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TOWARDS IMPLEMENTATION OF INFLATION
TARGETING IN INDONESIA
Halim Alamsyah , Charles Joseph , Juda Agung & Doddy Zulverdy
To cite this article: Halim Alamsyah , Charles Joseph , Juda Agung & Doddy Zulverdy (2001) TOWARDS IMPLEMENTATION OF INFLATION TARGETING IN INDONESIA, Bulletin of Indonesian Economic Studies, 37:3, 309-324, DOI: 10.1080/00074910152669154
To link to this article: http://dx.doi.org/10.1080/00074910152669154
Published online: 17 Jun 2010.
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TOWARDS
IMPLEMENTATION
OF
INFLATION
TARG ETING
IN
INDONES IA
HalimAlamsyah,CharlesJoseph,JudaAgungandDoddyZulverdy*
BankIndonesia,Jakarta
Theexperienceofhighinflationaccompanyingtheeconomiccrisisin1998hasbrought
backpainfulmemoriesofhyperinflation inthe1960s.Successwithinflationtarget
-ing(IT)inothercountrieshaspromptedIndonesiatoconsiderthisframeworkas
thebasisformonetarypolicy,aresponsethatseemsjustifiedonatleasttwogrounds.
First,monetarypolicyneedsa newanchorafterthe abandonment in1997ofthe
previousregimeofmanagedfloating.Second,thecentralbanklawenactedin1999
prescribesstabilityofthevalueoftherupiahasBankIndonesia’ssoleobjective.This
paperexploresthefutureframeworkofmonetarypolicyunderaformalITapproach
andhighlightstheconstraints BankIndonesiafacesinimplementing suchanap
-proach.Itdiscussesthemonetarypolicyframeworkbeforeandduringthecrisis,
andinthepost-crisisperiod.Itthengoesontooutlineapreliminary designfora
suitableITframeworkforIndonesia.
INTRODUCTION
Overthepastdecadeinflationtargeting (IT)has become a fashionable frame
-workformonetarypolicyinmanycoun
-tries.Thisnewframeworkinvolvesthe followingbasicelements:first,deciding on,andannouncing, atargetlevelofin
-flation forthe coming period; second, forecasting thelevelof inflation inthe coming period, given assumed mon
-etarypolicysettings(i.e.ofoneormore monetaryvariablesunderthecontrolof thecentral bank, such asbase money growthorakeyinterestrate);third,ad
-justingthesemonetarypolicysettingsin orderto achieve the targeted inflation rate;andfourth,adjustingthemonetary policy settings inline with revised in
-flation forecasts as new data come to hand.Itisamonetarypolicyalternative totargetingtherateofgrowthofmon
-etaryaggregates, theexchangerate,or interestrates.Effectively,ITintroduces
transparency,discipline, accountability andaforwardlookingoperatingproce
-dure.
Pioneeredby NewZealandandfol
-lowed by many industrial countries such as Canada,theUnitedKingdom, Sweden,Finland,Spain,Australiaand Israel, IT quickly gained support and was adoptedinseveralemergingmar
-ket countries such as Chile and the Czech Republic. Quite recently, Brazil andseveralAsiancountriessuchasKo
-rea,ThailandandthePhilippines have alsoofficiallyadoptedinflationastheir nominalanchorformonetarypolicy.
International experiencewithIThas shown some very positive results. In general, those countriesemploying an IT framework have experienced both lower rates of inflation and lower ex
countries (Bernanke et al. 1999;Allen 2000;Haldane1995).AstudybyCorbo
et al.(2001),for example, reports that inflationindevelopingcountriesadopt
-ing an IT frameworkdeclines signifi
-cantlytolow levels similar tothosein developedcountries.Countriesadopt
-ingIThavealsoenjoyedlowernominal interest rates. Finally, it is found that withincreasesincentralbankcredibil
-ityovertime,ITreducesthevariability ofbothinflationandoutput(Cecchetti andEhrmann1999).Thislastfindingis crucial,sincemanyarguethattheadop
-tionofITmaysacrifice outputgrowth, especiallyindevelopingcountriesthat mayputgreatweightonrapidgrowth to generatemuch needed welfare im
-provementsfortheirpopulation. Theexperienceofcountriesthathave pioneered IT seems to suggest that a prerequisite for the successful imple
-mentationofthisapproachisahighde
-gree of central bank independence, especially in the pursuit of monetary policy(Debelle1997;Debelleetal.1998). InallITcountries,thecentralbankhas somedegreeofindependenceeitherin formulating its objective (goal inde
-pendence)oratleastinchoosingthein
-strumentswithwhichtoachievetherate ofinflationdeemedappropriate bythe authorities (instrument independence). Relatedtothis,themonetisation offis
-caldeficitsneedstobe strictly prohib
-itedorlimited.
Apartfromthesuccessoftheframe
-workinothercountries,thereseem to beatleasttwoothergroundstojustify theuseofexplicitITinIndonesia.First, followingthe abandonmentin 1997of theuseofintervention bandsunderthe previous regime of managed floating, monetary policy needs an alternative nominalanchor;theinflationrateisone such alternative. Second,thenewcen
-tralbanklawenactedin1999prescribes thestabilisation oftherupiah’svalueas
thesoleobjectiveofBankIndonesia(BI). Althoughthelawdoesnotexplicitlycall for theuse of IT, thefeatures ofmon
-etarypolicyitoutlines—suchasthean
-nouncementof an inflation target,the adoptionofrupiah stabilityasthesin
-gleobjective,andthegrantingofinstru
-ment independence—appear to us to haveplacedBI’smonetarypolicyimplic
-itlyintoanITframework.
