Supply-side economics
WINARNO ZAIN
RBI has just increased its lending rate to contain inflation. But, as
Winarno Zain argues in the context of Indonesia, a strictly monetarist approach to the crisis might not be
the way forward
The central bank of Indonesia (BI) is now contemplating how to contain inflation, which has jumped after the government raised fuel prices last month. The most commonly used instrument to contain inflation is increasing interest rates. But given that inflation this time is mostly due to spikes in food commodites and oil prices caused by temporary shocks in supply and speculation, questions arise about whether monetary tightening is warranted.
Tightening monetary policy could stoke economic growth, the last thing the country expects in the midst of a global slowdown. The expectation is that prices will soften as supply responds to higher prices and commodity prices drop off their year-on-year comparison.
Food prices account for 40-50 per cent of the consumer price index in emerging countries, including Indonesia (as opposed to 15 per cent in G7 countries). Food prices weigh in heavily on inflation expectation and could easily spill over to other commodities. As inflation expectation spreads, demands for wage increases grow stronger, risking a wage-price spiral.
Inflation expectation should be firmly anchored through tighter monetary policies by the central bank. But the question is, how tight? This question is tricky because the central bank not only has to strike a balance between containing inflation and maintaining economic growth but also has to consider the monetary condition that existed prior to the spurt in inflation. This should determine the degree of the monetary tightening required.
Inflation in most emerging economies is firmly embedded because it is the result of several forces that reinforce each other. At first, it was higher income from higher economic growth in China and India that boosted demands. Then supply shock followed as more agricultural resources were diverted into non-food production and oil production lagged behind the growing demand.
But inflation in emerging economies is aggravated by the loose monetary policies they have been following for several years. Broad money supply has been growing at an average of 20 per cent per annum, almost three times the growth in G7 countries.
Since 2003, nominal GDP growth accelerated faster than interest rates. Real interest rates have been kept low for political reasons, to spur growth.
In China, the real interest rate has been kept at minus 1 per cent for several years. Central banks in emerging countries have been urged by the IMF and the World Bank to significantly tighten monetary policies to contain inflation.
But the case for Indonesia is a little different. Unlike in other emerging economies, the monetary policies in Indonesia were not overly loose despite several rate cuts by the central bank since 2006. The growth of broad money supply, although escalating from 2006 to 2007, was still roughly in line with the growth of nominal GDP.
Last year, both nominal GDP and broad money supply grew at 19 per cent. Expressed in percentage of nominal GDP, its ratio declined from 47 per cent in 2003 to 42 per cent in 2007. Although BI has cut interest rates several times since 2006, bank lending rates are still above inflation and still the highest in the region.
Because monetary conditions in Indonesia are not overly loose, a drastic interest rate hike by BI would be excessive, endangering fragile economic growth. If BI perceives that the monetary condition in Indonesia is as loose as in other emerging economies, there is the risk that BI might "overshoot" increases in interest rates. Interest rates would be increased more than what is actually required.
Given the perceived market risk, the relationship between BI's benchmark rate and the market rate is not straightforward and inelastic, as evidenced after fuel price increase in 2006-2007. Between 2005-2007, when BI slashed its benchmark rates by 475 basis points, bank lending rates only dropped by 220 basis points.
This showed that when inflation cooled off, and BI was able to cut its interest rates, banks did not cut their rates as fast as BI cuts its rates, thus preventing a quick recovery in the economy. The same cycle will repeat itself this year.
Furthermore in a situation where capital is mobile, and where the US Federal Reserve is exercising caution in increasing rates, too high a rate increase by BI could attract too much capital inflow, increasing domestic liquidity and creating inflationary pressure, the very thing BI has vowed to fight.
BI should consider taking other measures to contain inflationary pressure besides tightening monetary policies. Intervention in the foreign exchange market should be conducted more aggressively for various reasons. The rupiah has been constantly depreciating several months. What's happening with the rupiah is an anomaly. At a time when other currencies in the region like the Singapore dollar, Malaysian ringgit and Thai baht are appreciating against the US dollar, the rupiah is weakening.
This is happening at a time when BI reserves have reached a record level every month, now standing at nearly $60 billion. The traumatic experience during the crisis in 1998 has taught BI to secure its reserve by accumulating as much as possible. But accumulating reserve is not done for the sake of accumulation alone. At some point the reserve should be used for the benefit of the national economy. If BI sells more US dollars to the market, the dollar would fall against the rupiah, softening the impact of imported inflation.
