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Chapter 5

In ation


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Chapter 5: In ation

The Consumer Price Index (CPI) touched 6.59% in 2007, in line with the target o 6.0%1.0%set by the Government. Stable exchange rate, adequate supply o ood, and modest increases inadministered prices contributed to the relatively stable in ation in 2007 compared to the previousyear, when the CPI reached 6.60%. This achievement also stemmed rom the support o theGovernment in controlling actors that in uenced in ation, especially those which originatedrom increases in the prices o commodities in international markets. This condition, in turn,increased policy credibility, thereby giving a positive contribution toward e orts to keep the publicsin ationary expectations in line with the in ation target.

Infation Developments

In general, prices o goods and services at theconsumer level were relatively under control in 2007.

The reasonably stable in ation was the result o theairly low in ation in the frst hal o 2007. The CPI in thecalendar year up to June 2007 was recorded at 2.08%(ytd), including de ation o 0.16% (mtm) in April. Thein ation rate in the frst hal o 2007 was lower than inthe corresponding period o the previous year o 2.87%(ytd). A breakdown o in ation by component 1 showedthat nearly all components o the CPI experienced lowerin ation compared to the previous year with the biggestdecline occurring in the oodstu s component, edgingdown rom 5.16 % (ytd) in the frst hal o 2006 to 2.45%(ytd) in the same period o 2007. Moving into the secondhal o 2007 (July-December), however, in ationarypressures elevated airly substantially. Increases in theprices o international commodities, such as crude oil,crude palm oil (CPO), wheat, and gold, combined withthe weakening rupiah, were behind the higher in ation inthe second hal o 2007.

In addition, seasonal actors such as religious estivities,the start o the new academic year, and the year-end

1 According to the COICOP (Classifcation O Individual Consumptionby Purpose), 744 CPI commodities are grouped by the BPS into 7groups o goods and services. They are (1) the oodstu s group,(2) the processed oods, drinks, cigarettes, and tobacco group, (3)the housing, electricity, water, gas, and uels group, (4) the clothinggroup, (5) the health group, (6) the education, recreation, and sportsgroup, along with the (7) transportation, communications, danfnancial services group.

holidays resulted in urther in ationary pressures. Withsuch developments, CPI in ation climbed in the secondhal o the year to around 4.51%. The higher in ationrate re ected price increases in nearly all types o goods,especially oodstu s. Overall in 2007, CPI in ationretained its stability at 6.59% compared to 6.60% in theprevious year.

Factors A ecting Infation

Based on the in uencing actors2

, the relatively stablein ation in 2007 was mainly attributable to improvementsin non- undamental actors, with in ation romundamental actors being reasonably controllable. Fromthe non- undamental side, lower volatile ood in ation 3 coupled with government policy in leaving administeredprices unchanged 4 or strategic goods, such assubsidized uel and electricity tari s, were the two mainreasons or the improved in ation conditions. From theundamental side, the airly stable core in ation 5 wasmainly attributable to in ationary expectations remaining

2 Based on the characteristics o developments in commodity prices,CPI in ation can be grouped into volatile ood in ation, administeredprices in ation, and core in ation.

3 Volatile ood in ation is in ation in the group o ood commoditieswhose prices are highly uctuates because o certain actors suchas the time o the harvesting season, distribution bottlenecks, naturaldisasters, and plagues.

4 Administered prices in ation is in ation in the group o commoditieswhose prices are set by the government.

5 Core in ation is commodity in ation whose movements arein uenced by economic developments in general ( undamentalactors such as in ation expectations, the exchange rate, andaggregate demand and supply balances) which will have an impacton price changes in general and which tend to be permanent innature.


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in-check and the minimal pressures rom the interactionbetween aggregate demand and supply. Meanwhile,amidst a pick-up in imported in ation, pressure rom theexternal side remained subdued as the average rupiahexchange rate strengthened in 2007 (Chart 5.3).