Lessons from international experi
-encewillbeindispensable inproviding insightsintothepreconditions for,and the necessary institutionalset-up sur
-rounding, the implementation of IT. Theseinsightswillbeimportantevenif factors thatwere seen to be critical to ensuring thesuccessofIT inmorede
-veloped countries may have different weightsinthecontextofemergingmar
-kets like Indonesia. Experience from countriessuchasIsraelandChilesug
-gests that achieving and maintaining pricestabilityreliesonastrongpolitical commitmenttosustaininganappropri
-atemacroeconomic policymix.Further
-more, although technical capability is certainly not a rigid requirement, any lackofit,especiallyininflationandout
-putforecasting, mayinhibitthesmooth implementationofIT.Inbrief,although somebasicelementsofITcanbeidenti
-fied as necessary conditions, further analysis of the preconditions and the institutional set-up willalso becrucial when a developingcountry likeIndo
-nesiadecidestoadoptthisapproach.
THEEXISTINGM ONETARY POLICYFRAMEWORK:TOWARDS INFLATIONTARG ETING
ThemonetarypolicyframeworkinIn
-donesiahasevolvedgraduallyoverthe pastthreedecades.Forexample,mon
-etarymanagementhasmovedfromdi
the ultim ate objectives of monetary policy were vaguely formulated, and included keeping inflation under con
-trol,themainanchorofmonetarypolicy wasthe exchangerate.With a heavily managedexchangeratesystem,thecon
-ductofmonetarymanagementwasef
-fectively constrained and, given the multipleobjectivesofpolicy,thecentral bankendedupwithaneclecticapproach initsdecisions.Thisapproach—combin
-ing money,interest rate and exchange ratetargeting—provedverydifficultto administer,especiallyduringthe1990s when the integration of the economy withtheinternational financialmarket became more pronounced.1 With an
opencapitalaccountcoupledwithlarge andvolatile capitalflows,thepolicyof keepingtheexchangeratewithinarela
-tively narrow band facedtremendous challenges.Asthecurrencycrisisbegan togetunderwayinmid1997,specula
-tive pressures in both themoney and foreignexchangemarketsincreaseddra
-matically,leading tothe adoption of a flexibleexchangeratesysteminAugust 1997.
Underthenewflexibleexchangerate regime,choosinganalternativenominal anchor became critical to monetary policy.The1999centralbanklawsetout anew frameworkforsuch policy, and hasprovidedthebasisforBItosearch foranewandappropriate nominalan
-chor.Whileduringthepost-crisisperiod base money is still beingused as the anchorunder the IMFassistance pro
-gram,itssuitability forthefutureneeds tobe questioned. Inany case,asit re
-flectson pastexperience and contem
-platesthechallenges ahead,BIshould seethesearchforanewanchoraspart of a quest for econom ic discip line throughtransparency andaccountabil
-ity,andforamoreforwardlookingop
-erating procedure in the conduct of mo netary policy—that is, pla cing
greateremphasisonforecastinginflation andadjustingmonetarypolicysettings inlightoftheseforecasts.
TheM onetaryPolicyFramework PriortotheCrisis
Before thecrisis, monetary policy was conductedmainlybyusingbasemoney as theoperational instrumentfor con
-trollingothermonetaryaggregatessuch asbroadmoney.Whilethereweremul
-tipleobjectives—suchasalow levelof unemployment,higheconomicgrowth, asustainablebalanceofpaymentsposi
-tion anda tolerable rate ofinflation—
the anchorof monetary policy during thisperiodwasclearlythenominalex
-changerate,whichwasmanagedheav
-ilywithinarelativelynarrowbandthat depreciated at a fairly steady ra te (McLeod 1997a: 22). The band was graduallywidenedafter1992,reaching plusorminus12%fromthecentralpar
-ity in July 1997, about a month before Indonesia’s currency crisis broke. Al
-though the use of base money as the operational instrument for monetary policyseemedtohavebeeneffectivein the1980sandearly1990s,thesameap
-proach was strongly challenged there
-after,notleastbecausetherelationship between nominal income and broad moneybecameincreasingly unstableas aresult ofglobalfinancialinnovations andderegulation.
Therehasbeenconcernthatitisdiffi
-cult for policy makers to control base moneygrowthforatleasttwo reasons (Boediono1998).First, themarketsfor theinstruments withwhichopenmar
-ketoperationswereconducted,namely central bank bills (SBI, Sertifikat Bank Indonesia) and money market paper (SBPU, Surat Berharga Pasar Uang), were relatively thin and fragmented.2
Theliquidreservesofthebankingsys
by thestate banks, so thatthe private banks relied heavily on the interbank market to manage their liquidity, and were therefore vulnerable to sudden shocks.Withthisfragmentedmarketit wasquitedifficultforBItocontrolsys
-temliquiditywithoutcreatingpressure oninterest rates. For example,in Sep
-tember1984,whenBIsqueezedliquid
-ity from the market, the interbank overnightrate jumped to 90% per an
-num.Andinmid1987,whenBIwanted tocounteractspeculativetransactionsin theforeignexchange market,the state bankshad to be forced to repurchase SPBU,and state-owned enterprises to usetheirdepositsheldatthestatebanks tobuySBI,inordertoreducetheavail
-abilityoffundsforspeculation. Asimi
-larstorywasplayedoutearlyin1991. Second,incertainperiodsbasemoney is endogenous with respect tooutput. Forexample,duringperiodsofupswing in the economy, rising aggregate de
-mandisaccompanied bybothincreased foreign borrowingand theliquidation ofSBIbysaletothecentralbank,both of which result in increases in base money(giventhequasi-fixedexchange ratepolicyandareluctancetoallowSBI ratestorise).Controlling thegrowthof basemoney(andthroughit,aggregate demand)isthereforeadifficultjobthat sometimesneedsextremely highinter
-estrates.Thedifficulties ofcontrolling basemoneyusingmarketinstruments led,in some cases, to theuse of non
-marketinstruments such asreservere
-quirements, moralsuasion and tighter prudentialregulations forthebanks.
