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The Federal Reserve's recent move doesn't provide a solid
reason for Indonesia to cut its interest rates.
Markets worldwide reacted positively after last week's decision by the
Federal Reserve to cut the rate it charges for overnight interbank
lending -- known as the Fed Funds Rate -- by half a percentage point to
4.75 percent.
For Indonesia, apart from the rupiah strengthening 1.5 percent against
the dollar recently, yields (prices) in the bond market have also
declined (increased) markedly. For example, the yield on the benchmark
20-year bond has dropped from 10.05 percent the day prior to the Fed
Funds rate cut to 9.85 percent recently.
The rally in the domestic bond market has been driven by stronger
interest among foreign investors, and expectations that the central
bank may resume cutting its benchmark interest rate; i.e., the one that
anchors the discount rate for 1-month central bank papers, known as the
BI rate.
After the Fed move, the closely watched interest rate differential
between the BI rate and the Fed Funds rate widened to 350 bps (or
three-and-a-half percentage points), from the previous 300 bps. However
the argument that the domestic reference rate should be cut on this
basis alone is an oversimplification.
Aware of the need to be consistent in its policies, particularly
regarding the "inflation targeting framework", BI will be more likely
to have domestic inflation considerations in mind.
In this regard, the picture does not seem so rosy.
The hikes in soft commodity prices have started to creep through into
the prices of everyday goods in the consumer's shopping basket. For
example, cooking oil prices in Jakarta have risen by over 50 percent
compared to six months ago, while palm oil prices on the international
market rose concurrently by a similar amount.
Cooking oil accounted for nearly one-tenth of the monthly consumer
price inflation seen in August.
It may not end there. Wheat prices on the international markets have
risen by over 70 percent since March, while oil prices recently reached
an all-time high of US$82/barrel. The pass-through effects on the CPI
are yet to come.
Economists also look at money supply indicators as a leading indicator
of inflation. In this regard, there also seems to be limited room for
further monetary easing.
Along with rising credit growth, the rate of growth in the narrow money
supply, or M1 (a proxy for transaction balances), in July reached a
staggering 28 percent p.a. Meanwhile the broad money supply grew during
the same period by 18 percent.
As a rule of thumb, money supply should grow at a rate that is more or
less in line with the rate of growth in nominal GDP, which probably
would be in the region of 12 to 13 percent.
From a growth perspective, the argument for cutting rates can also be
debated. Indeed, a slowdown in the U.S. could impact on the Asian
region, Indonesia included.
According to a report by the Asian Development Bank, while intra-Asian
trade has flourished, developed economies such as the U.S. remain the
final destination for most Asian exports.
But this may or may not require additional monetary stimulus. For
Indonesia, the situation is quite distinct.
Three-quarters of economic growth is driven by domestic demand, and the
proportion of exports to the overall economy is relatively low (i.e.,
29 percent vs. 125 percent for Malaysia, 75 percent for Thailand and 43
percent for the Philippines) --suggesting some degree of relative
resilience against global economic fluctuations.
And perhaps what's more relevant to Indonesia are primary commodity
prices. Commodities related to agriculture and minerals comprise nearly
half of Indonesia's total exports. So, it could be argued that as long
as commodity prices do not go into free fall, Indonesia will be able to
survive a U.S. recession without too much damage.
Another strong reason not to cut interest rates is that the 3-month SBI
rate is already quite low. With only Rp 12 trillion in 3-month central
bank papers, or SBIs, outstanding (i.e., less than 5 percent of
outstanding 1-month SBIs), the 3-month SBI rate is not as widely
referred to by investors in the market.
However, being the benchmark rate used to determine coupon rates on
variable rate government bonds, it is a decisive element that affects
commercial bank margins.
Since the 3-month SBI rate is already half a percentage point below its
1-month counterpart, competition among the banks to lend more money has
intensified.
This appears to have helped bring down the base lending rate, which
forms the basis for banks in charging their customers interest, to a
post-crisis low of 13.3 percent. And despite the BI rate having been
held constant for the last 2 months, the base lending rate has
continued to decline.
If there is one lesson to be learned from the U.S. sub-prime collapse,
it is to not underestimate the degree to which monetary policy is
transmitted into the real economy. The U.S. economy's current woes are
undoubtedly linked to the negative "real" interest rate period between
2002 and 2005.
Indonesia is still some distance away from having negative real
interest rates. But with domestic inflationary risks on the rise, it's
difficult to ascertain just how far that distance really is.
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