Base money must remain steady to curb inflation

Base money must remain steady to curb inflation

Ross H. McLeod, Canberra

The inflation data released by the Central Bureau of
Statistics (BPS) at the beginning of this month have caught
everybody by surprise. The reported inflation rate through
October was almost 18 percent, far in excess of forecasts.

In September, it had been just over 9 percent. The drastic
increase in fuel prices at the beginning of October is seen as
the main culprit, although the increasing demand for consumer
goods in anticipation of the end of the Muslim fasting month has
also been mentioned.

The reported inflation rate is so high as to cause some
skepticism regarding its accuracy. In particular, prices in the
transport sub-component are reported to have risen by as much as
68 percent in the year to October, and this seems implausible,
for two reasons.

First, it is difficult for transport service providers to push
their prices up fully to cover big increases in their costs in
the very short run, partly because of decision making inertia and
partly because consumers are likely to resist. Yet the BPS
website suggests that its sample of transport service prices for
October was collected in only the first 10 days of the month.

Second, although average fuel prices have risen by a little
less than 200 percent (29 percent in March and 126 percent in
October), fuel is said to constitute only about 20 percent of
overall transport costs (the major costs being that of the
capital and labor employed).

On this basis transport costs should be expected to rise
eventually by about 40 percent at most. When the consumer price
index is split into its major components and particular sub-
components, we can see that the biggest contributor to the 18
percent inflation figure is fuel-related items (transport, and
the fuel, electricity and water subcomponent of the housing cost
index), at 8.3 percent.

But food items (including processed food, beverages and
tobacco products) contributed almost as much, at 7.1 percent. In
other words, the two fuel price hikes account directly for a
little less than half of inflation overall, while food items,
whose prices have been rising increasingly rapidly for several
months, account for almost as much.

This raises a question about the underlying causes of
inflation, which is important when we come to consider the
appropriate policy response. In the absence of shocks to the
economy such as the recent big increase in fuel prices, inflation
is the result of poor monetary policy. Specifically, if the
central bank allows the money supply to grow more rapidly than
the public's demand for money, the value of money falls -- that
is, the average price of goods and services rises.

In this case, it is entirely appropriate to tighten up
monetary policy. But if inflation is simply the temporary
consequence of a sudden increase in the price of a particular
commodity such as fuel, it is not necessary to tighten monetary
policy because a return to low inflation will occur automatically.

With large increases in fuel prices raising the average level
of prices, the demand for money on the part of the public
increases: people need more cash to fill their tanks, for
example. In the absence of any accommodating increase in the
supply of money, this will put downward pressure on all of the
other (non-fuel) prices, especially of goods and services that
have relatively low fuel inputs.

Production of these items will tend to contract, since more of
the national income is now having to be spent on fuel. In other
words, although a short-term spike in the average price level was
inevitable as a result of the huge fuel price increases, high
inflation would not be sustained over time because other prices
would move in the opposite direction.

If, however, the central bank decides to tighten monetary
policy, ignoring the market mechanism that will come into play
automatically, this will have an economy-wide contractionary
impact on top of the negative impact of the fuel price increases,
resulting in a quite unnecessary slowdown in growth.

Having said all this, it is necessary to return to the
observation that food prices were already increasing at an
accelerating rate before the fuel price increases were
introduced. Inflation overall had risen from 7.4 percent in May
to 9.1 percent in September. Bank Indonesia (BI) recognized
belatedly that its monetary policy had been too loose, and began
edging interest rates up from about April. The problem, however,
is that it does not really have any clear idea as to how far it
should go.

Although interest rate increases in recent months suggest
monetary tightening, the reality is otherwise. The supply of
currency-- money created by the central bank -- has actually been
growing quite rapidly. By June its growth rate had fallen to less
than 10 percent p.a., but this was not able to be maintained. By
September it was growing as rapidly as 16 percent p.a. At this
rate, inflation of the order of 10 percent is pretty much
inevitable. It is hardly surprising, then, that inflation has
been on an upward trend.

BI reacted immediately to the announcement of the October
inflation rate by increasing its interest rate to 12.5 percent,
following a series of increases in the last few months. But is
this the appropriate setting for monetary policy now? The honest
answer to that is that nobody knows.

Some months back the central bank opted for using interest
rates as its instrument of monetary policy, despite having
virtually no idea what interest rate will be compatible with low
inflation. Indeed, this has been a problem for some years now.

Although BI pretended for the last several years to be using
the money growth rate as its instrument of policy, its own data
show clearly that it has always been far more concerned to
control interest rates than money growth.

The consequences of this unfortunate policy choice become more
and more obvious with every passing month.

Decades of data on money and inflation, for both Indonesia and
its neighbors, show clearly that the way to keep inflation under
control is to keep the rate of growth of base money slow and
steady, and to be prepared to let interest rates move around in
order to achieve this. It is time for BI to acknowledge this
reality.

The writer is the Editor of the Bulletin of Indonesian
Economic Studies.