The Relation between Peaks in Inflation and Administered Price Adjustments

Peaks in Indonesia's inflation volatility correlate with administered price adjustments. Energy prices (fuel and electricity) are set by the government and therefore do not float according to market conditions, meaning that the subsequent deficit has to be absorbed by the government's state budget or by state-owned companies Pertamina and Perusahaan Listrik Negara (PLN). This decades-old program puts serious pressure on the government's budget balance while it also limits public spending on more long-term, productive matters such as infrastructure development or social development. However, since the Joko Widodo administration took office in late-2014, the Indonesian government has successfully scrapped a significant portion of energy subsidies and reallocated funds to infrastructure development as well as social development.

Widodo was well aware of the importance of imposing unpopular reforms as soon as possible after taking office (because the longer the delay, the lower the odds would become of being re-elected in the next election). In November 2014, barely one month after taking office, Widodo cut the subsidy by 31 percent for gasoline/petrol (premium) and 36 percent for diesel (solar), but his decision was met with few protests. The reason behind these few protests was that Widodo reduced a massive chunk of energy subsidies at a time when global crude oil prices were very low. In fact: so low that the price of subsidized fuel fell (!) after the cut in fuel subsidy. The dramatic drop of global crude oil prices that started in August 2014 in combination with the fixed subsidized fuel price had resulted in the paradoxical situation that the Indonesian consumers of subsidized fuel had been subsidizing the government because the subsidized fuel price had become more expensive than the real market value of fuel.

But despite the low global oil prices, the decision to cut fuel subsidies in late-2014 did push Indonesia's monthly inflation rate to 1.50 percent and 2.46 percent in November and December 2014, respectively.

Indonesian Energy Subsidies:

Year Fuel Subsidies
Electricity Subsidies
2017          47.0               50.6
2016          43.7               63.1
2015          64.7               73.1
2014         246.5              103.8
2013         210.0               99.9
2012         211.9               94.6
2011         165.2               90.4
2010          82.4               57.6
2009          45.0               49.5
2008         139.1               83.9
2007          83.8               33.1
2006          64.2               30.4
2005          95.6                8.9
2004          69.0                2.3

in trillion rupiah

As the global oil price continued to decline to historic lows in 2015 and 2016, the Indonesian government was able to further cut fuel subsidy spending in 2016. Meanwhile, the government also introduced a new price formula for subsidized fuel prices, one that is based on international oil prices and is to be adjusted each quarter, hence making Indonesia's subsidized fuel prices much more in line with the international movements and therefore relieving the government's budget.

However, in reality the government refrained from revising the subsidized fuel price since April 2016 despite the rebounding oil price (which has been rebounding since the start of 2016) and which is now causing new pressures on the government's budget balance. The motives behind this is politics. As we approach the local elections in 2018, followed by legislative and presidential elections in 2019, the government is not keen on imposing unpopular decisions (such as raising subsidized fuel prices) because that could jeopardize victory of the ruling parties and people in these elections. In fact, the Indonesian government has confirmed that it will not raise prices of subsidized fuel and electricity up to late-2019, implying it will need to add more funds to its energy subsidy budget in 2018 and 2019.

Prior to Widodo's subsidized fuel price reforms, international institutions such as the International Monetary Fund (IMF) and World Bank had been criticizing the Indonesian government for providing cheap fuel and electricity to its population because this policy has several negative consequences:

 It causes financial weaknesses, particularly after Indonesia turned into a net oil importer in the 2000s. In fact, it is simply an unsustainable policy as at some point in the future the government will need to raise these prices. By waiting longer, the negative impact can become more severe.

 It limits government spending in more productive sectors such as infrastructure and social development (in fact cheap fuel supports the nation's car sales and with infrastructure largely inadequate it resulted in increasingly heavy traffic congestion in the bigger cities of Indonesia).

 It distorts the economy by keeping prices artificially low. Considering prices of most products and services are linked to fuel costs, it implies most prices in Indonesia are artificially low. Although this does entail (short-term) advantages in terms of competitiveness and in the battle against poverty, it is a time-bomb waiting to explode. 

 The policy is misdirected because it is particularly the middle class (and elite) that benefit from lower fuel prices, not so much the poorer segments of Indonesian society (for which it is actually intended).

Indonesian society had become addicted to government subsidies, especially cheap fuel. This meant that attempts to re-arrange energy subsidies implied political risks for the ruling elite as social unrest (demonstrations) emerged inflicted by (the threat of) rising inflationary pressure. One characteristic of Indonesia is that a large portion of its population is clustered just above the poverty line, meaning that a relatively minor inflationary shock can push these people below that line.

For example, when the Susilo Bambang Yudhoyono administration (2004-2014) decided to reduce massive fuel subsidies in late 2005 (by raising subsidized fuel prices by more than double) due to the rising international oil price, it soon led to double-digit inflation rates of between 14 and 19 percent (year-on-year) until October 2006. Furthermore, the country's core inflation - which excludes items that are vulnerable to temporary price volatility - has been volatile as well because of second round effects of energy price adjustments that pass through to the broader economy (for example through rising transportation costs).

