Inflation pressures loom as Bank Indonesia keeps policy rates on hold

BI is expected to lower rates further, but an economist believes this will eventually necessitate a policy reversal.

On 12 January 2012 Leif Eskesen, Chief Economist for India and ASEAN at HSBC, reported:

Facts
Bank Indonesia today kept the key policy rate (reference rate) unchanged at 6.00% as expected by us and a small majority among economists.

The statement, as it did last time, notes that the current policy rate is consistent with the inflation target for the next two years, safeguarding financial stability, and supporting domestic demand in the context of global economic uncertainty.

On the global backdrop, the Board saw global economic conditions weakening as a consequence of the "protracted crisis in Europe" and expected to see further monetary accommodation globally as inflation pressures eased, including commodity prices.

Turning to the domestic economy, the Board remains upbeat about the outlook. Growth for 2011 is still expected to reach 6.5%, in line with our forecast, and for 2012 the statement restated the forecast of 6.3-6.7% and a further increase to 6.4-6.8% in 2013.

Growth will be supported by private consumption and investment, with investment also getting a "boost" as a consequence of the achievement of investment grade. Inflation is predicted to remain within the target range of 4.5%±1% in both 2012 and 2013.

In the forward guidance, the statement reads verbatim: "Bank Indonesia will continue to optimize the role of monetary policy in boosting economic capacity, maintaining financial market stability, and mitigating the impacts of global economic slowdown, while at the same time anchoring inflation expectation.

"Going forward, Bank Indonesia will continue to strengthen the policy mix through interest rate response, exchange rate policy, macro-prudential policies for capital flows management, macro-prudential policies for liquidity management, and policy coordination with the government."

Implications
Today's pause was expected and welcome. The domestically oriented economy does not need further growth insurance given the domestic orientation of the economy, the already accommodative monetary policy settings, and the associated upside risks to inflation further down the road.

From the BI's perspective, it likely wanted to pause to digest the impact of the aggressive cuts delivered so far. In addition, the BI was likely somewhat reluctant to cut considering the weaker exchange rate and the associated upward pressures through imported inflation.

Looking ahead, we believe that the BI remains keen to cut policy rates further and the forward guidance certainly suggests as much, albeit the translation reads a bit cryptic.

Moreover, with the current policy rate at 6% and BI's mid-target for inflation at 4.5%, the real policy rate would be at the high end of BI"s assumed real neutral policy rate (0.5-1.5) over the policy horizon.

Assuming that BI also anticipates an appreciation of the exchange over the next 6-12 months, this will likely in BI's view imply further room for cuts.

Consequently, we expect that the BI will lower rates by 50 bps during H1 this year, although potential downward pressures on the currency are likely to make BI cautious about rate cuts in the short term.

However, we believe that policy rates at current or even lower levels will ultimately stoke inflation. It's here worth keeping in mind that the economy is already operating above its potential, according to our estimates, and that growth is only expected to slow to around its potential (our 2012 forecast is 6.1%) given the resilience of the domestic growth engine.

This basically means that the output gap is not likely to close even as growth eases in 2012, leaving underlying inflation pressures firmly in place. Moreover, the floods in Thailand could add to upward pressures on food prices and there may be adjustments to electricity/fuel prices later in the year.

Moreover, the weakened currency doesn't help either. This is why we expect inflation to creep up during the course of 2012 and average 5.7% for the year as a whole.

In turn, in our view, this means that the BI will likely have to change course and begin to raise rates, but this is likely not going to happen until next year.

Bottom line: The BI kept rates on hold to allow itself some time to digest the impact of the aggressive rate cuts undertaken so far.

Moreover, concerns about potential inflationary pressures associated with the depreciated currency likely also played a role. But, we expect that BI will lower rates further in H1 2012, although this will, in our view, ultimately build up inflation pressures and necessitate a policy reversal.