Inshort,monetarypolicyusingquan
-titytargetsbecamelesseffective.Faced withthischallenge,BIinitiallyfollowed apragmaticoreclecticapproach.With
-out abandoning quantity targeting, it gave more attention to interest rates. Moreover,asnotedabove,theinterven
-tionbandunderthemanagedexchange
rateregimewaswidenedseveraltimes to allow greaterflexibility and toease theconflictwith monetarypolicy.This pragmaticapproachwasviewedaspart ofatransitional phaseduringwhichthe monetary authority was shifting its policy from quantitytargetingtoprice (interestrate)targeting.Toalargeextent, however,therecentfinancialcrisis has forcedBItopostponeadoptingtheprice targetingapproachandcontinuetouse thequantityapproach,forreasonsdis
-cussed below. Despite these reserva
-tions,priortothecrisistheoverallstance ofmonetarypolicyappearscomparable totheanti-inflationary stanceoftheUS FederalReserve’spolicyintheVolker–
Greenspanera:interestratesarefound to have reacted in virtually identical ways to changesin expected inflation andinoveralldemandinIndonesiaas theyhaveintheUnitedStates(McNelis 2000).
TheFrameworkduringtheCrisis Thefinancialcrisishadahighlydesta
-bilisingimpactontheeconomy.Pressure ontheexchangerateandonforeigncur
-rencyreservesearlyinthecrisis forced BI to abandon the crawling band ex
-change rate regime and to allow the rupiahtofloatinAugust1997.Triggered bydramaticdepreciation oftherupiah, thecrisisresultedinthemostsevereeco
-nomicdownturninmorethan30years. RealGDPshrankby13.2%during1998, alongsidea large-scale collapse ofthe bankingsystem,andwidespreadbusi
-nessfailuresandjoblossesinthemod
-ernsector,especiallyinconstruction. Soonafter floatingthecurrency, the governmentadoptedanextremelytight monetary policy, raisinginterest rates sharplyandforcingstateenterprises to withdrawfundsfromthebankingsys
asauctionsofSBPU,theDiscountFacil
-ityIandrepurchases ofSBI.3 Thejump
ininterestratesand theenormousde
-preciationoftherupiahseverelyaffected thebankingandrealsectors.Giventhe fragilityofbothsectors,thiscontributed to widespread corporate failures and resulted in a worsening of the banks’ assetquality.
Topreventbankrunsandacollapse of the entire banking system, BI was obliged,aslenderoflastresort,topro
-vide large-scale liquidity support to troubledbanks;thiscausedatemporary lossofmonetarycontrolinlate1997and early1998.Asaresult,basemoneygrew by115%andbroad moneyby68%be
-tweenNovember1997andJuly1998.As people’s confidence in the rupia h eroded,acycleofweakeningcurrency, soaring prices and expanding money supplythreatenedtobreakoutintohy
-perinflation. BI’smainobjective,there
-fore, was to restore confidence in the currency;hyperinflation hadtobepre
-ventedandinflationbroughtdown.BI believed that if prices were stabilised, thiswouldinturnstrengthenthevalue oftherupiahrelativetoothercurrencies. Toachievetheseaims,monetaryex
-pansionneeded first tobe halted,and BIneededtoregaincontroloveritsown balancesheet.Allsourcesofcentralbank moneycreation needed tobe brought undercontrol,andBIneededtoreabsorb excessliquidity from thebanking sys
-temandinthebroadereconomy.With the support of the IMF, BI pursued a tight money policy stance, with base moneyasthetarget.Quantitativetargets werealsosetforotheritemsinthecen
-tralbank’sbalancesheet.BIdidnotal
-lowdomesticassetstoexpand;broadly speaking,netdomesticassetsweretar
-geted for zero growth. To protect its foreignassetposition,afloorwasestab
-lishedfornetinternational reserves.In April1998,topreventfurthergrowthof
liquiditysupport,BIimposedhighpen
-altiesontheuseofthediscountwindow facilityandoncommercialbanks’nega
-tivebalances(overdrafts) atthecentral bank. Furthermore, in May 1998 BI placed ceilings on deposit rates and interbankrates forbankliabilities that hadbeenguaranteedbythegovernment sincelateJanuary.Thepolicy aimedat preventingbanksfromadoptingimpru
-dent measuresthat could lead to self
-reinforcing expansions of liq uidity support.
Becauseofanumberofconstraintson the use of money market instruments (suchasthethin marketforSBI),open marketoperationswerenotablefullyto absorballoftheexcessliquidityinthe economy. To achieve the quantitative target, attempts were made to render openmarketoperationsmoreeffective. On29July1998BIchangedtheauction systemofSBI,such thatemphasiswas shiftedfrominterestratetargetstoquan
-titativetargets.Furthermore, participa
-tionintheSBIauctionswasbroadened fromprimarydealerstoincludebanks, moneybrokers,capitalmarketbrokers and thegeneralpublic. These changes wereintendedtoallowgreatercompe
-tition among auction participants, so thattheSBIratewouldbetterreflectthe interaction betw een dem and and supply.
Another innovation that enhanced monetarypolicyoperationswas‘rupiah intervention’—theprovision ofa facil
-ityunderwhich banksthatfailtopur
-chasethedesiredquantityofSBIinthe regularauctionscanlendtheirexcessre
-servestoBIforshortterms(onetoseven days),ataninterestratelowerthanthat forlongermaturitySBI;thisinstrument is used tosupport monetary restraint. Controlof monetaryexpansion result
-ingfromgovernmentexpenditureisalso effectedfromtimetotime bysterilisa
thatis,bythesaleofforeignexchange, whichhelpstostrengthentherupiah.
