Indonesia Inflation: "Lucky" Scenario Becomes Base Case For 2011 (update2) - Morgan Satnley

DETAILS:

Changing Our Inflation and Policy Rate Forecasts
For 2011, we think Indonesia’s headline inflation peaked in 1Q (Exhibit 1) and the worst of inflation fears are likely past. We are thus revising our 2011 and 2012 average inflation forecasts from 6.5% YoY and 5.5% YoY to 5.9% YoY and 6.8% YoY respectively. Consequently, we are also changing our policy rate forecasts from 7.5% and 7.0% for 2011 and 2012 year-end to 6.75% and 7.75%, respectively. This means we are expecting no more policy rate hikes for the remainder of 2011 and expecting policy rate normalization to resume only in 2012.

We are lower than consensus inflation expectation (6.4%) for 2011 but higher for 2012 (consensus at 6.1%) (Exhibit 2). Some quarters are still calling for further policy rate hikes by late 3Q and 4Q – which we now find unlikely.

Factors in Outlook Revision:
The Three-Way Inflation Tug of War
Our inflation framework has not changed – but when facts change, our conclusions change too. We see Indonesia inflation trend as a three-way tug of war between:

a) Idiosyncratic factors, such as the impact of weather on food prices and of global oil prices on domestic retail fuel price policies. By nature, these are more difficult to predict in terms of timing, direction and magnitude.
b) Structural forces, which exert downward pressures on inflation.
c) Cyclical forces, which are now exerting upward pressures on core inflation.

We elaborate on each of these three factors below:

a) Idiosyncratic Factors: Now Working in Indonesia’s Favour

In an earlier report (See Indonesia Economics – Rate Pause: Walking a Tightrope, March 7, 2011), we had described a “lucky” scenario in which Indonesia may be able to muddle through on inflation and policy rate if a few stars are aligned – i.e. if weather patterns revert to normal and impact on food prices eases, oil prices fall and policymakers delay plans for the fuel subsidy rollback. We think these stars have come together for Indonesia. Recall that an unusually wet spell had caused chilli and rice prices to rise significantly in 2H10. Food prices have been declining since the start of this year. Based on our calculations, May food CPI index has now fallen back to the levels where it would have been if there had been no weather disruptions to begin with (Exhibit 3). This means that the high base effects in 2H10 will likely dampen headline inflation in the next one to two quarters.

In addition, markets have been oscillating between inflation and growth concerns given the recent soft patch in DM. This has had collateral impact on animal spirits and commodity prices. Brent prices have eased from earlier highs of US$128/bbl to US$119/bbl currently, alleviating at the margin the tail risks of retail fuel price hikes. In our original inflation forecasts, we had factored in a hike in retail fuel prices in 2Q11. This, together with the high base effects from weather disruptions a year ago, will likely be the dominant factor for inflation trends in the next three to six months and keep headline inflation below 6% for 2H11.

(b) Structural Inflation Anchor Also Pulling Its Weight
We have been strong proponents of Indonesia’s structural story for a long while now. An important part of this story is the structural decline in inflation it will bring about. The critical “enabler” in this aspect is currency stability. Due to capital account convertibility and higher external funding linkages in Indonesia, the currency has typically been seen as a key barometer of confidence. Historically, the rupiah has tended to be volatile given the high external funding linkages and low FX reserves ammunition. Currency volatility also tends to beget more currency volatility as the locals themselves switch out of rupiah into USD. The high level of dollarization means any currency volatility translates immediately into inflation. Inflation expectations become unhinged quickly, adding powerful second-round effects – and the vicious cycle continues.

Yet, improved macro fundamentals and higher foreign reserves have been greatly improving currency stability, helping to anchor inflation expectations. Thanks to the FX reserve ammunition, the currency has been extremely well behaved even in periods of risk aversion, most notably in the Jan-Feb equity and bond market sell-off. With foreign reserves crossing the US$100bn milestone much earlier than expected, (See Indonesia: The US$100bn War Chest, Feb 14 2011), policymakers now have more wherewithal to sustain the structural inflation downtrend.

(c) Cyclical Core Inflation – Reacceleration a Story for 2012
Clients ask whether we could see a re-acceleration of inflation pressures beyond the recent disinflation. In our view, underlying cyclical core inflation pressures are gathering pace gradually and will likely continue to do so. Monetary policy remains easy with Bank Indonesia having done only one rate hike. Moreover, still elevated commodity prices will also confer positive terms of trade for the second largest net commodity exporter in AXJ, lending support for growth momentum.

Indeed, though food inflation has eased from the peak of 16.2% YoY in Jan-11 to 10.2% YoY in May-11, inflation of tradeables-ex-food-and-energy – which we take as an indicator of pricing power in manufactured goods – has edged up from 5.6% YoY in Jan-11 to 6.2% YoY in May-11. Non-tradables inflation, which is more symptomatic of local inflation, has also edged from 3.1% in Jan-11 to 3.7%Yoy in May-11 (Exhibit 6).

In our view, %YoY headline inflation will re-accelerate in 4Q11 as core inflation edges slightly beyond 5% by 2011 year-end. However, the base effects from the idiosyncratic food factor will still keep headline inflation below 6% in 4Q11, which is the upper threshold of Bank Indonesia’s 5%+/-1% target range for 2011. Hence, in this context, we think inflation re-acceleration will likely become more of a focus in 2012 rather than 2011. This is why we have raised our 2012 inflation forecast even as we bring down our 2011 forecast.