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25 May 2018 (closed)
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The level and volatility of Indonesia's inflation rate have historically been higher than in peer emerging nations. Whereas other emerging markets had inflation rates of between three and five percent, per year, during the period 2005 to 2014, Indonesia had an average annual inflation rate of around 8.5 percent over the same period. Since 2015, however, Indonesian inflation has been under control. This section discusses why Indonesia's inflation rate is relatively high (compared to peers as well as developed countries), provides an analysis of recent developments and gives a forecast for the future pace of inflation in Indonesia, Southeast Asia's largest economy.
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 as time is needed to recover from painful reforms and restore the positive image of the president). 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. These very high monthly inflation rates can push part of the population that lives just above the poverty line into full-blown poverty. Hence, it required well-targeted government social assistance programs to prevent a rise in poverty.
Indonesian Energy Subsidies:
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 pressure on the government's budget.
However, in reality the government has 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 continuously 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, considering crude oil is an exhaustive and non-renewable resource it is simply an unsustainable policy as at some point in the future the government would 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 lower than they should be. 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).
Through the decade-old program, Indonesian society had become addicted to government subsidies, especially to cheap fuel. This meant that attempts to re-arrange energy subsidies entailed big political risks for the ruling elite as social unrest (demonstrations) emerged inflicted by (the threat of) rising inflationary pressures.
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. Moreover, cabinet plans for energy subsidy cuts allow room for criticism from political opponents as they can use people's eagerness to have access to cheap fuel for their political gain. In Indonesia there exists a high percentage of swing voters due to low party identification, thus voters tend to rapidly shift their support to another political party.
Fuel Subsidies under the Susilo Bambang Yudhoyono administration (2004-2014)
It is also interesting to take a quick look at the subsidized fuel price reforms that were made during the Susilo Bambang Yudhoyono (SBY) administration (2004-2014) as it shows that a too late response by authorities can cause steep inflation, while there are also great examples of how fuel prices become politicized.
In late-2005, after having been in office for around one year, the SBY administration decided to reduce massive fuel subsidies by more than doubling prices of subsidized fuels. This decision was made due to the rapidly rising international oil prices between 2002 and 2006. However, because of the big difference between real market prices and Indonesia's subsidized fuel prices 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: food and administered prices - has been volatile as well because of second round effects of energy price adjustments that pass through to the broader economy (through rising transportation costs). A late response by authorities to raise subsidized fuel prices can thus lead to much higher-than-necessary inflation and push many people into full poverty (if not accompanied by the government's social assistance programs).
As international oil prices kept rising - touching a record high in June 2008 - and therefore the SBY administration needed huge funds to keep subsidized fuel prices at just half the market rate, another fuel subsidy cut was necessary. Problematically, cheap fuel had helped to boost car sales to record highs and therefore fuel demand was ever-increasing. The decision of SBY to raise subsidized fuel prices in 2008 was met by another round of demonstrations. However, one year later (in 2009), SBY changed course as international oil prices declined during the global financial crisis. SBY cut prices of subsidized fuel in Indonesia, a move likened by the people. Besides the significantly falling international oil prices, it is assumed that SBY was also happy to lower domestic fuel prices ahead of the 2009 elections. The decision would surely boost his chances of being reelected.
When oil prices had surged again between 2009 and 2012 (as there emerged major concerns over Iran's exports) and resulted in a swelling budget deficit, the SBY administration (now in its second term) wanted to raise subsidized fuel prices again. However, leading Indonesian political parties opposed the plan. Key obstacle was Golkar, the country's second-biggest political party and part of the ruling coalition. After initially supporting the fuel price hike it suddenly changed its mind and rejected the hike after seeing many demonstrations on the streets of Indonesia. It was a shift that was merely based on gaining short-term popular support, while completely ignoring long-term effects and consequences. Hence, plans to raise fuel prices were postponed.
But when the government's budget deficit was nearly pushed beyond the legal cap of 3 percent of GDP amid the high global oil price and the government's generous energy subsidies in 2013, the SBY 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 (in the 2014 legislative election SBY's party dropped dramatically but it is fair to say that this decline was also the result of several major corruption scandals that broke out in his party as well as the fact that SBY himself could not compete in the 2014 presidential election due to the limit of two five-year terms to the presidency).