These in ation dynamics indicated that the role o lower volatile ood in ation was reasonably important insa eguarding the stability o CPI in ation in 2007. Thelower volatile ood in ation meant that its contributionin orming in ation experienced a decline rom 2.75%in 2006 to 2.09% in 2007. The lower in ation rom thevolatile ood group was able to o set the increasedin ation contribution coming rom core in ation andadministered prices such that, overall, the yearly in ationwas relatively stable (Table 5.1).

Non- undamental Factors (Shocks)

Volatile Food The year 2007 witnessed a drop in volatile ood in ationto 11.41% rom 15.27% in 2006. The decline was mainlyattributable to the all in the prices o rice , underpinnedby adequate supply and smooth distribution. Aside romincreased production, e orts to sa eguard su fcientsupplies o rice were also achieved through importsconducted by the State Logistics Agency (Bulog). TheIn ation o rice commodity, which has the largest weighin calculating the CPI, ell sharply rom 32.0% in 2006to 8.49% in 2007. This decline started to be apparent in

April a ter the government allowed Bulog to import rice,as part o the e orts to sa eguard stocks o rice. Overall,the contribution o rice toward the overall in ation moveddown rom 1.58% in 2006 to 0.52% in 2007 (Table 5.2).

Although, in general, volatile ood in ation in 2007experienced a decline, in ation o a number o commodities in this group increased due to rising priceso a number o commodities in international marketsand the occurrence o some natural disasters. Thesurging prices o CPO in global markets had a signifcantimpact on volatile ood in ation through higher prices o cooking oil which rose 41.40% (Table 5.2). The upsurgein cooking oil in ation was ollowed by increases in priceso products made rom CPO such as margarine andbutter which mounted 14.28% and 29.81%, respectively(Table 5.4).

Meanwhile, the soaring price o corn in internationalmarkets which were accompanied by surges in theprices o livestock eed pushed up the prices o chickenmeat and eggs by 12.30% and 19.04%, respectively.

The occurrence o ood also put pressures on volatileood in ation, as re ected in higher in ation o redonions, hiking sharply to 124.50%, or ar higher thanin 2006 when de ation o 18.8% was recorded (Table5.2). Seen rom its contribution to in ation, rice gave thelargest contribution amounting to0.52%. Meanwhile,cooking oil and red onions which both experiencedhigh in ation also contributed quite signifcantly


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in uencing core in ation, that is the interaction betweenaggregate demand and supply (the output gap), alongwith in ationary expectations, indicated relatively stabledevelopments.

Broken down by each type o product, the impact o hikes in international prices can be seen in gold andvarious types o ood. Gold jewelry contributed the mostto core in ation, with in ation o this product arrivingat 27.50% and giving a contribution o 0.33%. Variousoods also showed higher in ation, especially varioustypes o noodles, various types o cake and bread, aswell as soybean cake (Table 5.4).

Infation Expectations The publics in ation expectations were relatively stableat around 6%-7% in 2007. In general, market playerswere still convinced that in ation in 2007 would bearound 6%-7%, or still in the range o 6%1% targeted

by the government. Based on the Consensus Forecastsurvey, in ation estimates or 2007 rom a number o institutions demonstrated that in ation expectationsin 2007 were relatively stable at around 6.3%-6.7%(Chart 5.4). This result was also confrmed by the resultso a survey conducted by Bank Indonesia, that is theMarket Perceptions Survey (SPP), which showed thatthe majority o respondents expected in ation in 2007to be around 6%-7%. Even the number o respondentswho believed that in ation would be in the range o 6%-7% experienced an increase, while the number o respondents who said in ation would rise (in the rangeo 7.1%-8.0%) declined urther (Chart 5.5). The stabilityin in ation expectations re ects the confdence o themajority o market players that the Government andBank Indonesia were consistent in implementing policiesto reach the predetermined in ation targets.

Although relatively stable, the level o in ationexpectations going orward still needs to be scrutinized.

