Coping with high inflation

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.