Comment on ‘toward improved monetary policy in Indonesia’
Date
2003
Authors
de Brouwer, Gordon
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[Conclusion]: What really matters in the case of Indonesia is whether base money is the real story behind the inflation process. Here, it is worth making just two observations on the evidence presented in the article. First, it is not enough to say that inflation is caused by base money growth just because growth of base money leads inflation (McLeod’s Figure 3) and interest rates do not (McLeod’s Figure 5). McLeod’s argument confuses correlation with causation. For example, an alternative view of Indonesia’s inflation shock in 1998 is that it was driven by the collapse of the rupiah, exacerbated by deep political crises and capital flight. The growth of base money reflects the injection of funds into the banking system to stave off complete collapse, even if this itself, as McLeod rightly points out, provided some fuel to the capital flight. The collapse of the rupiah created the inflation, not the injection itself of funds into the banking system. With reference to his Figure 5, McLeod argues that since the rise in inflation preceded the rise in interest rates, interest rates cannot be used to explain inflation. This is misleading. It ignores the role of shocks in the dynamic path of an economy and the multiple sources of shocks to inflation, including – in addition to central bank financing of fiscal deficits and central bank direct credits – the exchange rate, labour market conditions, competition in the economy and foreign shocks. It is an extreme Monetarist view to argue that all movements in inflation are due to monetary shocks (as opposed to arguing that the remedy for inflation shocks is control of money). Interest rates rose after the inflation shock as a policy response to reduce inflation. If interest rates are the policy tool to respond to inflation shocks, they cannot rise before the shock occurs (when the shock is unanticipated). The second observation on the empirical importance of base money in Indonesia’s case focuses on what happened to traded and non-traded goods inflation during the 1998 episode. If base money creation were really the driver of inflation, there should have been no difference between traded and non-traded goods inflation. If the exchange rate was the key driver of inflation, then traded goods prices should have increased more than non-traded goods prices and should have increased before non-traded goods prices did (since the rise in non-traded goods prices would have captured second-round price effects of the exchange rate fall on the non-traded part of the economy). Figure 1 plots monthly annual traded and non-traded goods price inflation in Indonesia from 1991 to 2003. It shows that traded goods prices rose substantially more than non-traded goods prices in 1998 and that traded goods prices rose before non-traded goods prices rose. This would suggest that the depreciation of the rupiah, rather than the rise in base money itself, was the cause of Indonesia’s inflation surge in the crisis year of 1998. (And in this context it is worth noting that traded goods include commodities like rice which are subject to price controls; the non-traded goods component has relatively few commodities with controlled prices.) As an empirical proposition, McLeod’s view that all inflation is monetary does not look right. What remains important in McLeod’s paper is the broader spirit of the message it contains. Bank Indonesia needs to be clear about what it is doing. We can argue about the merits of base money targeting or using interest rates as the operation tool for monetary policy, and the value of inflation targeting and other policy objectives. But the key thing is for the central bank to have a clear and workable framework. It is also the case that Indonesia’s inflationary performance in the post-crisis period does not seem to be as good as it could have been, at least in comparison to some of its peers. In this context, there is always a place to encourage our central banks to do better.
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monetary policy, Indonesia, base money growth, stability, rupiah, inflation target, interest rates, traded, non-traded
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