When the government's budget deficit was nearly pushed beyond the legal cap of 3 percent of gross domestic product (GDP) amid the high global oil price and the government's generous energy subsidies in 2013, the Yudhoyono administration again decided to raise subsidized fuel prices. In June 2013 the gasoline price went up by 44 percent to IDR 6,500 per liter, while diesel increased by 22 percent to IDR 5,500 per liter. This move triggered public outcry and was also wrongly timed, about one year before the legislative election.

Indonesia Inflation Rate (annual % change on consumer price index):

Despite social outcry, reduction of Indonesia's energy subsidies remained a top priority on the central government's agenda. In early 2012, the government proposed a fuel price increase but social unrest and political opposition in parliament made a sudden increase impossible. Finally, in June 2013, gasoline was raised by 44 percent to IDR 6,500 (USD $0.66) and diesel by 22 percent to IDR 5,500 (USD $0.56) per liter as the massive fuel subsidies threatened to push the government's budget deficit beyond the three percent of gross domestic product (GDP) level (Indonesian law forbids the budget deficit from exceeding three percent of GDP). In order to support the poorer segments of society, the government engaged in direct cash-handout programs. However, inflation accelerated to 8.4 percent (y/y) by the year-end.

But despite the 2013 price hike, a significant portion of Indonesia's fuel prices remained subsidized, while subsidized fuel demand increased continuously, and therefore the World Bank, IMF and Indonesia's Chamber of Commerce and Industry (Kadin) continued to emphasize the importance to drop the program. After reform-minded Joko Widodo won the presidential election and was inaugurated as Indonesia's seventh president in October 2014, one of the first moves he made was to raise subsidized fuel prices. Gasoline (premium) was raised from IDR 6,500 to IDR 8,500 per liter, while diesel was raised from IDR 5,500 to IDR 7,500 per liter. This meant that the country's inflation pace, which had just started to ease toward Bank Indonesia's target level of 4.5 percent, had no time to recover further and accelerated to 8.4 percent (y/y) again at the end of 2014.

At the start of 2015, President Joko Widodo had the advantage that global petroleum prices had fallen dramatically from mid-2014 due to sluggish global demand while supply was strong due to persistent high oil production figures in the OPEC countries and the US shale gas revolution. Hence, Widodo decided to make a bold move. He basically scrapped gasoline subsidies while setting a fixed IDR 1,000 per liter subsidy for diesel. The Indonesian government still determines the price of gasoline and diesel (adjusted each quarter) but the prices will fluctuate in line with international prices. However, as global petroleum cautiously recovered in the first half of 2015, Indonesian inflation remained high in mid-2015 and only started to ease in late 2015. Bank Indonesia still sees the 2015 inflation at around 4 percent (y/y).

Inflation in Indonesia and Central Bank Target 2008-2016:

  2008 2009 2010 2011 2012 2013 2014 2015 2016
(annual % change)
 9.8  4.8  5.1  5.4  4.3  8.4  8.4  3.4  3.0
Bank Indonesia Target
(annual % change)
 5.0  4.5  5.0  5.0  4.5  4.5  4.5  4.0  4.0

Sources: World Bank and Bank Indonesia

Inflation in Indonesia:

Month  Monthly Growth
 Monthly Growth
 Monthly Growth
 Monthly Growth
January          1.03%          1.07%         -0.24%          0.51%
February          0.75%          0.26%         -0.36%         -0.09%
March          0.63%          0.08%          0.17%          0.19%
April         -0.10%         -0.02%          0.36%         -0.45%
May         -0.03%          0.16%          0.50%          0.24%
June          1.03%          0.43%          0.54%          0.66%
July          3.29%          0.93%          0.93%          0.69%
August          1.12%          0.47%          0.39%         -0.02%
September         -0.35%          0.27%         -0.05%          0.22%
October          0.09%          0.47%         -0.08%          0.14%
November          0.12%          1.50%          0.21%          0.47%
December          0.55%          2.46%          0.96%          0.42%
Total          8.38%          8.36%          3.35%          3.02%

Source: Statistics Indonesia (BPS)

Indonesia's characteristic volatile inflation rate causes a traditionally larger deviation from the annual inflation projections of Bank Indonesia. The consequence of such inflationary uncertainty is that it creates economic costs, such as the country's higher (domestic and international) borrowing costs compared to its emerging market peers. When a good track record of meeting annual inflation targets is established, greater monetary policy credibility will follow. But as volatile inflation was primarily caused by subsidized fuel price adjustments, we expect to see less deviation between initial inflation targets and realization.

The lack of quantity and quality of Indonesia's infrastructure also entails high economic costs. It hampers connectivity in the archipelago, thereby increasing transportation costs for services and products (hence causing high logistics costs and making the country's investment climate less attractive). Distribution disturbances due to infrastructure-related issues are frequently reported and made the government realize the importance of investing in the country's infrastructure.

