Back to basics in monetary policy

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are about 12.5 percent, while the unpublished negotiated rate for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.