BI HIKES POLICY RATE IN RESPONSE TO JULY INFLATION

UNCLAS SECTION 01 OF 02 JAKARTA 001487 SIPDIS SENSITIVE DEPT FOR EAP/MTS AND EB/IFD/OMA TREASURY FOR IA/MALACHY NUGENT COMMERCE FOR 4430/KELLY DEPARTMENT PASS FEDERAL RESERVE SAN FRANCISCO FOR CURRAN DEPARTMENT PASS EXIM BANK SINGAPORE FOR SBAKER TOKYO FOR MGREWE USDA/FAS/OA YOST, MILLER, JACKSON USDA/FAS/OCRA CRIKER, HIGGISTON, RADLER USDA/FAS/OGA CHAUDRY, DWYER USTR WEISEL, EHLERS E.O. 12598: N/A TAGS: EFIN EINV ECON EAGR ID SUBJECT: BI HIKES POLICY RATE IN RESPONSE TO JULY INFLATION ¶1. (SBU) Summary. Bank Indonesia (BI) raised its policy rate 25 basis points for the fourth consecutive month to 9.0 percent in response to higher than expected inflation. July inflation increased 1.37 percent (mom) and 11.9 percent (yoy),due mainly to higher food, housing and utility prices. The year-on-year increase in unprocessed food in July rose to 19.9 percent. Recent surveys indicate that rising food prices continue to strain household budgets and have forced a number of Indonesians to change consumption patterns. BI officials continue to favor measured rate hikes over more dramatic monetary tightening in an effort to maintain growth momentum in Indonesia, but pressures on prices remain in place. While BI's rate hike was in line with market expectations, some analysts note that the current pace of rate hikes may be insufficient to anchor inflation expectations. End summary. Food Prices Drive July Inflation -------------- ¶2. (SBU) The headline inflation rate rose 11.9 percent (yoy) in July, exceeding market expectations and the 11.03 percent recorded in June. The yoy number is likely understated due to the Government of Indonesia's (GOI) decision to alter the inflation basket and rebase the index last month. Consumer prices rose 1.37 percent compared to the previous month, due mainly to rising food prices. The rise in processed and unprocessed food prices accounted for over 40 percent of the month-on-month increase. Increases in housing and utility costs accounted for an additional 33 percent of monthly CPI rise, reflecting the impact of higher fuel costs. [Note: The Central Statistics Bureau (BPS) has not released a historical CPI time series or a core inflation figure since adopting the revised methodology in June. End note] ¶3. (U) Rising prices of staple food products continue to strain household budgets. According to data from the Center for Market Information at the Ministry of Trade, the price of rice, which accounts for as much as one-third of the budget of low income 
households, fell slightly between June and July due to the current harvest. However, rice prices are up 16.4% over the same period last year. The price of eggs and poultry soared in July, increasing 12.8 percent and 3.5 percent, respectively, over the previous month. Egg and poultry prices have increased 45.6 percent and 75.9 percent, respectively, since July 2007, due to historically high feed costs. The price of flour, soybeans, and instant noodles continued to rise in July, bringing the year-on-year increase to 60.7 percent, 30.9 percent, and 28.1 percent, respectively. ¶4. (SBU) Recent analysis indicates that rising food and fuel prices are forcing a number of Indonesians to change consumption patterns. The GOI cash transfer program and rice subsidy scheme have offset much of the May fuel price hike among poor households, according to World Bank staff. Yet, a recently issued Gallup Poll conducted in March 2008 revealed that standards of living across a large portion of Indonesia's population had eroded significantly before the fuel price increase. According to the Gallup Poll, 4 out of 10 Indonesians said their standard of living was declining and that it was difficult or very difficult to live on their current salary. A Roy Morgan Poll in May 2008 also found that roughly 40 percent of the population has switched to cheaper and/or lower quality foods in response to higher food prices. Roughly 16 percent of the population has cut the amount of food consumed in response to higher prices, according to the Roy Morgan report. BI Hikes Rates Modestly -------------- ¶5. (U) On August 5, Bank Indonesia raised its policy rate 25 basis points to 9.0 percent, continuing its policy of measured interest rate hikes to control mounting inflation expectations. In addition to pressure on food prices, the central bank noted in its policy statement that demand side pressure on prices continues to mount. Credit expansion continued at a robust pace through May 2008, increasing over 3 percent (mom) and more than 30 percent (yoy). JAKARTA 00001487 002 OF 002 Moreover, while GDP numbers for the second quarter have not been released, the BI policy statement noted that motor vehicles and cement sales remain robust, pointing to continued strong domestic demand in the second quarter. In an effort to control imported inflation, traders report that BI is also intervening in foreign exchange markets to increase the value of the Rupiah. The Rupiah is currently trading at a four month high at roughly RP/USD 9050. Although BI is active in exchange rate management, foreign exchange reserves remain high, at over $60 billion. BI officials are reportedly considering raising the reserve requirement for banks in an effort to slow credit growth. ¶6. (SBU) Despite BI's multipronged approach to fighting inflation, some analysts are concerned that the current pace of rate hikes is insufficient to anchor inflation expectations. According to IMF estimates, BI may need to raise interest rates to 10.5% in order to reverse current price trends and keep rising food and fuel prices from spilling over into core inflation. IMF economists also note that excessively slow interest rate hikes may lead to a loss of credibility at the central bank and will not prevent the need for further rate hikes. Furthermore, a recent JP Morgan report noted that Indonesia's current account surplus may be lower than initially recorded. If the trade surplus is overstated, capital flows are likely playing a significant role in supporting Indonesia's balance of payments position, leaving Indonesia more vulnerable to a reverse in portfolio investor sentiment. A loss of confidence among investors that leads to significant capital outflow would put significant pressure on the currency and fuel domestic price increases. HUME