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 What next after U.S. Fed interest rate cut?

26/09/2007 (The Jakarta Post) - The Federal Reserve's recent move doesn't provide a solid reason for Indonesia to cut its interest rates. Markets worldwide reacted positively after last week's decision by the Federal Reserve to cut the rate it charges for overnight interbank lending -- known as the Fed Funds Rate -- by half a percentage point to 4.75 percent.

For Indonesia, apart from the rupiah strengthening 1.5 percent against the dollar recently, yields (prices) in the bond market have also declined (increased) markedly. For example, the yield on the benchmark 20-year bond has dropped from 10.05 percent the day prior to the Fed Funds rate cut to 9.85 percent recently.

The rally in the domestic bond market has been driven by stronger interest among foreign investors, and expectations that the central bank may resume cutting its benchmark interest rate; i.e., the one that anchors the discount rate for 1-month central bank papers, known as the BI rate.

After the Fed move, the closely watched interest rate differential between the BI rate and the Fed Funds rate widened to 350 bps (or three-and-a-half percentage points), from the previous 300 bps. However the argument that the domestic reference rate should be cut on this basis alone is an oversimplification.

Aware of the need to be consistent in its policies, particularly regarding the "inflation targeting framework", BI will be more likely to have domestic inflation considerations in mind.

In this regard, the picture does not seem so rosy.

The hikes in soft commodity prices have started to creep through into the prices of everyday goods in the consumer's shopping basket. For example, cooking oil prices in Jakarta have risen by over 50 percent compared to six months ago, while palm oil prices on the international market rose concurrently by a similar amount.

Cooking oil accounted for nearly one-tenth of the monthly consumer price inflation seen in August.

It may not end there. Wheat prices on the international markets have risen by over 70 percent since March, while oil prices recently reached an all-time high of US$82/barrel. The pass-through effects on the CPI are yet to come.

Economists also look at money supply indicators as a leading indicator of inflation. In this regard, there also seems to be limited room for further monetary easing.

Along with rising credit growth, the rate of growth in the narrow money supply, or M1 (a proxy for transaction balances), in July reached a staggering 28 percent p.a. Meanwhile the broad money supply grew during the same period by 18 percent.

As a rule of thumb, money supply should grow at a rate that is more or less in line with the rate of growth in nominal GDP, which probably would be in the region of 12 to 13 percent.

From a growth perspective, the argument for cutting rates can also be debated. Indeed, a slowdown in the U.S. could impact on the Asian region, Indonesia included.

According to a report by the Asian Development Bank, while intra-Asian trade has flourished, developed economies such as the U.S. remain the final destination for most Asian exports.

But this may or may not require additional monetary stimulus. For Indonesia, the situation is quite distinct.

Three-quarters of economic growth is driven by domestic demand, and the proportion of exports to the overall economy is relatively low (i.e., 29 percent vs. 125 percent for Malaysia, 75 percent for Thailand and 43 percent for the Philippines) --suggesting some degree of relative resilience against global economic fluctuations.

And perhaps what's more relevant to Indonesia are primary commodity prices. Commodities related to agriculture and minerals comprise nearly half of Indonesia's total exports. So, it could be argued that as long as commodity prices do not go into free fall, Indonesia will be able to survive a U.S. recession without too much damage.

Another strong reason not to cut interest rates is that the 3-month SBI rate is already quite low. With only Rp 12 trillion in 3-month central bank papers, or SBIs, outstanding (i.e., less than 5 percent of outstanding 1-month SBIs), the 3-month SBI rate is not as widely referred to by investors in the market.

However, being the benchmark rate used to determine coupon rates on variable rate government bonds, it is a decisive element that affects commercial bank margins.

Since the 3-month SBI rate is already half a percentage point below its 1-month counterpart, competition among the banks to lend more money has intensified.

This appears to have helped bring down the base lending rate, which forms the basis for banks in charging their customers interest, to a post-crisis low of 13.3 percent. And despite the BI rate having been held constant for the last 2 months, the base lending rate has continued to decline.

If there is one lesson to be learned from the U.S. sub-prime collapse, it is to not underestimate the degree to which monetary policy is transmitted into the real economy. The U.S. economy's current woes are undoubtedly linked to the negative "real" interest rate period between 2002 and 2005.

Indonesia is still some distance away from having negative real interest rates. But with domestic inflationary risks on the rise, it's difficult to ascertain just how far that distance really is. -- The writer is an economist at PT Bahana Securities

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