Tightening money supply

Bank Indonesia (BI) has tightened its monetary stance again as inflation seems to be rearing its ugly head amid the weakening rupiah against the American dollar, the steady rise in international oil prices to as high as US$64/barrel early last week and the increase in the U.S. Fed fund rate to 3.5 percent.

The latest monthly meeting of the central bank's board of governors last week decided to increase the BI Rate by 25 basis points to 8.75 percent to address what it called the rising expectation of inflation among the public.

Cumulative inflation in the first seven months of this year already reached almost 6 percent.

The upcoming inflationary pressures, as forecast by the central bank, should be so tremendously strong, otherwise it would not have changed the BI Rate at the risk of damaging the credibility of its inflation-targeting framework, which was launched in early July. The BI Rate was supposed to be effective as the nominal anchor for the central bank's monetary policy until the end of September.

The inflation- targeting framework, which relies heavily on inflation forecasts, aims monetary stance to influencing aggregate demands to be in line with the economic capacity from the supply side. Put in another way, the current monetary policy aims at achieving the inflation target by influencing the future rate of inflation through interest rates rather than monetary aggregates. This is the objective of the launching of the BI Rates in early July.

But the falling rupiah rate and rising oil prices are indeed powerful ammunition for inflationary pressure as international inflation is immediately transmitted to the domestic market through higher import prices. Inflationary pressure has been closely linked with exchange rate developments because tradable goods comprise more than 60 percent of the consumer price index.

The central bank explained that after closely monitoring the macroeconomic condition and its impact on the monetary prospects within the next few months, it foresaw higher inflation expectations among the general public, especially with the plans to raise administered prices of oil and electricity.

The rupiah depreciated by 0.83 percent to Rp 9,810 against the dollar in July, and this trend could escalate if the oil prices remain above $60 a barrel for the rest of the year because of market jitters about Indonesia's worsening balance of payment prospects.

If the government does not act immediately to raise significantly oil fuel prices, fuel subsidies for the whole year could explode to as high as Rp 130 trillion ($13 billion), or almost twice as large as the total budgeted by the government for the whole fiscal year. On the other hand, rising oil fuel prices will trigger a chain of price increases in most goods.

The central bank is indeed mired in a dilemma. Higher interest rates certainly are not the panacea to curb inflation because price rises are not always a monetary phenomenon, especially in Indonesia's case, where administered prices bear significant weight in the consumer price index.

However, Bank Indonesia should tighten its monetary policy in anticipation of a credit crunch in the United States, otherwise portfolio investors may shift their investment in rupiah securities to dollar assets, because the U.S. Fed is expected to steadily increase its Fund rates to as high as 4 percent by the end of this year from 3.50 percent at present. A weaker rupiah would set off even higher inflation expectations.

High inflation not only adversely affects investment and business operations, as it makes reasonable risk calculation almost impossible, but also hits hard the poor, the fixed, low income people. Moreover, it is impossible for Bank Indonesia to maintain the stability of the rupiah exchange rate in a high- inflation environment.

The abrupt change in the BI Rate would not therefore adversely affect the credibility of the central bank's inflation targeting framework. In view of the likely strong inflationary pressures, especially in anticipation of the expected increases in administered prices (such as oil and power prices), changing the BI Rate could instead make the monetary instrument a more reliable guidepost for the making of inflation expectation among the public.

Nevertheless, in view of the novelty of the inflation- targeting framework as a monetary instrument and the learning process for its application, it would be well-advised for the central bank to set the inflation target in a reasonable range, not as a single, hard target. This range should be wide enough to accommodate the uncertainty ahead regarding oil fuel and electricity prices and their impact on the prices of other goods. ---------