Bank Indonesia (BI), as predicted by analysts, decided Thursday to up its base interest rate by 25 points to 8.50 percent to try to dampen anticipated inflationary pressures after the 30 percent increase in fuel prices on May 24.
Even though most analysts expected a tighter monetary position, the rate increase -- the first policy decision made by Boediono since taking over leadership of the central bank last month -- could still make him unpopular among politicians.
Tightening monetary policy by increasing lending rates is a difficult and unpopular decision to make when the purchasing power of most people is being eroded by strong inflationary pressure triggered by the fuel price increases. The central bank is caught between a rock and hard place.
However, that is the kind of strong and independent attitude we expect from the central bank, especially under Boediono's leadership, even against the backdrop of the upcoming presidential and parliamentary elections. The central bank should have the courage to take tough monetary measures, even at the risk of irritating politicians and the government, so long as such moves are prudent for the long-term good of the economy.
Rising inflation over the last five months has been pushed by steep increases in food and oil prices and not triggered by monetary policy. Tightening money supply could increase business risks as companies have to struggle with higher costs amid weakening market demand.
But the central bank has to make this bold move to show the market it is really serious about checking inflation, which is projected at between 11.5 and 12.5 percent for 2008, or about double last year's inflation.
The main purpose of the June 5 measures is therefore to lower expectations of higher inflation, rather then acting directly upon it. Higher-than-expected inflation depresses the rupiah exchange rate, further increasing inflationary pressures from imports.
All in all, the decision to increase the BI rate was unavoidable since inflation is rising faster than expected. Under tighter monetary conditions, increases in food and transportation prices could be offset by price falls in other sectors, keeping inflation under control.
We don't think the June 5 measure will be the last monetary tightening measure this year. There will still be a series of incremental increases within the next few months as the economy absorbs the impact of last month's fuel price increases with its knock-on effect on the prices of other goods and services.
Given the double impact of costlier oil and food and weakening global economic growth, the central bank's decision gives the right signal because the greatest concern now is to strengthen the stability of the consumer price index and currency market.
A highly volatile market is not conducive for business, and with more than one-third of foreign reserves as short-term foreign money and more than 80 percent of private savings comprising deposits of between one and three months, one can imagine how vulnerable our financial market can be to speculative attacks.
The cascading impact of high oil and food prices, sharp depreciation of the rupiah and a weakening world economy could lead our economy into another downward spiral.
But the interest rate differential -- now 6.50 percentage points -- between the United States Fed funds rate and BI Rate seems high enough to at least retain the foreign portfolio (short-term) investment in rupiah assets, notably government bonds and BI debt papers.
| 
|
|
|
|
|
|
|