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.