This is related to the rise in expectations o priceincreases ahead, especially at the end o 2007. Theconsumer survey at the end o the year showed thatconsumer expectations or prices 3 months and 6months ahead intensifed (Chart 5.6). This may be theresult o soaring prices o international commoditieswhich, it is eared, will push up production costs and,ultimately, the prices o domestic goods. Additionally, thehigher in ation expectations also re ect the dominanceo backward looking reasoning in the ormation o in ation expectations such that it took longer or in ationto be brought down.

Table 5.2

Volatile Foods Infation and Several Volatile Foods

Commodities Contribution to Infation

percent

Commodities2006 2007

Infation Contribution Infation Contribution

Rice 32.00 1.58 8.50 0.52Cooking Oil 6.70 0.08 41.40 0.49Shallot -18.80 -0.09 124.50 0.47Broiler Chicken Meat 10.40 0.14 12.30 0.17Broiler Chicken Egg 4.90 0.04 19.00 0.13Source: BPS-Statistics Indonesia

Table 5.3

Several Administered Prices Commodities Contribution

to Infation in Year 2007

percent

Commodities2006 2007

Infation Contribution Infation Contribution

Filtered CloveCigarettes

7.10 0.16 1.02 0.24

PAM DrinkingWater Tari

7.80 0.08 12.90 0.14

Clove Cigarettes 6.90 0.09 0.00 0.12Fuel 0.10 0.00 2.90 0.10Kerosene 1.80 0.04 2.70 0.07Cigarettes 5.60 0.02 7.10 0.03

Toll Road Tari 11.20 0.01 24.10 0.02LNG 1.10 0.01 2.10 0.01Parking Fee 3.20 0.01 3.10 0.01Source: BPS-Statistics Indonesia

Table 5.4Contribution o Several Food Commodities in Core

Infation to Infation in Year 2007 and Its Developments

percent

Commodities2007

Infation Contribution

1 Gold 27.50 0.332 CPO

Margarine 14.28 0.01Butter 29.81 0.00

3 Wheat

Flour 35.92 0.03Varieties of Noodles 16.19 0.06Biscuit 7.52 0.02Varieties of Cakes and Bread 9.81 0.20

4 Soybean

Moulded Soybean 18.60 0.09Source: BPS-Statistics Indonesia


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External FactorsIn 2007, in ationary pressures rom external actorswere primarily the result o higher imported in ation,emanating rom upsurges in the prices o internationalcommodities, especially crude oil, CPO, and wheat.

This condition heightened in ationary pressures in anumber o countries, leading to higher in ation ratesin Indonesias trading partners (Chart 5.7). This higherin ation was then transmitted to domestic in ation,as re ected in WPI imported in ation which rose rom7.01% in 2006 to 25.60%. Nonetheless, the increase

in WPI imported in ation was not ully transmitted tothe prices o domestic goods at the consumer level.

This was indicated by the act that the increase in thein ation o imported commodities was not as large as theincrease in WPI imported in ation. The rate o in ationo CPI imported commodities rose slightly rom 5.83%in 2006 to 7.20% in 2007 (Chart 5.8). The phenomenono lower in ation o imported commodities comparedto WPI imported in ation may be attributable to severalactors: (1) a number o imported goods ormed theinput components in the production process such that


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the proportion in the increase in the fnal price o goodswill be lower than the proportion in the increase in theprice o imported goods; (2) there were indicationsthat producers tried not to pass on all the increases o prices in input goods onto consumers a ter consideringconditions related to consumer demand and businesscompetition.

On the other ront, the relatively stable exchange ratelessened pressures arising rom imported in ation. On

average, the rupiah stood at Rp9,140 per dollar in 2007although it did or a time come under pressure due to theUS sub-prime mortgage crisis.

Interaction between Aggregate Demand and AggregateSupply (Output Gap)In ationary pressures rom the interaction o demandand supply was still minimal, as re ected negative outputgap. The supply side to turned out to be able to meetthe higher level o demand. The response on the supplyside is re ected in the elevated the production indexin the production survey carried out by the StatisticsIndonesia. The production index climbed rom 116.9%on average in 2006 to 123.12%. In addition, SKDU in theourth quarter o 2007 demonstrated capacity usage o 73.26%, indicating that most industries still had room toraise production i demand increased.

