JPM Indonesia: BI on-hold with an interesting inference (Sin Beng Ong)

As expected, Bank Indonesia (BI) kept its policy rate on hold at 6.5% (consensus 6.5%).

In the accompanying policy statement, the central bank noted that underlying growth continues to remain positive despite the uncertainties stemming from the recent moderation in growth in China and the US.

BI also noted the recent up tick in food prices, especially for rice and suggested that seasonal factors together with unusual weather has led to the increase in food prices. Indeed, recent news suggests that BULOG (The State Bureau of Logistics) has been authorized to release rice to areas hardest hit by the rice shortage and these bottlenecks should ease with the second harvest, which falls around the turn of July/August each year. This policy response should thus help alleviate the price impact and thus bring food-related prices lower in 3Q10.

Aside from food prices, core inflation has remained well behaved and thus did not require a policy response. What was interesting and this was conveyed in the after meeting statements was that “core inflation was still benign, helped by the rupiah’s rise.” This idea was also further expanded in the policy statement.

This inference that a stronger FX rate is helpful in managing core inflation is important to note and suggests that the tightening in monetary conditions will be executed through a combination of stronger exchange rates and a modest increase in the policy rate. It is likely that it was not a coincidence that the IDR appreciated through the psychological 9050 level on Friday ahead of the higher than expected inflation print on Monday.

This nuanced approach to monetary policy frames the expectation that the currency will also do some of the lifting in tightening policy unlike in previous years (see “IDR: Marking USD/IDR lower; go short,” Jul 30). Thus, J.P. Morgan expects that the policy rate will be lifted only in 1H11 with a 25bps hike with a good part of the tightening in policy coming from stronger FX rates.

Another aspect of the policy statement was the potential change in the reserve requirements for the banks, which would be tiered to increase the reserves for banks with excess liquidity. This ostensibly would help to lower excess banking system liquidity – and thus lower sterilization costs – but also could spur bank lending as banks seek to increase return on assets.