T

he year 2011 marks the sixth anniversary of the adoption of fully fledged Inflation Targeting (IT) as a monetary policy framework in Indonesia.

IT divides the work of monetary policy into three broad aspects: a short-term operating target, intermediate and final targets. Bank Indonesia (BI) has instrument independence, the BI rate, and intervenes in open-market operations (OMOs) to ensure that the amount of liquidity in the market supports the movement of the overnight interbank rate toward the BI rate.

The central bank seeks to fulfill its short-term operating target so as to hit the intermediate target of inflation — forecast in the form of an inflation target formalized in a finance minister’s decree.

These measures are intended to help BI acheive its goal of maintaining the stability of the rupiah.

Scrutinizing the performance of BI in this framework by solely looking at its ability to meet the inflation target, one can conclude that BI’s track record is far from perfect.

There has only been one year, 2007, when BI succeeded in keeping inflation within its targeted band. But there is not much discussion about how these frequent deviations from the inflation target affect the credibility of BI, since the inflation target is set by the government, albeit it is in consultations with BI.

Analyzing deeper into the time-series data of quarterly GDP growth and CPI during the four years before and after Indonesia adopted the fully fledged IT framework, the results from the mean of those variables show that Indonesia has seen higher growth performance and lower inflation during the IT period.

Hence, the country does not need to sacrifice its growth to attain lower inflation. It seems IT has brought buoyancy to the Indonesian economy.

However, the standard deviation in the inflation rate was relatively higher under the IT system than in the previous period.

This volatility was largely driven by deliberate adjustments in fuel subsidy policy. When oil prices climbed above US$50 per barrel in 2005, this created a large burden on the state budget.

Thus, the government decided to increase fuel prices by 87.5 percent. As headline inflation soared to a level far above the targeted range, BI responded by increasing the BI rate, which reached its highest level, at 12.75 percent, in December 2005.

BI reacted in a similar manner, again tightening the economy with the BI rate nearing its peak of 9.5 percent, when the government further reduced the fuel subsidy after oil prices climbed above $100 per barrel in 2008.

This sequence of events — the government reducing its fuel subsidies and then the central bank increasing its benchmark rate — sparked doubts over BI’s instrument independence.

It sent out a signal that the government could easily steer and influence the BI rate by adjusting its fiscal policy.

While the fiscal policy law limits the state budget deficit to 3 percent of GDP and a government debt/GDP ratio of less than 60 percent, the issue in fiscal framework is intertwined with monetary policy.

The government has a tendancy to “dump” the burden of its fuel subsidies through upward adjustments in fuel prices whenever world oil prices show an extreme increase.

Subsequently, BI would have to react by tightening monetary policy to counterbalance an abrupt change in inflation.

In such situations, the economy would further contract, employment levels would shrink and BI runs the risk of responding to merely temporary fluctuations in inflation.

The use of core inflation in the long run, which strips off the volatility components (i.e. food, energy and government-administered prices), could prevent such policy mistakes.

Supported by clear communication strategies, this move could help to anchor inflation expectations when the Consumer Price Index (CPI) increases temporarily and core inflation remains unchanged.

When the public understands that BI targets core inflation, they will realize that BI does not need to respond aggressively to a rise in domestic fuel prices caused by a reduction of government fuel subsidies.

As Frederic Mishkin, a former member of board of governors at the Fed, pointed out, with a well communicated use of core inflation, the public will be less likely to think that the central bank has weakened its commitment to curb inflation when it does not pursue tightening monetary policy to stabilize transitory shock in headline inflation.

Therefore, the inflation expectations will be relatively better anchored. This may lead to better outcomes in not only inflation but also employment levels as the central bank does not need to suppress the economy during the incidence of supply-shock.

The transition to applying core inflation in the current IT framework needs to be prepared well.

The recommendation is for a longer term implementation, as BI and the government must communicate the policy changes to the public and it may take time for the public to fully comprehend the nature of core inflation.

Their understandings about core inflation — which components it includes and which it does not — will play an important role in shaping their inflation expectations.

BI can learn from the Bank of Thailand’s experience in targeting core inflation.

Nonetheless, the learning points should adopted with caution given the different historical monetary framework in Thailand, which started the use of core inflation even in its initial period.

The writer is a postgraduate student at Lee Kuan Yew School of Public Policy, at the National University of Singapore.