Tosumup,targetingofthemonetary basewas adoptedbyBIafterthecrisis as a temporary measure intended mainlytoabsorb the monetaryexpan
-sionoriginating fromliquiditysupport to the banking system, rather than beingbasedonmorefundamentalcon
-siderations suchasastablerelationship between inflation and base money (Iljas1999).4
TowardanInflation TargetingFramework: The1999CentralBankLaw
Amajorchangeintheconductofmon
-etarypolicyintheaftermathofthecri
-siswastheenactmentofanewcentral bankinglawinMay1999,whichgives fullautonomytoBIinformulating and implementingmonetarypolicy.Theleg
-islation drew upon international best practice—for example, at the Bundes
-bankofGermany.5
Certainfeaturesofthenewlawhave importantconsequences fortheconduct ofmonetarypolicy.First,incontrastto thepreviouslaw,whichprescribedmul
-tipleobjectivesformonetarypolicy,the newlawclearlystatesthatthesoleob
-jectiveofmonetarypolicyis topursue andmaintainstabilityofthevalueofthe rupiah.Thisobjectivemightbeargued tobesomewhatambiguous.‘Thevalue oftherupiah’couldrefertoitsvaluein terms of another currency unit—pre
-sumably the US dollar, but perhaps someothercurrency suchastheJapa
-nese yen or the Euro. The alternative interpretationisthatitreferstothevalue ofthegoodsandservicestherupiahcan buy.Thisinterpretation impliesthatthe objectiveisthemaintenance ofdomes
-ticpricestability,anditisthisinterpre
-tation that has emerged as the operationalone.Thedistinctionbetween thesetwointerpretations,andanyattrib
-uted ambiguity, may be overstated, however.Inpractice,exchangerateand pricestabilityareusuallycloselycorre
-lated.Certainly,low inflationhasgen
-erally been consistent with reasonable exchangerate stabilityinthepast—al
-thoughtherecentcrisisraisesdoubtsas towhetherthiscanbetakenforgranted inthefuture.
Second,thenewlawprovidesBIwith a framework conducive to pursuing pricestability.Inconductingmonetary policy, BI is granted full authority to decide upon the inflation target to be achieved(goalindependence)andfree
-dom of choiceover various monetary instruments to achieve this target (in
-strumentindependence).6 Thelawalso
prescribes that BI, as an independent institution, isfreefrominterference by thegovernmentandallotherparties.
APRELIMINARYDES IG NFORAN INFLATIONTARG ETING
FRAMEWORK
Under an IT framework, monetary policyisdirectedatinfluencing aggre
-gatedemandsothatitisconsistentwith economiccapacityfromthesupplyside, tokeeptherateofeconomicgrowthsus
-tainable. The logic of this approach makesaninflationtargetformonetary policy widely acceptable.A problem arises at the level of implementation, however.Monetarypolicyconfersonly veryimperfectcontroloverinflation—
or,asMiltonFriedmanhasputit,mon
-etarypolicylagsarelongandvariable. Thechannelsthroughwhichmonetary policy instruments influencetheinfla
-tion rate—the monetary transmission mechanism—arestillunclear,suchthat some economists have dubbed the transmission mechanisma‘blackbox’.7
Themechanismiscomplexandthere
-lationship between the variables is somewhat unstable. In this environ
mindin designing a monetarypolicy framework.
Theseuncertainties aside, given the newbasisformonetarypolicythathas been laid out under the 1999 central banklaw,variouspracticalissuesneed to be considered in designing the IT framework.Theyincludetheabilityto forecastinflation;theappropriate meas
-ureofinflation;theoptimuminflation rate;theappropriate timehorizon;and theappropriate operatinginstrument.
AbilitytoPredictInflation
Anabilitytomakereasonablyaccurate predictionsofinflationisoneofthenec
-essaryconditions forimplementing an ITframework,sincesuchforecastswill determinewhatpolicyactionsshouldbe takeninordertokeepinflationontar
-get.WithinBIanumberofstudieshave beenconductedoftheinflationcycle,the diffusion indexof theconsumer price index(CPI),leadingindicatorsofinfla
-tion,andotherleadingeconomicindi
-cators that help to determ ine the directionofinflation;partialandgeneral equilibriummodelshavealsobeenbuilt toforecast theinflation rate.Theinfla
-tion cycle study servesas a means to capturecyclicalswings,inordertofore
-castroughlywhenpeaksandtroughsof inflationwilloccur;studiesofthediffu
-sionindexof theCPIcanalsoprovide thiskindofinformation. Ingeneral,this researchindicatesthattheinflationrate inIndonesia is broadlypredictable on thebasis of variables that include the outputgap(thedifferencebetweenac
-tual GDP and the estimated long-run trendvalueofGDP),aggregatedemand, realmoneybalances,importprices,and the exchange rate (Bank Indonesia 1999a).
Theindexofleadingindicatorsofin
-flation is anindex of componentsthat provideinformation onthelikelydirec
-tion ofchangeininflation.Thesecom
-ponentsincluderealbroadmoney(M2), realbankloans,SBIrates,stockprices, the importprice index, nominal GDP, and thenumberofdocumentscleared through thepayments system.The in
-dexofleadingindicatorsofinflationcan only indicate the direction of future changes in inflation, not their magni
-tude.Thisinformation canbeusedasa checkontheresultsfrominflationfore
-casts. The information obtained from otherleadingeconomicindicatorssug
-gests thedirectionof changein future economicactivity,especiallyonthede
-mandside.Sincedemandpressureswill affectinflationrates,theseeconomicin
-dicatorscanalsoserveasinputsforin
-flationforecasting.
WhichM easureofInflation?
BIusestheconsumerpriceindex,appro
-priatelymodified(asdescribedbelow), asitsbasictarget,inline withpractice inothercountriesthathaveadoptedIT. AtheoreticaladvantageofusingtheCPI (inpreferencetoothermeasuressuchas theGDPdeflatorortheproducerprice index) is that it directly indicates changesinthecostoflivingforconsum
-ersonfixednominalincomes.Apracti
-cal advantage is that the national statistical agency devotes more re
-sources to obtainingreliable CPI data thantootherpriceindices,asisalsothe case in other countries. CPI data are thereforeofbetterqualityandareavail
-ableonamoretimelybasis thanother pricedata.
