Careful policy mix is critical now

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.