Economy BI continues to focus on the risks of inflation and capital flows, rather than growth - DBS

Bank Indonesia kept rates unchanged at 6.75% yesterday. In the post-meeting statement, the central bank seems to have become more confident that headline inflation can be contained within the target of 4-6% this year, thanks to the recent drop in food prices, but recognises that core inflation is continuing to accelerate on the back of strong domestic demand and high inflation expectations. BI is vigilant against the upside risks to core inflation, as well as price pressures stemming from a possible shift in the government policy on fuel and electricity subsidies. On the other hand, BI remains confident about the growth outlook as well as export outlook, without mentioning the rise in global uncertainty caused by slowdown concerns in major economies including US and China . BI is optimistic that GDP growth this year can achieve the upper band of the 6.0-6.5% target.

Overall, the language of the statement still leaned toward the risk of inflation, rather than growth. As the domestic-driven economic growth is expected to remain strong, core inflation should climb higher in 2H driven by the increase in demand-pull price pressures. Meanwhile, food prices are likely to rebound from 3Q after the end of the local harvest season. The finance ministry plans to discuss the fuel subsidy policy during the mid-year budget review in July, and the possibility of a fuel subsidy cut can’t be discounted. It is also worth noting that consumers’ inflation expectations for the next three months recently have jumped by 8 points in May. Based on the forecasts of higher inflation and steady growth ahead, we maintain our view that BI will resume tightening in 3Q.

BI has somewhat highlighted the risk of continuation of strong capital inflows during yesterday’s statement, in addition to inflation risk. BI pledged that it will strengthen the policy mix of monetary and macro-prudential measures, with “a focus on managing capital inflows and domestic liquidity”. The related measures the central bank has pursued since last year include requiring a holding period on foreign investment in SBI, hiking banks’ reserve requirement ratios, and stepping up open market operations via issuing longer-dated monetary instruments. These measures would be further reinforced, should capital inflows remain strong in the coming months (depending on the development in global economic and financial conditions). Meanwhile, BI has allowed rupiah appreciation to ease the impact of foreign inflows on local liquidity. In yesterday’s statement BI remains comfortable with the trend of rupiah appreciation, with the view that a stronger rupiah in line with regional currencies helps mitigate inflation pressures and has little impact on export competitiveness.