As inflation surprised on the upside for the third consecutive month, surging at 7.02 percent last month on a year-on-year basis and up by 0.9 percent on a monthly basis from 0.7 percent in December, Bank Indonesia is coming under stronger pressure to tighten money policy.
Persistently bucking the upward trend in interest rates occurring in other major Asian economies may spark inflation fears and strengthen the downward pressures on the rupiah and on the Indonesian stock market, which thus far this year has lost more than 10 percent.
However, if the central bank significantly raises the benchmark interest rate at its monthly open market-operation meeting scheduled today (Friday) that could damage prospects of accelerated lending expansion to fuel the targeted 6.4 percent economic growth this year. Tightening credit may also dampen investor interest in the stock market on fears of declining corporate earnings.
On a positive note, however, core inflation decelerated slightly to 4.18 percent, signaling that substantial monetary tightening is not urgent because the consumer price rise last month was driven mainly by administrative prices and not by consumer demand.
The central bank last month launched measures to tighten liquidity in the economy by requiring banks to set aside more cash as reserves, including increasing the statutory reserve requirement (both rupiah and foreign currency), lengthening the tenure of Bank Indonesia Certificates (SBIs) and imposing restrictions on banks’ short-term external borrowing.
The dilemma, seen from the psychology of market sentiment, is that although core inflation remains an important component for policy rate deliberations, the central bank cannot simply ignore the blunt fact that domestic inflation expectations have already risen for three consecutive months. If this expectation is not checked, capital outflow could run at a faster rate.
On the one hand, Indonesia is confident the price of rice is expected to begin declining significantly next month with the onset of the harvest season. On the other hand, however, fuel prices will most likely continue to increase on fear of supply disruptions, one of the potential impacts of the crisis in Egypt. In addition, the government intends to limit private cars’ access to subsidized fuel — meaning raising gasoline prices for the majority of fuel consumers – beginning this April.
These developments will keep the pressure on the central bank to raise its rate to address market concerns and to send a convincing signal that it is serious about containing inflation.
However, we still expect Bank Indonesia to hold to its 6.5 percent policy rate, set since August 2009, waiting for further developments this month and in March, before deciding to gradually tighten its monetary stance.
Even though the downward pressures on the stock market may increase as more skittish foreign portfolio investors unload their rupiah assets to shift to other markets promising higher returns, a stable policy rate, at least for another month, would still be better than an immediate hike, except for a token rise of only 25 basis points.