Food prices are highly volatile in Indonesia (vulnerable to weather conditions) and subsequently impose a big burden on those poorer households that live under or just above the poverty line. These households spend more than half of their total disposable income on food items, particularly on rice. Higher food prices therefore cause serious poverty basket inflation which may lead to increases in the level of poverty. Failing harvests in combination with a slow reaction of the government to substitute local food products by imports are causes for inflationary pressure.

Indonesian Inflation per Component (%):

Indicator 2014
2015 2016
Food 10.57  4.93  5.69
Instant food, beverages,
cigarettes and tobacco
 8.11  6.42  5.38
Housing, water, electricity,
gas and fuel
 7.36  3.34  1.90
Clothing  3.08  3.43  3.05
Health  5.71  5.32  3.92
Education, recreation,
and sports
 4.44  3.97  2.73
Transportation, communication,
and financial services
12.40 -1.52 -0.72

Source: Statistics Indonesia (BPS)

Traditional Peaks of Inflation in Indonesia

Discarding administered price adjustments, there are two traditional annual peaks of inflation in Indonesia. The December-January period always brings higher prices due to Christmas and New Year celebrations, while the traditional floods in January (amid a peak of the rainy season) result in disrupted distribution channels in several regions and cities, thus causing higher logistics costs. The second inflation peak comes in the July-August period. Inflationary pressures in these two months emerge as a result of the holiday period, the holy Muslim fasting month (Ramadan), Idul Fitri celebrations and the start of the new school year. A marked increase is detectable in spending on food and other consumables (such as clothes, bags and shoes), accompanied by retailers adjusting prices upwards.

Monetary Policy and Bank Indonesia's Benchmark Interest Rate (BI Rate)

With annual GDP growth rising by an average five to six percent (y/y) over the past decade, the economy of Indonesia has been expanding rapidly, characterized by surging domestic demand (domestic consumption accounts for about 55 percent of the country's total economic growth), robust private sector credit growth and increased business access to credit. Moreover, public sector wages have increased due to administrative reforms and private sector wage growth has accelerated (Indonesia's regional minimum wages were raised significantly in 2012-2014). As robust economic growth brings along inflationary pressures, recent monetary policies (since 2013) were aimed at safeguarding the country's financial stability, particularly after inflation surged due to the 2013-2015 subsidized fuel prices reforms while the end of the Federal Reserve's quantitative easing program (and looming higher US interest rates) led to large capital outflows from emerging markets (causing sharply depreciating emerging market currencies), including Indonesia. Bank Indonesia's tighter monetary policy comes at the expense of a higher economic growth pace.

Bank Indonesia has as main objective to ensure rupiah stability. It uses a wide range of instruments to stem mounting inflationary pressures in the country. Its bank rate policy is adjusted when inflation targets are not met. Between February 2012 and June 2013, the country's benchmark interest rate (BI rate) had been set at a historic low of 5.75 percent. After this period, inflationary pressures increased due to subsidized fuel price reforms and global uncertainty about the US monetary policy. Subsequent capital outflows resulted in sharp rupiah depreciation. Therefore, starting from mid-2013, Bank Indonesia adjusted its BI rate upwards gradually yet aggressively from 5.75 percent to 7.75 percent. This move also led to declining credit growth in Indonesia.

As domestic economic fundamentals of Indonesia started to improve, Indonesia's central bank was able to cut its interest rate drastically from a high of 7.75 percent at the start of 2016 to 4.75 percent at the end of 2016 (this also includes the change from the BI rate to the seven-day reverse repo rate as the central bank's benchmark tool).

Another measure to tighten monetary policy was the raising of the reserve requirements on both local and foreign currency deposits at Indonesian banks. Lastly, BI curtailed foreign investors' demand for Central Bank bills (SBIs) by extending the required holding period from one to six months, stretching the maturity of SBI issues to nine months and by introducing longer maturity non-tradable term deposits (which are available to banks only). These measures aimed at mitigating the flow of 'hot money' into Indonesia.

Benchmark Interest Rate of Indonesia 2008-2016:

  2008 2009 2010 2011 2012 2013 2014 2015 2016
Bank Indonesia Rate
(% at year-end)
9.25 6.50 6.50 6.00 5.75 7.50 7.75 7.50 4.75

Source: Bank Indonesia

Indonesian Inflation in Global Perspective

The table below puts Indonesia's recent inflation performance (annual percent change) in global perspective by comparing it to inflation figures of the United States (USA) and China.

  2009 2010 2011 2012 2013 2014 2015
 USA -0.4  1.6  3.1  2.1  1.5  1.6  0.1
 China -0.7  3.3  5.4  2.6  2.6  2.1  1.4
 Indonesia  4.8  5.1  5.4  4.3  8.4  8.4  3.4

Source: World Bank

Updated on 20 January 2017