Major central banks have indicated their intention to persist with their present stance, favoring a policy of higher-for-longer interest rates in an effort to rein in persistently elevated inflation levels that have stubbornly exceeded the desired target.

Despite halting the increases in the Federal Funds Rate (FFR) during the June meeting of the Federal Open Market Committee (FOMC), the United States Federal Reserve has indicated that two additional hikes could still occur above 5.25 percent if inflationary pressures fail to abate.

The inflation rate in the US has gradually declined from its peak, dropping from 9.1 percent in June 2022 to 4.0 percent in May 2023. However, it continues to persist above the targeted inflation rate of 2 percent.

In its June meeting, the European Central Bank (ECB) made the decision to further raise its main refinancing operation rate to 4 percent, the highest level since the 2008 Global Economic Crisis, despite the European bloc entering a technical recession in the first quarter of 2023.

The ECB also revised its inflation forecast for this year and expressed its intention to continue raising the rate in the July 2023 meeting. The inflation rate in the eurozone has steadily declined from its peak, dropping from 10.6 percent in October 2022 to 6.1 percent in May.

Nevertheless, it remains significantly higher than the ECB's target of 2 percent.

From this, the following question emerges: To what extent will the persistently elevated inflation in the major economies exert influence on Indonesia's inflation rate?

Is it incumbent upon Bank Indonesia (BI) to align its actions with those of major central banks and continue raising the benchmark rate? How would this affect Indonesia's economic growth potential?

There exist at least three factors that exert an influence on BI’s determination of the direction of its benchmark rate, the BI 7-day Reverse Repo Rate (BI-7DRRR).

These factors are the domestic inflation rate, the state of Indonesia's external sector as demonstrated by the current account balance and the prevailing global economic conditions, primarily associated with the trajectory of global interest rates. The first factor plays a major role in the decision-making process, given Indonesia's adoption of the Flexible Inflation Targeting Framework (Flexible ITF).

In May, Indonesia witnessed a noteworthy decline in its annual inflation rate, reaching 4.00 percent year-on-year (yoy). This figure marked the lowest level observed in a span of 12 months.

The decrease in the inflation rate was more pronounced than expected, following the 5.95 percent yoy inflation rate in September 2022 amid the government's decision to adjust the prices of subsidized fuel. This notable decline is attributed to the manageable levels of food inflation, which demonstrated the smallest increase in 14 months in May of this year.

For the first time, the inflation rate has entered the upper end of the target range set by BI, which aims for a range of 2 percent to 4 percent. This development is noteworthy as, for the preceding 11 months, the inflation rate remained above the targeted range.

Should the inflation rate continue to be effectively managed and remain within the desired range going forward, the room for raising the BI-7DRRR, which is currently at 5.75 percent, could be limited.

Consequently, from this standpoint, BI will be able to sustain its present monetary stance, which is prioritizing stability and fostering economic growth.

Does the persistently high inflation rate in major countries exert any significant influence on Indonesia’s inflation rate? The probability appears exceedingly low, given the existing downward trajectory of global food prices and the deflationary trend observed in global energy commodities. The elevated inflation rates observed in these countries primarily stem from inflationary pressures associated with the service sector, correlating with heightened public mobility, rather than internationally tradeable commodities.

Amid the looming risk of sluggish global economic growth, there has been a discernible downward trajectory in commodity prices. This, in turn, has resulted in a weakening of Indonesia's external sector performance, as evinced by the reduction in the current account surplus from 1.27 percent of the gross domestic product (GDP) in the final quarter of 2022 to 0.89 percent of GDP in the initial quarter of 2023.

It is likely that this surplus will continue to diminish in the future. Although May 2023 marked the 37^th consecutive month of a trade surplus, it dwindled to a mere US$440 million, representing the smallest trade surplus since April 2020.

Yet, it is still expected that the current account will register a minor surplus or a tolerable deficit for the entire year of 2023, as the decline in commodity prices will be more gradual for several reasons, namely China's economic reopening, OPEC+ oil production cut, lower production of some commodities amid a high probability of El Niño this year and an easing global energy crisis.

This still could provide some measure of support for external sector stability.

While it holds true that the disparity between the FFR and BI-7DRRR tends to diminish, thereby heightening the apprehension of the capital outflow risk from Indonesia, it is anticipated that BI will exercise caution in promptly addressing the Fed's latest perspective.

The ramifications of FFR transmission will manifest more prominently via fluctuations in government bond yields. If the yield on the 10-year Indonesian government bond continues to decline and nears the 6 percent threshold, there exists no imperative for BI to raise the BI-7DRRR.

Furthermore, the real rate or the difference between the nominal interest rate and the inflation rate of Indonesia’s financial instruments, continues to exhibit a positive trend and surpasses that of the United States. Indonesia's assets consequently retain their comparative allure and profitability.

In conclusion, to ensure that monetary policy remains effectively aligned with supporting the economic recovery, it is imperative for the government to adopt advanced strategies for maintaining a stable and resilient food supply and for BI to exhibit heightened vigilance and adaptability in response to the ever-evolving global economic landscape, which remains fraught with substantial levels of uncertainty and complexity.

*****

The writer is an economist at Bank Mandiri.

Popular

Jakarta's minimum wage bump faces disappointed laborers

Profound budget policy changes failed to lift growth in 2025

Yearender: Police reform met with doubt amid persistent brutality, impunity