Pacific Money

Indonesia: Inflation in the Offing?

A rate hike this week appears to have been preemptive action. Will it be enough?

Investors have had plenty to think about of late, with ongoing financial turmoil and economic adjustments, worries about the Fed’s policy plans, and fears that China’s headline growth rate may be slowing amidst a cash crunch.  

Jitters seem to be everywhere, and Southeast Asia in particular has been suffering from capital outflows as fund managers try to second guess Bernanke’s frame of mind as U.S. economic data remain mixed (with growth improving but unemployment not). The Philippines, South Korea and New Zealand all elected to keep their rates unchanged, but Indonesia finally cracked and took action. Bank Indonesia, the country’s central bank, raised an interbank interest rate on Tuesday, and then on Thursday raised the benchmark rate by 0.25 of a percent to 4.25%.  

As covered previously in Pacific Money, Indonesia’s economy has been performing well these last few quarters. In the first 3 months of 2013, GDP expanded 6.02% from the previous year, only slightly lower than the 6.11% figure from the last quarter of 2012.

Part of the reason for the rate hike was the recent fall in the value of Indonesia’s currency, the rupiah. It dropped below 10,000Rp against the dollar for the first time since the U.S. currency’s spike during the nadir of the global crisis back in 2009.  The authorities have been trying to arrest the currency’s slide by selling off reserves, but worries about the economy made the situation difficult, and hence the interest rate move.

Another reason for the hike is almost certainly connected to expectations of inflation. Indonesia is on the cusp of increasing fuel prices significantly, probably during or shortly after the upcoming government budget. Currently, the subsidy program that has held prices so low is creating too much strain on government finances.  If the fuel price increase goes ahead, inflation is certain to jump. The government itself has predicted that this jump will lift inflation from a “no fuel price increase” level of 4.9% up to a “with fuel price increase” rate of 7.2% this year. 

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Inflation expectations can create actual inflation – in one of many feedback loops that exist in economic theory: Anticipating higher prices in the future, economic actors decide to make purchases now rather than later, this increases demand which, in turn causes prices to rise. An inflationary spiral is always difficult to stop, so Bank Indonesia may well have been wise to act now (some may say a little too late) in order to signal the market that it is prepared to tackle the upcoming inflationary pressure.

Given the capital outflows from emerging markets, the connected fall in Indonesia’s rupiah, and inflationary pressure related to the country’s ongoing strong economic growth and imminent fuel subsidy price change, the rate increase is not much of a surprise. The question now remains; has the government done enough, and how much will inflation increase following next week’s budget?