Nevertheless CPIinflationinIndone
-sia is very much characterised by ex
-treme pricechangesforcertaingoods, usuallyasaresultofsupplyshocksas
-sociatedwithweatherorseasonalpat
-terns. Since supply shocks primarily affect food items, and since food ac
-plicationisthatitcouldbedestabilising touseoverall(or‘headline’)inflationas thetarget.Forexample,ifthereisade
-mandshockthatleadstohighinflation, thecentralbankwill respondbytight
-eningmonetaryconditions. Inthisway, monetary policy canadjust growth in aggregatedemand soastomatch out
-putcapacity. However, if inflation in
-creasesbecauseofasupplyshocksuch asbadweatherthatraisesfood prices, tightenedmonetarypolicymightcause an unintended slowing of economic growth.Likewise, if the headlinerate fallsinspiteofanincrease inunderly
-inginflation,simply becausea supply shock pullsdownsome food prices, a responsethatloosenedmonetarypolicy wouldaddto theunderlying inflation rate.
To avoid such destabilising effects, some (e.g. Freedman 1997) argue that monetarypolicyshouldrespondonlyto the second-rou nd effects of supply shocks,ignoringthefirst-roundeffects: thatis,sincesupplyshockscauseprice volatility in some components of the CPI, these components shouldbe ex
-cludedfromthemeasureofinflation.To putitdifferently,giventhestronginflu
-enceofsupplyshocks,thereisanargu
-mentfordividingheadlineCPIinflation intotwoparts:core(orunderlying) in
-flation and noise.8 ThusBI usescore,
ratherthanheadline,inflationasitstar
-get,sinceonly coreinflationis consid
-ered to be controllable by monetary policy. The guiding principle is that monetarypolicyshouldnotberespon
-sible fornon-monetaryfactors thatin
-fluenceprices.
Inchoosing to use core rather than headlineinflationasthetarget,however, BIfaces adilemma.Headlineinflation isfamiliartothegeneralpublic,whereas theconcept of core inflation is not.In consequence, mostmembersofthegen
-eralpubliccareabouttheformerbutnot
thelatter,soiftheinflationtargetisthe coreinflationratethiswillbemuchless acceptable, andthecredibilityofthetar
-getmight bequestioned. Furthermore, sinceBIhasbeengrantedindependence insettingtheinflationtarget,calculation ofthecorerateofinflationbythesame institutioncouldexacerbatethecredibil
-ityproblem.Forthisreasonitmightbe preferableifthejobofcalculating core inflationcouldbegiventothenational statisticsagency.
Methodologies havebeendeveloped recently within BI tomeasure core in
-flation. These include adjustment by exclusion(excluding certaincategories ofgoodssuchasenergyandfoodfrom the price index calculation), specific adjustment (excluding categories of goods and services with government
-controlled prices at times when their pricesarealtered),andstatisticalmeas
-urestoreducetheimpactofvolatilityin certainprices.Severalcountriesusethe exclusion method,excludingfood and energy.However,experience withinBI inestimatingcoreinflationsuggeststhat statisticalmeasurestoexclude(or‘trim’) extremepricechangesintheCPIbasket aremorerobust.
TheTargetInflationLevel
The new la w prescribes that BI is obliged toconvey informationto the publictransparentlythroughthemass media at the beginning of the year, co vering topics such as m onetary policyplansandtargetsderivedfrom theinflationtarget.Thus,forexample, there have been announcements fol
-lowingmeetingsoftheBoardofGov
-ernors stating that the target rate of inflation for2000was 3–5% andthat fo r 2001 w as 4–6% .9 These targets
prices, civil servants’ salaries, and otheradministeredprices.
Thereisnospecificruleonhowlow thetargetlevelofinflationshouldbe.If interpreted literally,theterm‘pricesta
-bility’suggests a zero inflation target. However, given imperfections in the measurement ofinflation,thetargetfor mostITcountriesisusuallysetslightly higherthan zero. Indevelopingcoun
-tries, where noise inflation due to supplyshocksappearstobemoresig
-nificant than in developed countries, inflationtargetsareusuallysetatastill higher level (Mishkin and Schmidt
-Hebbel2001).
TheITframeworkischaracterisedby forwardlookingmonetarypolicy,imple
-mentedinresponsenottopastinflation but toexpected inflation. That is, it is implemented after takingintoaccount potentialinflationary pressures in the future.Forthisreasonafurtherconsid
-eration is that achieving the inflation targetisdifficultintheshortrun.There isalag betweenchangestothesetting ofmonetarypolicyandthefulleffectof theseoninflation.Thislagisinfluenced bythechannelthroughwhichmonetary policyistransmittedtotherealeconomy, andalsovariesdependingonwhether monetarypolicy is beingtightened or loosened.Accordingly,inadditiontoa short-termtarget,BIplanstoestablisha medium-term target to bereached in stages,todemonstrateBI’scommitment toreachingandmaintaining low infla
-tion. This medium-term target is in
-tendedtobecomeabasicreferencepoint indetermining thepublic’sinflationex
-pectations.
T h e i nfl atio n targ et c an b e ex
-pressedasarangeorasasinglepoint. Arangetargetmaygivemoreflexibil
-ity in monetary management, espe
-c i al l y i f s h o c k s ar e no t al w a y s immediatelyrecognisedandtheirim
-pacts on the general price level are
difficulttopredict.Ontheotherhand, a range target may compromise the credibility of the centralbank, asthe exact inflation rate upon which the centralbankbasesitsmonetaryplan
-ningandpolicy maynot beapparent to ec ono m ic agents. In sever al IT countries,thestrategyinitiallywasto announceasinglepointinflationtar
-get, but as credibility has increased, theircentralbankshavebeenmoving graduallytoward arelativelynarrow rangetarget.Othercountries(e.g.Is
-rael)initiallyoptedtousearangetar
-get, but gradually shifted toward a singlepointtarget.InIndonesia’scase, given the depth of the crisis and the longer transition period to recovery that might be needed, a more prag
-matic orflexible approachthat relies onarangetargetseemsappropriate.
