The Tale Of Two Central Banks: Two Different Medicines To Cure One Illness

By W.A Wijewardena-July 15, 2013 

Dr. W.A. Wijewardena

Indonesia tightens its monetary policy

Reports from Indonesia say that the country’s central bank, Bank Indonesia, has increased its interest rates by half a percent, the second such increase it has made within one month. Previously in June this year, it raised its interest rates by a quarter of one percent.
Though the market had expected Bank Indonesia to make this move in July, it had not anticipated an increase of this magnitude since the normal increases in interest rates in the past have been only by notches of a quarter percent on each occasion. Hence, the high quantum of increase this time signifies the high importance which Bank Indonesia has assigned to the current problem faced by the country.

These types of interest rate increases by central banks are known in the markets as ‘quantitative tightening’ since they seek to reduce the increases in the quantity of money. The continued quantitative tightening by Bank Indonesia in this manner has been prompted by two considerations.

High interest rates to prevent inflation becoming permanent

The first is to tame the initial increase in the cost of living of people brought about by a massive increase in the retail prices of petroleum products by the government earlier in June. Though Indonesia has been a petroleum producing country, the retail prices of all petroleum products had been subsidised by the government by selling them below costs.

Since this subsidy was no longer affordable, in June, the price of petrol was increased by 44% and that of diesel by 22%. This has caused the consumer price index to jump to 5.9% in its annual growth as at June thereby exceeding the government’s inflation target of 3 to 5.5% set for 2013.

Since the mandate of the Indonesia’s central bank is to maintain inflation at the targeted level and it cannot come out with excuses later if it has failed to do so, it has taken tough action to tighten the quantity of money being produced in the country.

Raise interest rates to prevent the currency from depreciating             Read More