Tightening money supply

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. ---------