TimeHorizon
Twoquestionsneedtobeconsideredin specifyingtheappropriatetimehorizon forreturningtothetargetedlevelofin
-flationshouldtheactualrateturnoutto be different. The first is how long it wouldtaketoreachtheinflationtarget with minimum output loss (assuming thetargethasbeenexceeded).Thisde
-pendsmainlyontheshort-runtrade-off between output and inflation as re
-flectedinthePhillipscurve,andonthe credibilityofthemonetaryauthority(as reflectedinhowthepublicformsitsex
-pectationsofinflation).Thesecondques
-tionishowlongisthemostappropriate forecasting horizonformonetarypolicy determination,whichdependsonmon
-etarypolicy lags. Usingvarious meth
-ods, an internal BI study suggests a policylagoffourtoeightquarters—that is,ittakesfromonetotwoyearsforany changeinSBIratestohaveitsfulleffect ontheinflationrate.Thisfindingiscon
OperatingInstruments
Therehadbeendebatebeforethecrisis aboutswitchingtheparadigmofmon
-etary policy from conventional mon
-etarytargetingtoIT.Aftertheproblem oftemporary loss ofmonetarycontrol duringthecrisiswas resolved,theuse ofinterestratesasmonetaryoperating instruments could be considered seri
-ously,resultinginaninternalBIstudy thatsuggests thatinflationcan be tar
-geted more effectively using interest rates as the operational instrument ratherthanbasemoney(BankIndone
-sia1999b).10
AtthetimeofwritingBIisconsider
-ingusingatypeofTaylorrulebasedon thoseusedbycentralbanksinNewZea
-landand the UK (Batini and Haldane 1999;DrewandHunt1999)asthebench
-mark for its monetary policy reaction functionforadjustingmonetarypolicy settingsinaccordancewithrevisionsto forecastsofinflationandoutput.Asim
-ple Taylor-type rulefor adjusting the interestratecanbeexpressedas:
rt-rt-1=a p( t k+ -p*)+b(yt k+ -y*)
subjectto
rt-rt-1£h,
wherertis the currentinterestrate on thechoseninstrument, pt+kand yt+kare projectedinflationandoutputkperiods intothe future,respectively,p* and y*
are the inflation target and potential output,respectively,atthattime,anda,
bandhareconstants.Thelargerarea
andb,thelargertheadjustmentofthe interestratetogiven deviationsof in
-flationandoutputforecastsfromthetar
-getandpotentiallevels.Theroleofh is tolimittheoverallchangeintheinter
-est rate from one period to the next. Uncertaintiesinherentinthetransmis
-sionmechanismstillsuggesttheadvis
-abilityofavoidingan approachthatis too mechanistic,however—thatis, we should not totally eschew reliance on discretion.
Havingmadethechoiceinprinciple of an interest rate rather than base money asour operational instrument, itisstillnecessarytochoosetheparticu
-lar rate. Inother words, which short
-term market rate should the central bank manipulate, and how should it move this market rate to the desired level?Inparticular,BIisnowtryingto decide whether it should implement active open market operationssimilar tothoseusedbytheUSFederalReserve (whichbuysorsellsgovernmentbonds orothersecuritiesinordertoinfluence market rates), or whether it should adopt passive monetary management like that of the Reserve Bank of New Zealand,bycreatinganofficialcashrate with accompanyingdeposit and lend
-ingfacilitiesatBI.
Another issue is whetherthere is a role for reserve requirements in an IT framework. Many IT countries have abandoned,oratleastreduced,therole ofreserve requirements asa monetary instrument. Our research indicates, however,that thereserve requirement canstillplayasignificant role,particu
-larlyinreducingthevolatility ofinter
-estratesandinimprovingthesensitivity tointerestrate changesofthe demand forbankreserves.
Finally,ourexperienceduringthecri
-sis shows that price stability does not alwaysgohandinhandwithexchange ratestability,atleastintheshortrun.BI often found itself faced with the di
-lemmaof whetherto let theexchange rate move freely or try to smooth its movementinordertominimiseitsim
thenatureoftheexchangerateshocks sothatwecanrespondappropriately.
PROBLEMSANDCONS TRAINTS DespiteBI’skeeninterestinpursuingIT asthepreferredapproachtomonetary policy,and despitehaving developed someaspectsofaninitialframework,in practicethebank hasnotyetfully im
-plementedstrictITsuchasispractised inNewZealandortheUnitedKingdom. Its current ITregime retains consider
-ableflexibility, because the bank still facesmanyconstraints, includingchal
-lenges in the institutionalframework, unresolvedpolicyissues,andproblems oftechnicalcapability.
TheInstitutionalFramework
Withregardto constraints intheinsti
-tutionalframework,BI’sindependence iscurrently uncertain,in the lightof a recentlongdebateinthelegislature on possibleamendmentstothenewcentral bank law. More fundamentally, how
-ever,centralbankindependence isnot merelyamatteroflegislation.Tobetruly independentacentralbankmustcom
-mandgreatrespectthroughoutsociety andmusthavesufficientprestigetoen
-ableit to resist external pressure.This levelofrespectandprestigecanonlybe developedovertime,asthebankproves itsabilitytosafeguardfinancialstabil
-ity.For thetime being, BI feelsunable totally to ignore pressures from out
-side—for example, urging it to avoid raisinginterestratestoofar.
UnresolvedPolicyIssues
Asmentionedearlier,BI’slegalrespon
-sibilityto maintain the stabilityof the rupiahcanbeinterpreted asreferringto eitherpricestabilityorexchangeratesta
-bility.Byadoptingafloating exchange rateregimeithas,ineffect,optedforthe firstoftheseinterpretations. Neverthe
-less, recent volatility in the exchange
rate, driven mainly bynon-economic factors, has at times led BI to takere
-sponsibility forstabilising it.Takingon twoobjectives(priceandexchangerate stabilisation) makesitdifficultforBIto determineitsoverallpolicystance:mon
-etarypolicy overallbecomessubjectto conflicting demandsthatmaycompro
-misethe centralbank’s abilityto keep inflationwithinthetargetedrange.Thus undercurrentconditionsitisdifficultto decide whetherBI should include the exchange rate directly in its reaction function, adjustingmonetarypolicy in response to undesirable exchange rate movements.
