Why not to increase our interest rates at a time like this

Helmi Arman ,  Analysis   |  Thu, 04/10/2008 11:24 PM  |  Business

Last week, Indonesia's bond and equity markets were taken by surprise. The government announced that consumer prices rose by nearly 1 percent during the month of March, far above the figures estimated by economists.

Compared to the same month a year earlier, the consumer price index in March is up by 8.2 percent, above Bank Indonesia's benchmark policy rate (BI rate) of 8.0 percent.

Accordingly, many have been wondering how likely it is for Bank Indonesia to raise interest rates, i.e. as part of efforts to rein-in inflation. In a further spook to the markets, a senior central bank official has hinted such a possibility to the media.

In shedding light on how things will evolve, it is useful to analyze how this surge in inflation came about. The required policy response to cost-push inflation should be different from that of demand-pull inflation.

The former, often due to shocks in prices of goods used in production, is mostly regarded as temporary, and mainly does not need a monetary policy response. The latter, which is due to excessive growth in aggregate demand and money supply, has a more persistent dimension and often requires a tightening of monetary policy.

While there have been signs aggregate demand has been improving in recent years, it appears to fall short of being excessive. Economic growth increased from 5.5 percent last year, but only moderately to 6.3 percent in 2007.

Meanwhile, Indonesia's M1 money supply (the common proxy for transactions) has been growing at a rate close to 22 percent per annum. This is higher than the growth rate of nominal GDP which stands at 19 percent, however it is still far below the 40 percent surges seen in the 1990s.

From a more micro perspective, it is also interesting to consider how net profit margins at the company level are doing. If aggregate demand has been growing excessively, firms would have been more able to raise prices without inducing a fall in demand for their products.

Thus in such conditions, one would expect to see net profit margins widen as firms increase their profitability.

How does the evidence on the ground hold in this regard? We looked at net profit margins of 11 of Indonesia's biggest listed consumer goods and retail companies (in terms of sales).

The data in general does not appear to show substantial increases in profit margins. On the contrary, the average net profit margin for these companies actually declined to 6.9 percent, from 7.1 percent in 2006.

Note that in level terms profit margins are still far below the double digit figures seen in the pre-crisis era, when aggregate demand was undoubtedly growing excessively.

So the notion that recent surges in inflation are caused by demand-pull pressures, while not totally invalid, does not seem very convincing. There is considerable concern that a rate hike conducted at this juncture could be superfluous.

Perhaps the more visible link between monetary policy and inflation right now is through the exchange rate. What needs to be monitored is a severe depreciation of the rupiah relative to the dollar and other currencies.

This is because depreciation directly raises the domestic currency price of imported goods, and hence the inflation rate. To the extent that any depreciation occurs as a result of capital outflows, a policy rate hike may well be needed to prevent further declines.

But even in this sense, the risk of depreciation should not be overemphasized. The rupiah's value against the dollar has been quite stable, and Indonesia's foreign reserve is still increasing at a sturdy rate.

In March alone it grew by nearly US$1.9 billion or 3.3 percent. This means the current pressure on the rupiah is actually for it to appreciate, not to depreciate.

It should not be taken for granted either, that Indonesia's policy rate is currently significantly higher than interest rates in the U.S. (which are now in the 2 percent range), and could further widen if the latter continues to cut rates.

Indonesia does not offer the highest short-term rates in the region, but does offer high interest rates coupled with a robust current account surplus.

Other high-yield countries such as Pakistan, India and even Australia offer higher rates, but their currencies are more inclined to depreciate. The current account balances in those countries are in negative territories.

Further justification is needed before the current monetary policy stance is altered. Raising domestic interest rates at this juncture may result in an overkill and even lead to excessive volatility down the road for the currency.

Given that global commodity prices are still fluctuating heavily, the country is in for some inflation turbulence ahead. Let's see if the policy-makers can ride it out.

The writer is an economist at Bahana Securities

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