Bank Indonesia’s (central bank) decision last Monday to keep its policy interest rate unchanged at 6.5 percent for the 11th consecutive month was the right monetary measure and in line with market expectations because the stronger inflationary pressures last month had nothing to do with demand.
The upward trend in the prices of daily basic needs over the past weeks was not a monetary phenomenon that should be addressed with a monetary measure because the price rises were a temporary problem caused by the disruption of supplies due to weather anomalies.
The surge in the monthly inflation rate to 0.97 percent last month was caused also by inefficient logistics that increased distribution costs.
Moreover, within that policy rate offshore interest in Indonesian bonds continued to rise, with foreigners now owning more than 26 percent of outstanding rupiah government bonds. Year to date, according to Barclays Capital analysts, offshore investors have bought Rp 54 trillion (US$5.96 billion) of bonds. In the month of June alone, foreigners bought Rp 17.96 trilllion of bonds, their highest level of buying in the past five years.
The solid fundamentals of the country also have turned investor sentiment more positive on Indonesian assets of late, leading to the market repricing risk on government bonds.
But we do not agree with the view of the central bank’s acting Governor Darmin Nasution who simply dismissed concerns over likely stronger inflationary pressures within the next few months.
The combination of the impact of the 10 percent increase in basic electricity rates for middle and big households and industrial consumers starting this month and the seasonally high consumer demand during the Islamic Ramadan and Idul Fitri celebrations in August and September will force Bank Indonesia to rethink its inflation target this year of 5 percent, plus or minus one percentage point.
Even though core inflation remains manageable at around 4 percent at present due partly to the dampening effect of the strong rupiah, inflation will continue to grind higher, as core prices rise in line with stronger domestic demand.
This challenge will place the central bank on a delicate balancing act of setting its benchmark interest rate at such a level to make it still attractive to portfolio investors who want to gain from the interest rate differential. But at the same time the rate should still be low enough so as not to whip up inflation expectations or jeopardize the central bank’s bid to lower lending rates of commercial banks and to stimulate credit growth to 22-24 percent this year.
However, Bank Indonesia alone is not able to check inflation and bring down lending rates, still considered as one of the main factors that make Indonesian products less competitive overseas.
The government should continue to make significant improvement in its basic infrastructures to decrease logistics (distribution costs) and step up concerted efforts to address its structural issues that have daunted the Indonesian economy and made business risks extremely high.
The inefficient and oligopolistic market structures caused by over-regulation, which protects incumbent large companies, have hindered investment growth and caused low productivity and inefficiency in production factors. This in turn has led to supply side rigidities that hamper response to macro stimulus policies.