Inrelation toprice stabilisation,infla
-tion isnoteasilycontrolled bythecen
-tral bank alone. This is a particularly severeproblemforIndonesiaatpresent. Althoughthe free-falling rupiah, soar
-inginflationandhighinterestratesthat togetherled the economyto nearcol
-lapse in 1997–98 have been brought undercontrol,thereisstillmuchuncer
-tainty aboutthespeedof therecovery process.Thefragilityofthebankingsys
-tem,thehugefiscaldeficit,massivear
-rearsonprivatedebtandanuncertain socialandpolitical environment inthe firsthalfof2001allcontributedtoweak
-eningoftheexchangerate,andsowere likelytocreateinflationary pressureby increasingthepricesoftradablegoods andservices.Thisisthereasonthetar
-getedrangeforcoreinflationannounced at the beginning of 2001 was revised upward,creatingproblemsforBIwith respecttoaccountability andcredibility. Tomaximisecredibility,inflationtargets were initially announced and inter
-pretedasofficialinflationprojectionsor forecasts.Asinflationfellovertimethis procedurewaschanged,andtheprojec
-tion targets only after there has been somesuccessfuldisinflation and stabi
-lisationoftheexchangerate.Therefore, BIisunlikelytocommitfullytoexplicit inflationtargetinguntilthefinancialand bankrestructuringprocessiscompleted. Athird interesting issue of current policyiswhetherBIshouldallowmore rapidgrowthofthemonetaryaggregatesto encourage spending,in order to absorb idlecapacityandspeeduptherecovery, orwhethercontrolling inflationshould remain the top priority, regardless of whetherthisjeopardisesnear-termeco
-nomicexpansion.Estimatesofcapacity utilisation fromBI’smonthlySurveyof ManufacturingIndustry forMay2001, covering522firmsfromarangeofsec
-tors in 20 provinces, indicate that the averagefirmisrunningatonly40%of full capacity. This suggests that there should beample room fordemand to grow without generating inflationary pressure.Theissueisnotclearcut,how
-ever.Allcategoriesofcommercialbank lendingarewellbelowpre-crisislevels, reflectingthebreakdownofthebanks’ intermediary function.Howdoesmon
-etarypolicyaffectthe realeconomy in circumstancesinwhichthebanksarenot makingnewloans?Inotherwords,how does the transmission mechanismbe
-haveinsuchasituation?Thispuzzlehas keptBIwonderinghowtodecideonthe rightinstrumenttouseasthemonetary policytool.
Another factor thatdiscourages the adoptionofITforthetimebeingisthe factthatthefiscalburden of bankrecapi
-talisationcostshasplacedadefactocon
-straint on mo netary policy. The government has financed more than 80%ofthecostofthebankrecapitalisa
-tionprogram by issuing bondswhose interestcosts are covered bythe state budget.AsatJune2001,Rp409trillion (about$41billionatanexchangerateof Rp 10,000/$)of bank recapitalisation
bondshadbeenissued;thecostofserv
-icingthesebondsin2001isbudgetedat Rp 61 trillion, or4.2% ofGDP. Higher interestrateswouldincreasethisalready heavyburdenonthebudget,andmight prove unsustainable. Theywould also undermine efforts to restructure the huge volumeof non-performing loans inthebankingsector.
BI has already increased the bench
-mark one-month SBIinterest rate by more than twopercentage points over thesixmonthstoJune2001,inattempt
-ingtohelpdefendtheailingrupiahand to reduce inflation. A further conse
-quenceofhigherSBIrates,however,is thatwiththecurrentstockofoutstand
-ing SBI and rupiah (borrowing) inter
-ventions approaching Rp100 trillion, everyonepercentagepointincreasein SBI and moneymarket ratescosts the centralbanksomeRp1trillionperyear. Thushigherinterestratescreateahuge extraburdenbothforthebudgetandfor thecentralbank.
TechnicalCapabilities
On the technical front, a good dealof empiricalresearchhasbeendonetotest the causality betweenmoney, interest ratesandprices,usingnon-structuralana
-lyticaltoolssuchas timeseriesmodels. Some preliminary studies have shown thatthereisasignificantrolefortheone
-month SBI rate in affecting inflation throughthemoneymarketchannel(i.e. depositratesat thecommercial banks), theexchangerate,aggregatedemand,and thegapbetweenpotentialandactualout
-put(WarjiyoandZulverdi1998).Theim
-pactoftheSBIrateonratesinthemoney marketverifiestheefficacyofmonetary policy in providingsignalstothis mar
CONCLUDINGCOM MENTS
Inlightofthe1999centralbanklawthat grantsBIbothgoalandinstrumentin
-dependence,and underwhichits sole objectiveistomaintainstability ofthe valueof therupiah,wearguethatthe mostsuitablemonetarypolicyapproach forthefutureisIT.Wearguethataflex
-ibleITframeworkis more suitablefor thetimebeing,however,becausethere remain many constraintsthat are not conducivetotheeffectiveimplementa
-tionofastrictITapproach.AflexibleIT frameworkcanbe definedasone that allowstheinflationtargettobesetasa rangethatiswideenoughtoaccommo
-dateuncertainty,andthatadoptsatime horizonlongenoughtoachievethein
-flation target with minimum loss of output.
Severalissuesneed tobeaddressed beforeITcanbefullyimplemented.In theshortruninparticular,bankrestruc
-turingisatthetopofBI’sagenda.Res
-to ratio n of the banking sector ’s intermediary functionisveryimportant toeconomicrecovery,andsupportfrom ahealthybankingindustryisalsobadly needed to make various monetary policyinstrumentseffective,thusboost
-ingthecapacityofthemonetaryauthor
-itytoplan andcarry outits functions. Inaddition,delaysinrestructuring the banksincreasethecostinvolved,sowe believe that this task should be given prioritybeforeBIacceptsthechallenge ofadoptingastrictITstrategy.
