As Indonesia's inflation rate has eased to 6.25 percent (y/y) in October 2015 from 6.83 percent (y/y) in the previous month, and given that Indonesian inflation will ease more markedly in the last two months of 2015 as the impact of the subsidized fuel price hike in November 2014 will vanish, the central bank of Indonesia (Bank Indonesia) seems to have more scope to cut its current relatively high benchmark interest rate, hence giving rise to accelerated economic activity.
After having set a historic low benchmark interest rate (BI rate) of 5.75 percent between February 2012 and June 2013, Bank Indonesia raised its key policy rate gradually, yet aggressively to 7.75 percent after inflation surged due to the 2013-2015 subsidized fuel price reforms while the end of the Federal Reserve's quantitative easing program (and looming higher US interest rates) led to severe capital outflows (causing a sharply depreciating rupiah rate). The higher BI rate was also implemented in order to curtail the country's wide current account deficit. In February 2015, Bank Indonesia surprised markets by cutting its BI rate by 25 basis points to 7.50 percent becoming the 18th central bank to cut monetary policy in 2015. Indonesia's central bank made this decision on the back of confidence that inflation was under control.
Inflation in Indonesia, Central Bank Inflation Target & BI Rate 2009-2015:
(annual percent change)
|Bank Indonesia Inflation Target
(annual percent change)
|Bank Indonesia Rate
(percent at year-end)
¹ indicates forecast
Sources: World Bank and Bank Indonesia
However, the interest rate environment in Indonesia remains high and a negative side-effect of this is that it contributes to slowing economic growth in Southeast Asia's largest economy. In the second quarter of 2015, Indonesia's gross domestic product (GDP) expanded at the slowest pace in six years at 4.67 percent (y/y). As such, many politicians and businessmen have repeatedly requested the central bank to cut its BI rate again. However, this has fallen on deaf ears as Bank Indonesia prefers financial stability over accelerated economic growth. The central bank is particularly concerned about the fragile rupiah. So far this year, the Indonesian rupiah has depreciated nearly 10 percent against the US dollar on looming higher US interest rates. However, in the past couple of weeks the rupiah's value has appreciated significantly as investors started to believe that the Federal Reserve will postpone a Fed Fund Rate hike until next year.
Indonesian Rupiah versus US Dollar (JISDOR):| Source: Bank Indonesia
But with inflation under control (Indonesia's 2015 inflation realization may in fact fall below the 3-5 percent y/y central bank target), a BI rate cut becomes more realistic, despite ongoing pressures caused by looming further US monetary tightening and concern about China's economic slowdown. After Bank Indonesia's October policy meeting, the central bank opened the door to a BI rate cut when it stated that "Bank Indonesia believes that pressures on macroeconomic stability have eased, making room to loosen its monetary policy." However in the same statement it mentioned that current high uncertainty in the global market means that Bank Indonesia remains vigilant and continues to monitor global risks. Its policy will "continue to focus, in the near term, on currency stabilization measures by continuing to maintain rupiah stability, strengthening rupiah liquidity management as well as the supply and demand of foreign exchange."
Given Bank Indonesia's prudent financial policy in recent years, we assume the central bank will maintain its key rate at 7.50 percent in the next couple of months as it will push inflation to around 3 percent (y/y) by the year-end, supports the value of the rupiah, and contributes to an improving current account balance. However, in case Q4-2015 US macroeconomic data are sluggish, limiting room for a Fed Fund Rate hike in December 2015, then Bank Indonesia can decide to cut its BI rate by 25 basis points before the year-end.
US-based investment bank Morgan Stanley stated that Indonesia has room to cut its benchmark policy rate by 50 to 75 basis points in 2016 without doing damage to the macro-economy. In a statement Morgan Stanley notes: "[Morgan Stanley] highlights that it is real rate differentials [adjusted to the effects of inflation] which will drive portfolio debt flows and hence currency. As such, we note that Indonesia’s real rate differentials relative to the US are expected to become more favorable even with the BI rate cuts that we expect and the prospective Fed rate hikes."