Indonesian inflation targeting: an evaluation
It is now just over 10 years since Indonesia introduced its initial tentative inflation targeting. The experience so far has been, on balance, positive. Taking the inflation targeting period as a whole, inflation averaged 8 percent (i.e. much the same as the average of the pre-1997-crisis period), but is on a clear downward trend. Current inflation is low; core inflation has come down a little over time; and two large adverse price shocks were accommodated without price expectations shifting much.
But Indonesia's inflation record is still well behind many of its regional peers, which have been recording inflation rates similar to advanced countries, around 2-3 percent.
Let's put to one side for a moment the two BBM (fuel-Ed.) price shocks in 2005 and 2008, and ask the question: why did inflation continue at 4-6 percent, even when demand was not excessive and there were no strong supply-sided price shocks? There are many different forces driving underlying inflation, but the explanation which fits the Indonesian experience best is that underlying inflation continued because people expected it to continue. Price-setters have become accustomed to raising their prices regularly and buyers are accustomed to paying a bit more each year. It has its own self-generating dynamic, driven by people's expectations that inflation will continue at 4-6 percent.
This stability of price expectations shows clearly during the two BBM shocks. In early 2006, for example, while actual inflation was running at around 18 percent, surveys show that the public expected inflation to return to its normal pace of 4-6 percent in 2007. Even the huge shock of the BBM increase did not alter people's expectations about on-going underlying inflation.
This inertia of inflation expectations has both pluses and minuses for longer-term price stability. The positive aspect is that when a price shock occurs (such as the BBM increase), the higher inflation doesn't last long. The negative aspect of this inertia is that it is very hard to get underlying inflation much below 4-6 percent.
This central role of expectations in driving inflation is the key to understanding why inflation targeting holds out the greatest promise for getting Indonesia's inflation down to the levels of its regional peers. Among the various approaches to monetary policy, the inflation targeting framework puts price expectations at the heart of its inflation-stabilization logic.
The key is credibility. For inflation targeting to be effective, the public must believe that Bank Indonesia will do 'whatever it takes' to keep the medium-term rate of inflation within the target band on average. Does this sound as if Bank Indonesia has to be tough, crunching the economy with high interest rates every time inflation moves?
The answer is an unequivocal 'no'. To start with, credible inflation targeting means that price stability can be maintained without crunching economic activity. If people believe that Bank Indonesia will do 'whatever it takes,' then Bank Indonesia won't actually have to do it: Price-setters will conform to the target without the need for Bank Indonesia to create a deflationary gap between actual and potential output.
Moreover, Bank Indonesia certainly doesn't have to respond to every adverse price shock that pushes inflation temporarily off target. At the same time, inflation targeting doesn't require inflation to be on target continuously: What is important is that the setting of policy is such that it will bring inflation back to target within a reasonable time say a year or two. This gives the inflation targeting framework enough flexibility to absorb shocks and the business cycle without damaging output growth.
In a well-functioning inflation-targeting framework, monetary policy works largely through expectations about policy actions, and objectives can be achieved without crunching the economy. There are elements of a 'free lunch' to be had here: Bank Indonesia can keep inflation expectations low (and hence inflation low) without resorting to high interest rates. Just the threat of tighter policy is enough.
What might Bank Indonesia do to reinforce the effectiveness of inflation targeting? First and foremost, it needs to tell people what it is doing. Bank Indonesia surveys have shown that very few people know that this is Bank Indonesia's policy framework. You can't have credibility and influence inflation expectations if people don't know what you are aiming to do and how you intend to achieve it.
To enhance credibility, Bank Indonesia has to do what it says it will do; the public will focus on changes in policy instruments to see whether the central bank's actions match its words. Bank Indonesia needs to convince the public that the target can and will be achieved. For this, it needs to provide greater clarity regarding objectives, instruments, and explanations.
*Visiting Fellow, Lowy Institute for International Policy-Sydney, Australia
By Stephen Grenville*
No. 44/12, June 26, 2012