Monetary Policy – Indonesian style divider line

Andrew Pegler – 10 September 2010

Hello readers and Selamat pagi. I’ve just returned from Indonesia where interest rates aren’t the only way they keep inflation under wraps.

As we have discussed before, central banks control inflation by raising or lowering interest rates. Lowering them encourages spending and growth and vice versa. But this hits growth pretty hard and Bank Indonesia (BI), Indonesia’s central bank, has a pro-growth policy so raising interest rates goes against this. So instead BI controls the supply of money to the economy using something called the “primary reserve requirement”. What happens is BI forces Indonesian banks to park a certain fraction of their deposits with it in reserve i.e. a primary reserve requirement. And it can increase and decrease this reserve requirement as it sees fit. The thinking is that this is a neater way to alter the amount of money available for people to borrow without raising interest rates and hence control inflation. This method is not a commonly used monetary policy tool in western industrialised nations but Asian countries like it because it doesn’t hit growth as badly as raising interest rates. And in Asia growth is always the new black. But aside from academic interest, the reason I bring all this up is because right now the BI is worried that Indonesian banks have too much money available to lend to people and it fears this will feed Indonesia’s growing inflation, which just hit a 16-month high. So it has increased the banks’ primary reserve requirement from 5% to 8% of their deposits, sucking out Rp 50 trillion ($5.6 billion) from the economy in one hit. This will slow spending and cap inflation while giving BI the room to delay a rate increase if global growth picks up because, as I said, in Asia growth is always the new black.

One obvious problem I can see in all this, however, is that raising the reserve requirement reduces the amount of money around. And with less money available for people to borrow, it will be more expensive to borrow i.e. rates will go up in line with the laws of supply and demand.

FYI at the moment the Indonesian interest rate is at a record low of 6.5% – ours is 4.5%, the US’s is close to 0% and the UK’s is 0.5%. Also the BI targets an inflation rate of 4-6% while the RBA is a more sober 2-3%. The difference reflects the fact ours is a more developed economy.

Terima kasih banyak readers!