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.
Indonesian Inflation Rate (annual % change):
But despite the 2013 subsidized fuel price hike, a significant portion of Indonesia's fuel prices remained subsidized through the state budget; funds that could be invested in structural development and are now merely used for consumption. Meanwhile, domestic demand for subsidized fuel increased continuously, and therefore the World Bank, the International Monetary Fund (IMF), Indonesia's Chamber of Commerce and Industry (Kadin), and all the important credit rating agencies continued to emphasize the importance of scrapping energy subsidies.
It would need a reform-minded president to walk that path. After Joko Widodo won the 2014 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. A negative side effect was that the country's inflation pace, which had just started to recover toward Bank Indonesia's target level of 4.5 percent (after the subsidized fuel price hike in 2013), had no time to recover any further, and instead accelerated again to 8.4 percent (y/y) again at the end of 2014. It was a painful decision but one that is necessary for structural, long-term economic growth in the future.
At the start of 2015, President Widodo had the advantage that global petroleum prices had fallen dramatically from mid-2014 amid sluggish global demand, while the supply was strong due to persistent high oil production figures in the OPEC countries as well as 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.
Inflation in Indonesia - Headline Consumer Price Index:
Source: Statistics Indonesia (BPS)
Inflation in Indonesia and Central Bank (BI) Target:
(annual % change)
|BI Median Target¹
(annual % change)
(annual % change)
|BI Median Target¹
(annual % change)
¹ presented in the tables is the median of Bank Indonesia (BI)'s annual inflation targets. BI always uses a ±1 percent margin, thus a 4.0 percent median is actually the range of 3.0 - 5.0 percent
Source: Bank Indonesia
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 Bank Indonesia's inflation targets and actual inflation realization in 2018 and 2019 (as the government confirmed that prices of subsidized fuel and electricity will not be revised until at least late-2019).
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. Weak harvests in combination with a slow reaction of the government to substitute local food products with imports are key causes of inflationary pressures in Indonesia.
Indonesian Inflation per Component (%):
|Instant food, beverages,
cigarettes and tobacco
|Housing, water, electricity,
gas and fuel
and financial services
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. It is important to note that the Ramadan and Idul Fitri period is continuously moving since the Islamic lunar calendar year is 10 to 11 days shorter than the solar year and contains no intercalation. Hence, in the next five years this period will move to May and April. During the second inflation peak a marked increase is detected in spending on food and other consumables (such as clothes, bags and shoes), accompanied by retailers adjusting their prices upwards.
Monetary Policy and Bank Indonesia's Benchmark Interest Rate
With annual GDP growth rising by an average five percent (y/y) over the past 15 years, the economy of Indonesia has been expanding rapidly, characterized by robust domestic demand (domestic consumption accounts for about 56 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, new monetary policies 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. Meanwhile, there were concerns about the widening current account deficit of Indonesia.
Bank Indonesia's subsequent tighter monetary policy stance (reflected by a rising benchmark interest rate) in the 2013-2014 period came at the expense of a higher economic growth pace for Indonesia (amid higher borrowing costs credit growth fell significantly). But it should be applauded that financial stability is preferred over accelerated (yet unsustainable) economic growth.
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, while global uncertainty about the US monetary policy put severe pressure on the rupiah. Subsequent capital outflows resulted in sharp rupiah depreciation. Therefore, starting from mid-2013, Bank Indonesia adjusted its benchmark BI rate upwards gradually yet aggressively from 5.75 percent to 7.75 percent.
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.
Starting from 2015, when the rupiah was stable, inflation low and the current account deficit under control, Bank Indonesia could loosen up its monetary policy and start a process of rather aggressive monetary easing, reflected by a lower benchmark interest rate (see table below). The benchmark was cut from a high of 7.75 percent at the start of 2016 to 4.25 percent in September 2017 (it also includes the change from the BI rate to the seven-day reverse repo rate as the central bank's benchmark tool).
However, there have emerged concerns over the weak pace of credit growth and bleak household consumption in Indonesia.
Benchmark Interest Rate of Indonesia 2008-2017:
|BI's Benchmark Rate
(% at year-end)
|BI's Benchmark Rate
(% at year-end)
Source: Bank Indonesia
Last update: 23 May 2018