Indonesia Inflation: "Lucky" Scenario Becomes Base Case For 2011 (update3) - Morgan Satnley

No More Rate Hikes in 2011; Policy Normalization to Resume in 2012
So far in this cycle, Bank Indonesia has used a mixture of policy tools – i.e., currency appreciation, liquidity management and policy rate hikes (to a limited extent). With capital inflows being strong, concerns that interest rate hikes will attract even more capital inflows, and BI facing one of the highest net sterilization costs in the region, policymakers have been comfortable allowing currency appreciation as a side effect of capital inflows to manage both inflation and ‘trilemma” pressures. With capital inflows still coming and with headline inflation likely below 6% for 2H11, we think policymakers are unlikely to hike policy rate further in 2011 given the inflation target range of 5%+/-1%.
We think policymakers will only resume policy rate normalization in 2012 for a few reasons. At 4.5%+/-1%, Bank Indonesia’s inflation target range for 2012 would be tougher compared to 2011 (5%+/-1%). Both headline and core inflation re-acceleration will become more evident in 2012. As domestic demand gets stronger, the current account surplus will dwindle, giving BI more room to navigate “trilemma” pressures. We look for a 100bps hike, taking the policy rate to 7.75%, by 2Q12.

Key Risks: Where We Could Go Wrong, What to Watch For
Inflation risks remain skewed to the upside from binary events. With retail fuel prices marked to about US$65/bbl oil, commodity prices will be key to watch. In mid-2008, policymakers hiked retail fuel prices by ~30% when oil prices were at US$120-US$130/bbl. Retail fuel prices have since been brought down to previous levels. With the now stronger currency, we think oil prices at US$140/bbl would be an important threshold.

In addition, we would also watch the refined oil trade deficit as a gauge of oil smuggling and arbitrage activities, which would increase fiscal burden. Credit growth and current account balance would also be useful in gauging whether domestic demand is going into overdrive territory and whether cyclical inflation pressures would behave differently from our expectations. A potential change in retail fuel price policy is captured in our bear case scenario. Our bull case features a structural Goldilocks scenario (Exhibit 10).
We outline our assumptions and outlook for the various scenarios below.

Base case: Base Effects in 2H11, Reacceleration in 2012
Assumptions

1) Oil prices to average ~US$115/bbl for 2011 and 2012; no retail fuel price hikes.

2) Sequential food price pressures gather pace in the run-up to Ramadan in August but are overwhelmed by base effects.

3) Demand-pull pressures to build up gradually.

Inflation peaks and policy moves: Headline inflation to peak at 7.0% YoY in 2Q12; Policy rate normalisation to resume in 1Q12; total policy rate increase of 50bps.

Bull Case: Structural Goldilocks
Assumptions

1) Oil prices falls to US$90/bbl and stay there for the rest of 2011 and 2012; no retail fuel price hike.

2) Structural forces keep cyclical inflation pressures largely anchored.

Inflation peaks and policy moves: Headline inflation peaks at 6.2% in 2Q12; policy rate normalization to resume in 2Q12; total policy rate increase of 100bps.

Bear Case: Tail Risks Materialize
Assumptions

1) Oil prices rise to US$140/bbl and stay there for 2011 and 2012; retail fuel price hike of ~30% by Sep-10. This quantum would be similar to what happened in mid-2008.

2) Strong second-round impact seen in other tradables segment, given the healthy domestic-demand momentum and that road transport accounts for 80%-90% of freight transport.

Inflation peaks and policy moves: Headline inflation peaks at 8.6% in 1Q12; Policy rate normalisation to resume in 4Q11; Total policy rate increase of 150bps