates should curb
\nspending and encourage savings. Hence the pullback from
\nconsumption should limit and eventually reverse inflationary
\ntrend. And hiking the cost of capital discourages investment,
\nwhich is another form of demand. But this only works if people
\nbelieve that high interest levels will remain sufficiently long.
\nOtherwise consumers may well not delay spending financed by
\nborrowing. And investments may become conceivable as long as the
\nreturns justify paying high interest rate for only a short
\nperiod.<\/p>\n
In short when the threat of expensive cost of borrowing is
\nnot credible, its impact on reducing demand will be limited. Only
\na credible central bank (credible in the sense of willing to
\nsacrifice growth for price stability) can persuade agents to
\nreduce demand sufficiently.<\/p>\n
The commitment of the government to fight inflation by slowing
\ndown the economy is even more questionable. Beset by political
\npressure, most governments would rather have a higher than trend
\ninflation along with higher real growth. Governments also have an
\neconomic incentive to run a higher level of nominal economic
\ngrowth. After all tax revenues are based on nominal income while
\ninflation reduces the real value of debt. Generally, the
\ncorrelation of nominal growth with revenues is larger than
\nexpenditures. Hence a higher nominal growth will reduce deficits
\nleaving more room to spend on politically favorable items.<\/p>\n
This brings us to the crux of the necessary policy mix in the
\ncurrent economic cycle. It must be acknowledge, perhaps not
\npublicly, that economic growth must be sacrificed in the short
\nterm for the sake of reducing inflation. Once inflation has
\nstabilized pro-growth measures can be introduced.<\/p>\n
The central bank has done its part, although lately it begins
\nto exhibit reluctance to raise rates dramatically, citing a
\nflexible rather than strict adherence to inflation targeting. One
\nreason has to be its cost constraint. The other is fear of
\njeopardizing financial stability.<\/p>\n
We must now pin hope on the government to do its part to also
\nrestrain from spending too much in early 2006, especially with
\nfunds carried over from 2005. If it does so, the direction of
\ninflationary expectations, already on the way down, could be
\nreversed.<\/p>\n
Studies show that government spending impacts regional
\ninflation more than monetary factors. Therefore, a restraint on
\nspending by regional governments, however painful, is a necessary
\nstep in maintaining the declining inflationary path.<\/p>\n
The government should also coordinate well with BI the timing
\nand magnitude of the inevitable hikes in minimum wages and
\nelectricity tariffs. The former will raise inflation by raising
\nproduction cost.<\/p>\n
However the impact on demand should be limited as raising
\nwages merely returns a small measure of purchasing power back
\nonto the hands of workers. The latter will raise inflation
\nthrough its impact mainly on households rather than industry
\nwhich have seen its electricity tariff increased since 3Q05.<\/p>\n
It is laudable that besides budgetary impact on inflation the
\ngovernment is also looking into ways to reduce structural
\nrigidities especially supply constraints enabling investment to
\npick up without causing demand-pulled inflation.<\/p>\n
Bottom line<\/p>\n
Slower economic growth in a period of rising inflation needs
\ncareful, decisive and well coordinated policies. Until recently
\nthe quality of public decision making left much to be desired,
\nespecially its risk management features. This has led to shocks
\nto the system and questions about the overall economic program.<\/p>\n
With the two hikes in domestic fuel prices, government budget
\nsensitivity to oil shocks have now been substantially reduced.
\nMandiri Sekuritas estimates that missing a few key 2006
\nassumptions, but still within consensus forecast, would not
\njeopardize the budget in a big way.<\/p>\n
Confidence in the decisiveness of the leadership and fiscal
\nsustainability have returned and need to be maintained. And the
\nwillingness and ability of BI to contain inflation has also been
\nvalidated by raising interest rates. Although it remains to be
\nseen how long negative real interest rates will not result in the
\nweakening of the Rupiah.<\/p>\n
In the future better risk management will be essential, and a
\nset of contingency plans must be prepared for most eventualities.<\/p>\n
Now both fiscal and monetary authorities must work ever closer
\nto ensure that the policy of each is supported by the other.
\nOtherwise inflation will be prolonged and recovery will have to
\nwait even longer.<\/p>\n
The writer is a lecturer at Economics Department of the
\nUniversity of Indonesia. This is a personal opinion.<\/p>",
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