Careful policy mix is critical now

Kahlil Rowter Jakarta

Without doubt 2005 was a turbulent year. The rupiah and gross domestic product (GDP) growth fell substantially while inflation and interest rates rose dramatically. Late policy responses caused the crisis to spread from microeconomic to macroeconomics. Therefore policy adjustments caused a shock to the system. The situation has since stabilized, and confidence in economic management has resurfaced. It is now time to synchronize macro policies to allow for quick turnaround in inflation which will provide room for expansionary policies.

What took place?

The rise in international oil prices caused the initial shock to the economy. Excess demand for U.S. dollar from Pertamina caused the Rupiah to slide. And exchange rate pass-through did the rest to raise domestic prices. Meanwhile, domestic fuel price hike became unavoidable due to the huge cost of fuel subsidy. Hence domestic prices got another cost induced shock. With the rise in inflation, the central bank started to tighten, resulting in rising interest rates. Economic growth declined as demand fell on lowered purchasing power. To top these off, government spending was delayed, causing an inadvertent fiscal induced contraction.

Should we be surprised?

Were these shocks a surprise and ensuing adjustments inevitable?

I argued in The Jakarta Post in October 2004 that the new government then had 70 days until the end of 2004 to work on the budget and adjust the crucial oil price assumption. It was not until March that this to took place. By then fuel price hike already entered inflationary expectations.

The March adjustment itself was deemed insufficient, causing further rise in inflationary expectations which accumulated until another adjustment in October, this time to a more realistic level. But with the buildup in expectations, massive hoarding resulted in frequent "disappearance" of fuel especially kerosene in many regions. Kerosene was the most lucrative to speculate on as it had the highest potential percentage price rise.

Oil shock, therefore, is not something unavoidable or even surprising. It has been long in the making. A more decisive move and less public debate on the issue could have avoided most of the unnecessary predicament.

A trouble which started rather small, one commodity in this case, but unresolved, became a macroeconomic issue. Questions started surfacing on fiscal sustainability and snowballed onto credibility of the government overall economic program. And rising inflation without a decisive early move from the central bank also resulted in questions on monetary policy stance. So people voted with their wallet.

They pulled money first from government bond based mutual funds, and then from the Rupiah. From another angle this can be seen as shifting funds from the long end of the yield curve to the short, and switching currencies to a safer haven although luckily most of this foreign currency deposits are still onshore.

And now?

Both the government and BI have now done the hard part in shifting their key policy levers. It is unfortunate that policy makers must choose between price stabilization and economic slowdown. Handling both only nullifies each other. Taming inflation inevitably results in slower growth, while stimulating growth entails flaring up inflationary pressure.

With its stabilization mandate, BI is doing its part in soaking up liquidity and hiking key interest rates. The government raised fuel prices and put back its fiscal deficit in line within a prudent range.

But these stabilization measures are very expensive. In an inter-temporal sense, the economy is paying for its past indulgences. But most people discount the future (and the past) more than the present; hence the pain now is severe. Only a sufficiently large promised future gain can overcome this. But promising too much now actually defeats the stabilization policies.

Take the case of inflation. Raising interest rates should curb spending and encourage savings. Hence the pullback from consumption should limit and eventually reverse inflationary trend. And hiking the cost of capital discourages investment, which is another form of demand. But this only works if people believe that high interest levels will remain sufficiently long. Otherwise consumers may well not delay spending financed by borrowing. And investments may become conceivable as long as the returns justify paying high interest rate for only a short period.

In short when the threat of expensive cost of borrowing is not credible, its impact on reducing demand will be limited. Only a credible central bank (credible in the sense of willing to sacrifice growth for price stability) can persuade agents to reduce demand sufficiently.

The commitment of the government to fight inflation by slowing down the economy is even more questionable. Beset by political pressure, most governments would rather have a higher than trend inflation along with higher real growth. Governments also have an economic incentive to run a higher level of nominal economic growth. After all tax revenues are based on nominal income while inflation reduces the real value of debt. Generally, the correlation of nominal growth with revenues is larger than expenditures. Hence a higher nominal growth will reduce deficits leaving more room to spend on politically favorable items.

This brings us to the crux of the necessary policy mix in the current economic cycle. It must be acknowledge, perhaps not publicly, that economic growth must be sacrificed in the short term for the sake of reducing inflation. Once inflation has stabilized pro-growth measures can be introduced.

The central bank has done its part, although lately it begins to exhibit reluctance to raise rates dramatically, citing a flexible rather than strict adherence to inflation targeting. One reason has to be its cost constraint. The other is fear of jeopardizing financial stability.

We must now pin hope on the government to do its part to also restrain from spending too much in early 2006, especially with funds carried over from 2005. If it does so, the direction of inflationary expectations, already on the way down, could be reversed.

Studies show that government spending impacts regional inflation more than monetary factors. Therefore, a restraint on spending by regional governments, however painful, is a necessary step in maintaining the declining inflationary path.

The government should also coordinate well with BI the timing and magnitude of the inevitable hikes in minimum wages and electricity tariffs. The former will raise inflation by raising production cost.

However the impact on demand should be limited as raising wages merely returns a small measure of purchasing power back onto the hands of workers. The latter will raise inflation through its impact mainly on households rather than industry which have seen its electricity tariff increased since 3Q05.

It is laudable that besides budgetary impact on inflation the government is also looking into ways to reduce structural rigidities especially supply constraints enabling investment to pick up without causing demand-pulled inflation.

Bottom line

Slower economic growth in a period of rising inflation needs careful, decisive and well coordinated policies. Until recently the quality of public decision making left much to be desired, especially its risk management features. This has led to shocks to the system and questions about the overall economic program.

With the two hikes in domestic fuel prices, government budget sensitivity to oil shocks have now been substantially reduced. Mandiri Sekuritas estimates that missing a few key 2006 assumptions, but still within consensus forecast, would not jeopardize the budget in a big way.

Confidence in the decisiveness of the leadership and fiscal sustainability have returned and need to be maintained. And the willingness and ability of BI to contain inflation has also been validated by raising interest rates. Although it remains to be seen how long negative real interest rates will not result in the weakening of the Rupiah.

In the future better risk management will be essential, and a set of contingency plans must be prepared for most eventualities.

Now both fiscal and monetary authorities must work ever closer to ensure that the policy of each is supported by the other. Otherwise inflation will be prolonged and recovery will have to wait even longer.

The writer is a lecturer at Economics Department of the University of Indonesia. This is a personal opinion.