Economy - DBS Vickers

No rate change is expected at BI meeting this Thursday. Inflation forecast for 2011 is lowered to 6.7% from 7.0% based on declines in food prices in 2Q, but 2H inflation risk is on the upside

Bank Indonesia is widely expected to keep the overnight reference rate unchanged at 6.75% when they meet this Thursday. May inflation data out last week has strengthened the case for no rate change this week. Headline CPI inflation has eased further to 6.0% y-o-y in May from 6.2% in April, thanks to the continued declines in food prices supported by local harvest. On the other hand, growth seems to be moderating in 2Q amid a less favourable global economic climate, which also means BI may prefer to take a cautious approach to monetary policy at this point. Owing to the supply chain disruption in Japan , motor vehicle sales in Indonesia have fallen significantly by 6.9% y-o-y in April. Exports remained robust at 37.3% as of April, but a slowdown is expected for May in line with the downward correction in the global commodity cycle.

The faster-than-expected declines in food prices in 2Q have led to lower our inflation forecast for the full year slightly to 6.7% from 7.0%. But we still caution against inflation risk in 2H. Note that consumers’ inflation expectations for the next three months have jumped by 8 full points in May, based on the latest consumer sentiment survey conducted by the central bank. Traditionally inflation expectation index correlates well with the actual CPI (Chart). Indeed, the downward trend in food prices has already slowed in May compared to Mar-Apr, along with the local harvest passing the peak. A rebound in food prices is expected from 3Q onwards, considering the end of the harvest season and the arrival of the Ramadan festival. Meanwhile, despite the drop in global oil prices in May, there is no guarantee that oil prices will not rebound in 2H. As the gap between the unsubsidized and subsided fuel prices in Indonesia remains wide (comparable to the gap in mid-2008), the government may still consider a fuel subsidy cut in 2H. The Finance Ministry plans to discuss the fuel subsidy policy during the mid-year budget review scheduled in July. Besides food and oil, we also expect core inflation to pick up in 2H, mirroring a positive output gap and faster growth in money supply. As such, we maintain our view that BI will be under pressure to resume tightening in 2H. We continue to expect a total of 75bps rate hike for the remainder of this year.