Lesson from Bank Indonesia’s latest interest rate hike

Yesterday, Indonesia’s central bank, Bank Indonesia (BI), hiked its 7-day repo rate by 25 basis points to 6.25%. Of 41 analysts surveyed by Bloomberg, only 11 saw this coming.

So, why are they doing this? If we look at BI’s statement, they wrote that the interest rate hike is “…to strengthen the stability of the Rupiah exchange rate from the impact of worsening global risks and as a pre-emptive and forward-looking step to ensure inflation remains within the target…”

From the way I see it, the rate hike is justifiable, given that the Indonesian Rupiah is among the worst-performing currencies in the ASEAN region, depreciating by 4.9% on a year-to-date basis.

Furthermore, I think they are taking the assumption that the Federal Reserve will change their views on where the Fed Funds Rate will be by the end of the year. As of this point of writing, the market assumes that the Federal Reserve will cut the rate by between 50 – 75 basis points. Given the strong macro data coming, such as retail sales, and stubbornly high inflation, the probability of a 50 – 75 basis points rate cut this year is diminishing. I will not be surprised if the Federal Reserve makes no rate cuts this year.

So, given that Bank Indonesia has made the first rate hike among the regional central banks, we need to ask two key questions: First, how strong is the relationship between the ASEAN currencies and the interest rate differential? Second, how strong is the relationship between the ASEAN currencies and domestic inflation?

Let’s focus on Indonesia first. The chart below shows that Indonesia has the largest correlation value between its currency and the interest rate differential, followed by Thailand, Malaysia, and the Philippines. Plus, the movement of the Indonesian Rupiah is highly influential on domestic inflation (red bar). As I mentioned earlier, the interest rate hike is justifiable. A wider interest rate differential will lead to a weaker Rupiah, which will result in higher domestic inflation.

So far, the Thai currency has depreciated by 8.4% on a year-to-date basis against the US Dollar. Nevertheless, Thailand’s inflation rate is currently in negative territory. Therefore, the Bank of Thailand has no good reason to push up interest rates despite the weakening Thai Baht. There are more cases for a rate cut(s) due to growth concerns.

The Philippine currency only depreciated by 3.9% on a year-to-date basis against the US Dollar. Nevertheless, the relationship between its currency and interest rate differential is only 30%, which is insignificant. The latest inflation reading in the Philippines is 3.7%, which is still within the central bank’s 2 – 4% inflation target range but has been on an upward trend throughout the year. The central bank is also open to the option of another rate hike.

Now, this brings us to our next suspect: Malaysia. If we look at the correlation value between the Ringgit and interest rate differential, it yields close to 40%, which is quite high from my point of view. Furthermore, we can see that domestic inflation is highly influential in the movement of the Ringgit. To provide some sense, Malaysia imported around RM79 billion of food products (Khazanah Research Institute, 2022), and food products contribute close to 30% to the CPI weightage.

Given the Federal Reserve’s uncertainty about where the Fed Funds Rate will be by the end of the year, it’s fair to say that the higher-for-longer should be the base case now. Given the wide rate differential between Malaysia’s rate and the Fed Funds Rate, that should put some pressure on the Ringgit, which will influence domestic inflation.

Another point to watch is the subsidy rationalisation, which should be a double-whammy for domestic prices since (i) transportation contributes 11% to the CPI weightage and (ii) most logistics depend on petrol and diesel.

Given these factors (interest rate differential and subsidy rationalisation), there may be a case for one more interest rate hike. Still, most analysts in town are not pricing this one yet.

Supporting materials: Interest rate differential, currency, and domestic CPI charts among selected ASEAN economies.

Footnote:

1. Bank Indonesia usually publishes its monetary policy statement in Bahasa Indonesia. It usually takes days to publish one in English.
2. All analyses are from 2016 to the most recent available data. So, the numbers/results may differ from my previous analysis.
3. I did not include Singapore in this post, since the Monetary Authority of Singapore (MAS) does not use policy rate as monetary policy tool.