Indonesia Macro Flash - BI Hikes Rates 25bps to Temper Inflationary Expectations - Citigroup

 Rates hiked 25bps in line with our call, surprises the market — BI hiked the policy rate by 25bps to 6.75% after being on hold for 18 months. This is in line with our view but consensus (15 out of 22 analysts) called for no hike.
 Rising inflationary expectations the reason for hike — BI noted that Jan inflation was still driven by volatile food prices on disruptions to the production and distribution of basic necessities. Nonetheless, BI cites that inflationary expectations are rising, as reflected in the Consumer Expectations Survey, Producer Survey, and financial asset prices. With pressure from volatile food, rising global commodity prices and the planned policy to cut subsidized fuel consumption (which we estimate could add 0.2ppt to headline inflation in March) also driving expectations, BI decided to hike rates “preemptively”.
 Assessment of economic activity remains upbeat — BI expects broadbased 1Q11 GDP of 6.4% and full-year 2011 growth of 6.0-6.5% amid robust domestic demand and the global economic recovery. BI expects a large Current Account surplus in 1Q11 as well as a large Financial and Capital Account surplus on strong FDI inflows. While FX reserves dipped slightly to $95.3bn in Jan (6.3 mos. of imports of official debt repayments) vs. $96.2bn in Dec (7.1 months), BI earlier forecasted reserves to rise back to $112.6bn by year-end.
 What’s new? BI mentioned using IDR to reduce inflation pressures — While noting that IDR weakened about 0.1% in Jan, BI believes that the capital outflows and IDR weakness is only temporary as fundamentals remain strong. What is new in the policy statement (though was mentioned in the media) is BI saying it will manage the rupiah in line with mitigating inflation risks going forward.
 What’s next for rate hikes? — With increasing concern about the need to temper inflation expectations, we maintain our view that BI will hike further this year. Given that we see inflation risks to the upside, we now expect BI will hike another 75bps this year to 7.5% (vs. 7.25%).
 Market implications – IDR stronger; IDR bond curve bull-flattens – Local players appear to have been caught short anticipating no rate change. The IDR bond yield curve bull-flattened post-announcement, with the 10y and 20y tenors lower by about 30bps and the 3y and 7y tenors lower by 10-15bps. We think
rally could be capped ahead of bond auctions next Tuesday. USD-IDR was down quite sharply to 8990-8995 from 9030-9035 and could take further cues from upcoming US NFP data. BI’s ‘surprise’ hike is a welcome relief to the market, but we think Indonesia’s inflation worries are hardly over— we don’t anticipate a sustained rally in IDR bonds just yet.