On the technical front, since IT is forwardlookingin nature,a forward
lookingmonetaryreactionfunctionor a feedbackrule suchas a Taylorrule isworthincorporatingwhenrevising BI’smonetarypolicymodels.Because of the significant lags in monetary policy,BImustrely oninflationfore
-casts to achieve any given inflation outcome,sotheavailabilityoftimely data is essential. In addition to BI’s existing business survey, other sur
-veys such asa consumersurvey and anexport–importcontainersurveyin majorportswouldbeausefulsupple
-ment to BI’s leading macroeconomic indicators.
Given present conditions in which theeconomyis characterised by weak domesticdemand,anundervaluedex
-change rateand aslow bankrecovery process, several important questions still need to be answered by BI as it moves toward an explicit IT regime. First,shoulditincludetheexchangerate inits reaction function (giventhatthe central bank’s ‘sole objective’ as de
-scribed in the 1999 law can be inter
-preted to include exc hange rate stability)at times whenexchange rate pressuresemergeasaresultofnon-eco
-nomic factors? Second, are monetary aggregates or interest rates the most appropriateinstrumentsfortheconduct ofmonetary policyforthetimebeing, orwould acombination ofthetwobe preferable? Finally, what research pri
-orities need to be established before moving to strict IT, givenBI’s current technicalcapabilitiesinforecastingGDP andinflation?
NOTES
* An earlier version of this paper was
presentedattheBankIndonesia–Inter
-national Monetary Fund Conference
on‘MonetaryPolicyandInflationTar
-geting in Emerging Economies’, Ja
-karta, 13–14 July 2000. The authors
thank Re za Ang lingkusumo,A khis
HutabaratandFadjarMajardiformak
-ing their research results available.
They alsothank twoanonymous ref
-ereesforcommentsandsuggestions.
1 Conflicts between multipleobjectives
were discussedbyMcLeod(1997b),al
particular,hearguedthatIndonesia’sef
-fortstolimitthecurrentaccountdeficit
to2%ofGDPconflictedwithits5%an
-nualinflationtarget.
2 SBPUarepurchasedbyBIfrombanksat
timeswhen an expansionof system li
-quidityisrequired.
3 BI’sDiscountFacilityIisdesignedtoal
-lowbankstocoveranyshortfallintheir
requiredminimumreserves.Themaxi
-mum maturity of this facility is one
month,butborrowingscanbeextended
byamontheachtimetheyfalldue.
4 Whether theuse of quantity targeting
duringthe crisiswas appropriate has
be en the subject of recent deba te.
Grenville(2000a,2000b)arguesthatthe
growth ofbasemoney,especially cur
-rency,is demand determined.Thein
-creaseinthedemandforbasemoneyin
theearlymonthsofthecrisiswasinevi
-tableowingtoalossofconfidenceinthe
banking system, and the authorities
needed to respond byprovidingcash.
Alongsimilarlinestowhathasbeensug
-gestedabove,healsoarguesthatthere
-lationshipbetweenbasemoneyandthe
ultimateobjectives(eitherinflationorthe
growthofnominal GDP)isunstablein
boththeshortandthelongrun.Bycon
-trast,Fane (2000a,2000b) defendsthe
IMF’sstrategyoftightercontrolofmoney
growth,arguingthatthecollapseofthe
rupiahwastheresultoftheinabilityof
BItocontrolbasemoney.Furthermore,
he argues that targeting base money
would helpthemonetaryauthority to
rebuilditscredibility,asthepubliccan
quicklymonitorwhetherthecentralbank
ishittingits target.Under high uncer
-taintyduringthecrisis,targetingdomes
-tic pricescould have undermined the
centralbank’scredibility,asitwouldbe
verydifficultforBItoachieveanygiven
inflationtarget.
5 SeeMcLeod(1999)forabriefdescription
ofsomeaspectsofthenewlaw.
6 Onemayarguethatgoalindependence
fora centralbank issuperfluous given
instrument independence (e.g. Blinder
1998)—thatis,thatprovidedthecentral
bank is able to implement monetary
policyfreeofoutsideintervention,itdoes
notmatterwhethertheinflationtargetis
set by it or by the government.But
Schmidt-Hebbel(1999)arguesthatgoal
independence is needed in emerging
economies prone tosteadilyincreasing
budgetdeficits.Amiddlewayisperhaps
the ‘cooperativeapproach’, asimple
-mented intheCzech Republic.In this
approach,thelong-runinflationtargetis
determinedbyagreement betweenthe
governmentandthecentralbank. The
rationaleforthisisthatatargetthathas
beenagreedtobysocietyshouldresult
ingreaterpricestability,sinceagentswill
usetheinflationtargetintheirdecision
making.
7 Seeforexamplevariouspaperspresented
ataSymposiumontheMonetaryTrans
-mission Mechanism in the Journal of
EconomicPerspectives9(4)(1995).Fordis
-cussion of the monetarytransmission
mechanism inIndonesia,seeBoediono
(1998);SarwonoandWarjiyo(1998);and
Agung(1998,2000).
8 Headlineinflationisinflationbasedon
theCPI,asannouncedbytheCentralSta
-tisticsAgencyandreportedinthenews
-papers,whilecoreinflationisameasure
thatexcludesveryvolatilecomponents
suchasfoods,and/orcomponentswith
administered prices,suchasenergy.
9 Thetargetfor2000wasmissed;corein
-flationwas5.9%.Headlineinflation,ex
-pectedtobe5–7%,wasactually9.4%.The
majorsourcesofinflationarypressuresin
2000werethehigherthanexpectedde
-preciationoftherupiah,theimpactofthe
increasesinfuelandelectricitypricesand
minimumwages,andtheexpectationof
higher inflation.Toreduce these infla
-tionarypressures,BItighteneditsmon
-etary policy by increasing SBI rates.
However,thescopefortightermonetary
policy waslimitedbecause thefunda
-mentalconditionoftheeconomywasstill
veryweak. Thetargetfor2001wasre
-visedupwardinMayforsimilarreasons.
10Usingcointegrationtests,thestudycon
-cluded thatthelong-run relationships
betweenM0(basemoney)andM1(nar
-rowmoney),andbetweenM0andM2,
existedonlyuntil1988.Afterthatperiod
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