§ Given the recent heightened focus on Indonesian inflation, we look at the outlook for the economy in 2011.
Inflation
§ We are forecasting CPI inflation to average 6.0% YoY in 2011. In these forecasts we have factored in aggressive increases in food prices stemming from: 1) potential supply-side shocks that exaggerate the normal seasonal upswings for Chinese New Year and Ramadan; and 2) structurally higher global commodity prices. That said, there is upside risk to this forecast.
§ For core CPI inflation, which accounts for ~60% of the index and strips out volatile commodity prices and administered prices, we see a trajectory that begins to lift in 1Q11 and nears 5.0% YoY in mid-2011 before moderating in 2H11, as is the case with headline CPI inflation. The emergence of more favourable base effects in 3Q11 created by 2010’s supply-side shocks are the primary reason for this anticipated inflation moderation.
Rates
§ For 2011 we believe Bank Indonesia (BI) will raise rates a cumulative total of 100bp to 7.50%. Thus far, volatile food prices have been the main driver of inflation pressure and in 2007-08 there was strong passthrough from food
prices to cost-push pressures, borne out in core CPI inflation.
§ Guidance from BI suggests that should core CPI inflation break above 5.0% YoY, it would hike rates. Given that core CPI should begin to edge toward that level from March, we believe the March/April meetings stand as likely starting points for rate hikes.
§ Rate increases at this stage should be viewed as part of efforts to manage inflation expectations, prevent an inflation spiral, and ensure the long-term sustainability of Indonesia’s economic growth. Note that 6-month forward
inflation expectations are below their July 2010 level, suggesting demanddriven price pressure is not as strong as headline CPI suggests.
§ A downside risk is that if cost-push inflation pressures increase, and BI is behind the curve, it may cause delays to subsidy rationalisation, or worse increased subsidies. This, in turn risks undermining improvements to public finances and could hurt credit rating upgrade prospects. It also risks damage to the balance of payments position and a structural weakening of the rupiah.
§ The upcoming rice harvest could prove crucial. La Niña is typically supportive of higher crop yields, hinting food price pressure may ease in the coming months and potentially containing inflation expectations. This raises the
prospect that BI could leave rates unchanged in 2011. Note, this would also ease pressure for rupiah gains (Macq USD/IDR end-2011 forecast 8000).
Growth
§ We maintain our 2011 full-year GDP growth forecast of 6.5%, driven by consumer spending and investment, with support from the continued external recovery and rising global commodity demand.
§ While convention is inflation hurts consumption, Indonesia's large rural population (50% of total) and agricultural labour force (40% of total labour force) suggest an uptick in domestic food commodity prices bolsters incomes
and may benefit consumer spending. Additionally, higher global commodity prices improve the feasibility of resources-related investment in Indonesia, providing further support to growth.
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