RISING PRICES PROMPT INTEREST RATE INCREASE

UNCLAS SECTION 01 OF 02 JAKARTA 000901 SIPDIS SENSITIVE DEPT FOR EAP/MTS AND EB/IFD/OMA TREASURY FOR IA-SETH SEARLS AND JWEEKS SINGAPORE FOR SBAKER TOKYO FOR MGREWE COMMERCE FOR 4430/KELLY DEPARTMENT PASS FEDERAL RESERVE SAN FRANCISCO FOR TCURRAN DEPARTMENT PASS EXIM BANK USDA/FAS/OA YOST, MILLER, JACKSON USDA/FAS/OCRA CRIKER, HIGGISTON, RADLER USDA/FAS/OGA CHAUDRY, DWYER E.O. 12598: N/A TAGS: EFIN EAGR ECON PGOV ID SUBJECT: RISING PRICES PROMPT INTEREST RATE INCREASE REF: Jakarta 871 ¶1. Summary. On May 6, the Indonesian central bank - Bank Indonesia (BI) - increased its reference interest rate by 25 basis points to 8.25% in response to higher than expected inflation in March and April. BI also signaled that they expect to raise interest rates further this year. While the 25 basis point increase surprised some analysts, most macroeconomists in the region felt the rate hike was overdue. The rate hike is also a sign that the Government of Indonesia (GOI) plans to implement subsidized fuel price increases in the near term. While a student led protest of planned fuel price hikes in Makassar turned violent this week, overall public reaction to the planned fuel price hike has been subdued. End Summary. Bank Indonesia Shifts Policy Stance -------------- ¶2. Acting BI Governor Miranda Goeltom announced that BI raised its reference interest (SBI) rate on May 6 by 25 basis point to 8.25% in an effort to combat rising price levels. Core inflation has been under significant pressure in recent months due to public expectation that fuel prices will rise and high global commodity prices, according to BI. The CPI inflation rate rose to 9.0% (y-o-y) in April, after jumping to 8.2% (y-o-y) in March. Food prices, which account for 25% of the CPI basket, rose 15.7% and 13.6% (y-o-y),in April and March, respectively. In its accompanying policy statement, BI signaled that additional rate hikes may be forthcoming. They noted that challenges to macroeconomic stability remain due to rising commodity prices and the risk of a global economic slowdown. Market Reaction Generally Positive -------------- ¶3. Most market analysts had been calling for monetary tightening, but few expected BI to move prior to incoming BI Governor Boediono's inauguration on May 17. Analysts had expressed concern in recent weeks that the GOI was slow to realize the pace at which rising fuel and food prices were impacting inflationary expectations in Indonesia. Analyst statements after the interest rate increase expressed relief that BI is taking the inflation threat seriously. The market response to the news has been limited, with the Indonesian stock index rising slightly on May 7. Fuel Price Increase Will Exacerbate Inflation -------------- ¶4. BI also acknowledged that the rate increase factored in GOI plans to increase the price of subsidized fuel by as much as 30% in May or June (reftel). Investors generally view the fuel price increase positively, as it indicates the GOI is committed to maintaining fiscal discipline. Public protests of potential fuel price hikes have been limited to date, although a student protest in Makassar this week turned violent and resulted in six arrests. The GOI plans to implement a direct cash transfer program to 19 million poor households to soften the impact of rising fuel prices. ¶5. If implemented, the fuel price increase could accelerate broader price increases this year, as transportation and energy costs for many sectors rise. HSBC and Standard Chartered expect inflation to rise to 11 percent this year, if the GOI increases the price of subsidized fuel by 25-30% and global commodity prices remain high. Most analysts expect BI to respond by raising interest rates by 100-200 basis points by the end of the year, although political pressure to limit the impact of higher interest rates on economic growth will be strong in advance of the election. GDP growth slowed in the first quarter due to weaker consumption and investment, according to BI. (Note: The Central Statistics Bureau will announce the official first quarter GDP growth rate on May 15. End note.) Aggressive monetary tightening this year, while likely necessary, will slow growth prospects in 2008 and into 2009. JAKARTA 00000901 002 OF 002 HUME