Because monetary policies could adversely affect growth, relying solely on monetary policies to contain inflation is too risky. That's why BI should pursue a more appropriate policy. (The writer is an economic analyst)
Winarno Zain argues in the context of Indonesia, a strictly monetarist approach to the crisis might not be
the way forward
The central bank of Indonesia (BI) is now contemplating how to contain inflation, which has jumped after the government raised fuel prices last month. The most commonly used instrument to contain inflation is increasing interest rates. But given that inflation this time is mostly due to spikes in food commodites and oil prices caused by temporary shocks in supply and speculation, questions arise about whether monetary tightening is warranted.
Tightening monetary policy could stoke economic growth, the last thing the country expects in the midst of a global slowdown. The expectation is that prices will soften as supply responds to higher prices and commodity prices drop off their year-on-year comparison.
Food prices account for 40-50 per cent of the consumer price index in emerging countries, including Indonesia (as opposed to 15 per cent in G7 countries). Food prices weigh in heavily on inflation expectation and could easily spill over to other commodities. As inflation expectation spreads, demands for wage increases grow stronger, risking a wage-price spiral.
Inflation expectation should be firmly anchored through tighter monetary policies by the central bank. But the question is, how tight? This question is tricky because the central bank not only has to strike a balance between containing inflation and maintaining economic growth but also has to consider the monetary condition that existed prior to the spurt in inflation. This should determine the degree of the monetary tightening required.
Inflation in most emerging economies is firmly embedded because it is the result of several forces that reinforce each other. At first, it was higher income from higher economic growth in China and India that boosted demands. Then supply shock followed as more agricultural resources were diverted into non-food production and oil production lagged behind the growing demand.
But inflation in emerging economies is aggravated by the loose monetary policies they have been following for several years. Broad money supply has been growing at an average of 20 per cent per annum, almost three times the growth in G7 countries.
Since 2003, nominal GDP growth accelerated faster than interest rates. Real interest rates have been kept low for political reasons, to spur growth.
In China, the real interest rate has been kept at minus 1 per cent for several years. Central banks in emerging countries have been urged by the IMF and the World Bank to significantly tighten monetary policies to contain inflation.
But the case for Indonesia is a little different. Unlike in other emerging economies, the monetary policies in Indonesia were not overly loose despite several rate cuts by the central bank since 2006. The growth of broad money supply, although escalating from 2006 to 2007, was still roughly in line with the growth of nominal GDP.
Last year, both nominal GDP and broad money supply grew at 19 per cent. Expressed in percentage of nominal GDP, its ratio declined from 47 per cent in 2003 to 42 per cent in 2007. Although BI has cut interest rates several times since 2006, bank lending rates are still above inflation and still the highest in the region.
Because monetary conditions in Indonesia are not overly loose, a drastic interest rate hike by BI would be excessive, endangering fragile economic growth. If BI perceives that the monetary condition in Indonesia is as loose as in other emerging economies, there is the risk that BI might "overshoot" increases in interest rates. Interest rates would be increased more than what is actually required.
Given the perceived market risk, the relationship between BI's benchmark rate and the market rate is not straightforward and inelastic, as evidenced after fuel price increase in 2006-2007. Between 2005-2007, when BI slashed its benchmark rates by 475 basis points, bank lending rates only dropped by 220 basis points.
This showed that when inflation cooled off, and BI was able to cut its interest rates, banks did not cut their rates as fast as BI cuts its rates, thus preventing a quick recovery in the economy. The same cycle will repeat itself this year.
Furthermore in a situation where capital is mobile, and where the US Federal Reserve is exercising caution in increasing rates, too high a rate increase by BI could attract too much capital inflow, increasing domestic liquidity and creating inflationary pressure, the very thing BI has vowed to fight.
BI should consider taking other measures to contain inflationary pressure besides tightening monetary policies. Intervention in the foreign exchange market should be conducted more aggressively for various reasons. The rupiah has been constantly depreciating several months. What's happening with the rupiah is an anomaly. At a time when other currencies in the region like the Singapore dollar, Malaysian ringgit and Thai baht are appreciating against the US dollar, the rupiah is weakening.
This is happening at a time when BI reserves have reached a record level every month, now standing at nearly $60 billion. The traumatic experience during the crisis in 1998 has taught BI to secure its reserve by accumulating as much as possible. But accumulating reserve is not done for the sake of accumulation alone. At some point the reserve should be used for the benefit of the national economy. If BI sells more US dollars to the market, the dollar would fall against the rupiah, softening the impact of imported inflation.
Because monetary policies could adversely affect growth, relying solely on monetary policies to contain inflation is too risky. That's why BI should pursue a more appropriate policy. (The writer is an economic analyst)
The Jakarta Post/ANN
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