Back to basics in monetary policy
This is the first of two articles on monetary policy by Tubagus Feridhanusetyawan, senior economist and head of economic affairs at the Centre for Strategic and International Studies (CSIS) in Jakarta.
JAKARTA (JP): Inflation will reach 11 percent year-on-year this May and recent trends suggest inflation will continue to rise. Fuel and electricity prices are expected to increase by 30 percent and 20 percent respectively in the next few months to maintain the government's fiscal deficit at a sustainable level.
The prices of transportation, utilities and other services will also increase very soon, and the pressure for higher inflation is definitely on the rise. With prolonged political and economic uncertainty, the risk premium for all financial assets is high and the capital inflow that could prevent the rupiah from depreciating is not likely to be forthcoming.
In fact, Indonesia's net capital outflow is expected to continue while exports are weakening, depleting foreign reserves. The demand for foreign currency remains high as a result of both precautionary actions and real underlying transactions such as debt repayments and trade financing activities.
A prolonged depreciation of the rupiah and higher import prices would create additional inflationary pressure. So without policy action we are facing double-digit inflation this year.
Bank Indonesia (BI) has announced that it will tighten the money supply and conduct some discretionary interventions in the currency market if necessary.
Due to increasing political uncertainty and rapidly growing base money in the beginning of the year when the rupiah was still below Rp 10,000 per US dollar, the policy options seem simple: increase the interest rate really fast or let the rupiah fall to the 12,000 level. It is clear that interest rate rises have been very slow, the rupiah remains around Rp 11,000 to Rp 12,000 per US dollar and the clear trend of depreciation continues.
The Bank Indonesia Certificate (SBI) rate is more than 16 percent now, and BI has acknowledged selling part of its foreign reserves to support the rupiah, but none of this seems to be effective.
Prolonged uncertainty has made direct intervention in the market ineffective and costly, and interest rate increases so far seem to be too little too late. The deposit rates at major banks are about 12.5 percent, while the unpublished negotiated rate for large depositors could be as high as 14 percent to 15 percent.
After correcting with the 20 percent tax on interest income, and with more than 11 percent annual inflation this month, the real interest rate is close to zero or even negative. It is not surprising that people are converting their rupiah to US dollars on a daily basis, and with the absence of significant capital inflow this conversion is financed by the depletion of foreign reserves at BI.
How tight is a tight policy?
Some BI officials say the money policy is tight enough to control inflation, but loose enough to maintain the momentum of economic recovery. Academically speaking, this means that BI could fix the money supply and let the interest rate float, or set the interest rate and let the money supply adjust -- but definitely cannot do both at the same time.
There is a clear negative relationship between money supply and the interest rate, but there are several channels through which money supply and interest rate equilibriums can affect inflation. First, any excess supply of money leads to higher inflation.
But there is another channel, as a lower interest rate leads to capital outflow, a weaker currency and then higher inflation. Whether targeting the interest rate or the money supply works better in controlling inflation is actually an empirical question.
Therefore the increase in administered prices, such as for fuel and electricity, will not necessarily lead to higher inflation if BI can keep the money growth low enough, or the interest rate high enough. For a fixed supply of money, any increase in money demand will lead to higher interest rate, larger capital inflow and a stronger rupiah, and therefore inflationary pressure will not be permanent.
But what is the appropriate target for money growth during the period of high inflationary pressure this year? During the boom days of the early 1990s, BI could maintain single digit inflation by letting the base money grow at about 20 percent, and the interest rate at about 15 percent, because the rupiah was strong and imported inflation was low due to massive capital inflow. Any excess supply of money was basically absorbed by the rapid economic growth and by the conversion to foreign currencies.
The current situation is totally different. Economic growth is expected to slow to between 3 percent and 3.5 percent this year, the capital account is showing a net outflow rather than inflow and imported inflation is high due to rapid rupiah depreciation, so it will be impossible to achieve single digit inflation by maintaining the base money growth at 20 percent.
Based on a simple rule of thumb, with 3.5 percent economic growth, BI should maintain less than 12.5 percent base money growth to keep inflation below 9 percent. In fact, a pure monetarist would argue that the targeted inflation rate of 9 percent could only be achieved by maintaining base money growth at 9 percent.
The growth of base money has been more than 17 percent year-on-year since May last year, even though the one month SBI rate has increased from about 11 percent to more than 16 percent over the last 12 months. If we were consistent with the base money targets set in the letter of intent signed with the International Monetary Fund last year, the base money should be below Rp 100 trillion now.
But the base money has been well above Rp 100 trillion since the end of November 2000, which means that the monetary policy has not been tight enough. By looking at the experience of the last two years, the base money target in the letter of intent itself has been growing, and it remains unclear who is to blame, the IMF or Bank Indonesia, for the increasing target.
One thing is clear now: The interest rate has to go up, faster and higher, or the level of the base money target has to be reduced. The period of high interest rate does not have to be long, and the rate could then decline when the inflationary pressure ceases. In fact, the period of high interest rate in 1998 and early 1999 was relatively short before inflation could be contained.
But not everyone is happy with the higher interest rate, of course. Some commercial banks might be in trouble if the interest rate goes up further to about 20 percent or more. Some recapitalized banks that have large amounts of fixed-rate government bonds are in trouble because of the growing negative interest-rate spread.
Higher interest rates could also lead to higher levels of nonperforming loans and lower capital adequacy ratios. So the bankers are nervous about higher interest rates. Higher interest rates and the possibility of a second banking recapitalization would also lead to a higher fiscal deficit, so the government could also be in trouble.
The private sector would definitely complain about any increase in interest rates, even though they should only be concerned about the real interest rate -- which is actually close to zero or even negative.
Are capital controls an alternative?
An argument against higher interest rates also comes from the notion that the movement of the exchange rate seems to be less sensitive to the movement of money supply when there is so much uncertainty. During normal times, higher interest rates and a tighter money supply would attract more capital inflow leading to a stronger rupiah. But when there is so much political and social uncertainty, the increase in the interest rate has to be very high to attract significant capital inflow.
One can show here that the movement of the exchange rate, at least in the very short run, is a function of political news rather than economic fundamentals. Both precautionary and underlying demands for foreign currency remain high despite high domestic interest rates.