At this stage of the market cycle, we believe there is still room for Bank Indonesia (BI) to further cut interest rates, particularly given that the June consumer price index (CPI) came in at 3.45 percent year-on-year (yoy), below our expectation of 3.6 percent yoy. This is still on track to achieve our 2016 full-year inflation target of 3.9 percent (exhibit 1).

The June CPI rose 0.66 percent month-on-month (mom), significantly lower than last year’s Ramadhan-related inflation (July 2015: 0.93 percent mom), supported by lower staple foods inflation of 1.62 percent mom (July 2015: -2.02 percent) on such commodities as onions and tomatoes, while other components were still on the rise with clothing rising 0.7 percent mom (July 2015: 0.39 percent yoy) and processed foods were up 0.58 percent mom (July 2015: +0.51 percent).

Note that the government has recently decided to allow private importers to import secondary cuts of beef and offal (jeroan) in an attempt to stabilize beef prices. Previously, lower grade secondary cuts of beef and offal were allowed to be imported only by state-owned enterprises, while the private sector was allowed to import lower grade beef only for hotels, restaurants and cafes. With the change in regulation, secondary beef can be distributed by private firms to households.

We believe this is a positive step to ease inflationary pressure on the ground going forward. As a result, we expect that this will encourage BI to continue its loosening cycle.

From the global perspective, recent accommodative policy post-Brexit has already triggered the yields of 10-year US Treasury bills to record low at 1.36 percent, leaving a wider real-yield spread between Indonesia and the US, allowing BI to further cut rates.

The last time this low US T-bill yield occurred was in 2012 (exhibit 2) when Indonesia’s inflation was about 4 percent with the BI rate at the time having reached an all-time low of 5.75 percent. We believe this situation would be favorable for further capital inflows and limited currency depreciation risk going forward.

Under this changing global dynamic, we revise down our interest rate forecast with the seven-day reverse repo rate to be at 4.5 percent at year-end, 75 basis points (bps) lower than the 5.25 percent at present, translating to a lower 10-year government bond yield target of 6.5 percent at year-end from the current level of 7.2 percent (exhibit 3).
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The writer is an economist at Bahana Securities.

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