Coping with high inflation

The steep rise in inflation to a six-year high of 8.70 percent in October, or an annual rate of almost 17.90 percent, is imposing formidable challenges for fiscal and monetary management.

Inflation was expected to be high during October due to the combination of the more than 120 percent average increase in the prices of kerosene, gasoline and automotive diesel oil, with its multiplier impact on the prices of other goods and services, and also because of the Islamic fasting month, which usually sees the highest monthly rise in the consumer price index.

The 8.70 percent increase in the consumer price index in October that brought cumulative inflation for the 10 months of the year to 15.65 percent was nonetheless a painful surprise, being double official estimates. The inflationary pressures will most likely continue, though at a weaker pace, for the next two months, but the year could still end with cumulative inflation at more than 17 percent.

The central bank responded immediately to the disclosure of the inflation rate last Tuesday by raising its short-term benchmark interest rate (BI Rate) from 11 to 12.25 percent.

Minister of Finance Jusuf Anwar acknowledged last week that higher interest rates would certainly affect the state budget because of the huge domestic debts of the government. He estimated that for every one percentage point rise in interest rates, the interest costs would add more than Rp 650 trillion (US$65 billion) to the budget.

Businesses, which have been severely hit by the fuel price increases, will be dealt another blow from higher interest rates. Not only will demands for new loans fall sharply; more credit could turn sour as companies try to survive amid the cascading impacts of general price increases and higher costs of capital.

Certainly, high inflation not only adversely affects investment and business operations, as it makes reasonable risk calculation very difficult; it also hits the poor, and people on fixed, low incomes, as their purchasing power is quickly eroded.

Moreover, it is also extremely difficult for Bank Indonesia to maintain stability in the rupiah exchange rate in a high- inflation environment.

Since the U.S. Federal Reserve will likely continue to increase its interest rates to as high as 4 percent by the end of this year, the central bank is facing a dilemma with regard to its monetary management.

True, raising interest rates is not always effective in curbing inflation, especially because the high inflation last month was by no means a monetary phenomenon. The enormously strong inflationary pressures were caused almost entirely by the sharp hikes in administered prices (i.e. fuel prices).

However, Bank Indonesia has still to tighten its monetary policy in anticipation of higher interest rates in the United States, otherwise portfolio investors may shift their investment in rupiah securities to dollar assets, thereby setting off pressures on the rupiah.

The biggest challenge for Bank Indonesia therefore is to strike a balance in maintaining interest rate differentials high enough to prevent capital flight to dollar assets, and yet not so high as to choke businesses with punitively tight credit and bad loan risk. Depressed business conditions and a rising rate of bad loans could jeopardize economic growth expectations and consequently put downward pressure on value of the rupiah and set off a vicious circle within the economy.

But monetary measures alone, however good they may be, are certainly not enough to cope with the strong inflationary pressures, which will certainly continue, though at a slower pace, over the next three to four months.

The government should act firmly in implementing the package of fiscal incentives and reform measures, which were launched in conjunction with the fuel price increases last month in a concerted bid to remove high-cost factors from the economy.

The deregulation measures in the trade and transportation sectors are especially urgent and imperative for businesses to cut costs in order to partly offset the steep rises in fuel prices and their multiplier impacts on the prices of other goods and services.

The minister of transportation's decision last week to slash terminal handling charges on 20-foot containers from US$150 to $95 per box and 40-foot containers from $230 to $145 and the processing fee for bills of lading from $30 to $40 per document to only around $10, is a good start. But many more similar measures are needed to help businesses weather the extremely difficult conditions ahead.