Dilemma Bank Indonesia: To Cut Interest Rates or Not?
The central bank of Indonesia (Bank Indonesia) is currently dealing with a dilemma. On the one hand, its relatively high interest rate environment (with the benchmark BI rate at 7.50 percent) is partly responsible for the country’s slowing economic growth as credit expansion is curtailed and economic activity declines. On the other hand, Bank Indonesia’s high BI rate is needed to safeguard Indonesia’s financial stability as inflation is still above the central bank’s target, the current account deficit nearly unsustainable, and capital outflows loom.
More capital outflows are looming as the US Federal Reserve is expected to raise its benchmark Fed Fund Rate before the end of 2015. This move could mean that a significant amount of capital - that was once invested in lucrative emerging economies amid the loose US monetary policy - moves back to the USA where yields become more attractive. A high BI rate may be able to somewhat limit these outflows from Indonesia.
However, as several US macroeconomic data have been weak in the first quarter of 2015, including a US GDP growth rate of 0.2 percent (y/y) in the first quarter of 2015 (far below analyst projections at 1 percent y/y), the Federal Reserve will most likely not raise interest rates too soon. After seeing weak US economic data markets started to speculate that US interest rates will not increase in June nor at the end of the second quarter, but more likely in September 2015, the earliest.
If Indonesia’s central bank is convinced that it will take nearly another six months before the Federal Reserve is to raise its interest rate environment, then Bank Indonesia may have room to cut its BI rate to 7 percent from 7.50 percent currently in order to provide ammunition for accelerated economic growth in Southeast Asia’s largest economy. The Indonesian government has already requested Bank Indonesia to lower its BI rate. However, recently Bank Indonesia Governor Agus Martowardojo emphasized that Bank Indonesia is content with its relatively high interest rate environment and will not be influenced by pressure from the central government. Still, seeing analysts’, consumers’ and business players’ recent pessimistic tones about the Indonesian economy, this may be a reason for the central bank to cut its BI rate. In February 2015 it had cut its BI rate by 25 basis points to 7.50 percent as inflation was under control.
However, contrary to the situation in February, inflation is currently a bit less controlled in Indonesia and thus makes it tougher for Bank Indonesia to cut the BI rate further. Due to higher fuel prices (as global oil prices have somewhat recovered) inflation accelerated to 6.79 percent (y/y) in April 2015. Moreover, given that inflationary pressures are about to increase as the holy fasting month Ramadhan is to start in July (while the new school year also brings along higher prices), the central bank may feel that it is too risky to cut interest rates now. After all, the country’s current account deficit still hovers around 3 percent of GDP (which is about the boundary that separates a sustainable from an unsustainable deficit), while the rupiah has been depreciating amid bullish US dollar momentum. Lastly, in mid-year dividend pay-outs and debt payments increase, hence boosting local US dollar demand.
Bank Indonesia’s next Board of Governor’s meeting is scheduled for Tuesday 19 May 2015.