Bank Indonesia's move last week to raise for a fourth straight time its benchmark interest rate by a quarter of a percentage point to 9 percent sent a strong message to the market that it is serious about anchoring inflation expectations.
Since inflation has increased at the fastest pace in nearly two years, due to the 29 percent increase in domestic fuel prices last May and the consequent cascading impact on prices of other goods and services, such a consistent, strong signal from the central bank is necessary, especially in view of the annual Islamic fasting month beginning in early September and Idul Fitri celebrations in early October.
However, the mere quarter percentage point rise also told the market that, despite its determination to tame inflation, the central bank is doing its best to minimize the negative impact of the tight money policy on economic growth. Hence, the gradual interest rate increase since June.
Consumer prices jumped 11.9 percent in July. Food costs increased 19.9 percent, the highest in more than a decade.
The business community, of course, cried out against the central bank policy but such a bold move will show the market the bank is determined to check inflation, which is projected to average between 11.5 and 12.5 percent for the whole year.
Bank Indonesia wants to quell people's expectation of higher inflation as there is a direct relation between inflation and exchange rates. Unexpectedly higher inflation will depress the rupiah's exchange rate, further increasing inflationary pressures from imports.
High inflation not only adversely affects investment and business operations, as it makes reasonable risk calculation almost impossible, but also hits hardest those on low or fixed incomes.
Moreover, Bank Indonesia will find it nearly impossible to maintain the stability of the rupiah exchange rate in a high-inflation environment. Fortunately though, the rupiah strengthened significantly during the past few weeks, thereby reducing inflationary pressures from imports and allowing the central bank to continue its gradual rate increase.
The seven-percentage point difference now between our interest rate and the U.S. federal funds rate is quite attractive, if not to stimulate new capital flow then to retain portfolio investment, thus helping stabilize the rupiah rate.
Bank Indonesia Governor Boediono has repeatedly assured the public that the central bank will deploy all means at its disposal to check price pressures to bring inflation down to between 6.5 percent and 7.5 percent in 2009.
This does not, however, mean the economy will continue to grow robustly as it did last year, when it expanded at a rate of 6.3 percent.
Even before inflationary pressures began to affect the economy immediately after the 29 percent increase in fuel prices last May, the economic outlook had soured due to the weakening global economy and the international credit crunch, caused by the U.S. subprime mortgage crisis.
Bank Indonesia acknowledged last week that our economic growth might have slowed down, comparing year to year, to a mere 6 percent in the second quarter from 6.3 percent in the first quarter. Comparing year to year, the economy had expanded by between 6.1 and 6.5 percent every quarter since the last quarter of 2006.
The weakening global economy has depressed international demand for Indonesian commodities, as evidenced by the decline in exports during the past two months.
Moreover, inflation has been eroding people's purchasing power, depressing household consumption and reducing business confidence.
Even more worrisome is that the prospect of economic growth has worsened due to crumbling infrastructure. The acute electricity shortage has forced rotating power blackouts in many areas and caused many businesses to reduce production. Utterly poor road conditions are affecting the distribution of goods in many provinces, increasing costs.
However painful it may seem, in view of the weakening economy, the central bank's tight money policy is just the right medicine to maintain macroeconomic stability, the prerequisite for economic growth.
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