Evaluation o Realized InfationIn 2007, the Government set the CPI in ation targetat 6% with a deviation o 1% 7. The target was setbased on assumptions at the beginning o the year inregard to undamental and non- undamental actors(shocks) causing in ationary pressures (Table 5.5).With regard to the undamental actors, in ation wasexpected to originate rom external actors in terms o the weakening o rupiah. As to other external actors, itwas assumed that the price o crude oil in internationalmarkets was US$60/barrel. With pressures rom the

output gap anticipated to be minimal and in ationaryexpectations expected to remain stable, the core in ationwas estimated to arrive at around 6.3%. As regard thenon- undamental actors, volatile ood in ation wasexpected to remain high, although experience a decline.Meanwhile, administered prices in ation was anticipatedto have a minimal impact on CPI in ation given thegovernments commitment to neither hike uel prices norelectricity tari s. In reality, the actors which in uenced in ation, eitherundamental or non- undamental, were actually similarto the original expectations, such that CPI in ation in2007 was in the range o the predetermined in ationtarget. This achievement was the result o improvingcoordination between Bank Indonesia and theGovernment. Consistency in monetary policy to ensure

7 This was decided in a coordinating meeting on macroeconomicsat the O fce o the Coordinating Minister or the Economy on 17March 2006. The in ation target revised the in ation target as setby the government at 5.0% with a deviation o 1%, which is statedin Ministry o Finance decision No. 399/KMK.011/2004 dated 6September 2004.

Table 5.5

Comparison o Assumption and Realization o Infation

Target in Year 2007

Variable2007

Infation Target Realization

Assumption Exchange Rate(Rp/$)

9,300 9,140

Oil Price ($/barrel) 60 72.3Projection GDP (%) 6.0 6.3

Core Infation (%) 6.30 6.29 CPI Infation (%) 6.60 6.59

In uencingFactors

Exchange Rate slightly weaken relative stable Infation

Expectationstable but

remain highstable but

remain high Output Gap Low Low Administered

PricesLow Low

Volatile Foods high, rice importlimitation

high, no riceimport limitation

CPI In ation Target 6.0% 1%


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E orts to Comprehend the Behavior o In ation in Indonesia: The PermanentComponent o In ation and the

Persistency o In ation

E orts to control in ation demand deep understandingand knowledge regarding the behavior o that in ation.

Two aspects o in ationary behavior which have orsome time been a challenge in e orts to lower oreven control in ation in Indonesia are the di fculty inlowering the pace o in ation to a lower level 1 and thehigh persistency o in ation. The di fculty o bringingthe rate o in ation down raises the question o whether

there really is one inherent in ation level or Indonesia.Comprehension on this matter is very use ul - orexample in determining a certain in ation target in arealistic manner. The establishment o an unrealistictarget will orce the central bank to adopt monetarypolicy which is too extreme, such that there will be alarge cost or the economy. Meanwhile, the matter o persistency is related to how quickly in ation will return toequilibrium a ter experiencing a shock. Persistent in ationmeans that when a shock occurs, the rate o in ationwill tend to take some time to return to its level prior to

the shock. The condition o persistent in ation will alsohamper e orts to bring the rate o in ation to a lowerlevel. There ore, the understanding o the persistency o in ation is also very important as it will determine howpreemptive Bank Indonesia should be in responding toeconomic shocks that a ect price stability.

Studies show, however, that Indonesias in ation hasthe characteristic o being rather stubborn in returningto a lower level (sticky in ation). By calculating averagein ation, the long-term in ation trend or the period1980-2007 was 9.8%, while or the period 2000-2007the long-term in ation trend is 8.8%. The high level o Indonesias long-term in ation trend raises the questionwhether there is one level o permanent component inorming in ation in Indonesia. An econometrics approachproposes the technique o decomposing in ation intopermanent and transitory components 2. The permanent

1 The lowest level o in ation was around 5%. This was seen in 1992,1996, and 2003.

2 A andi, Yoga (2007): A Small Monetary System or Indonesia.Bank Indonesia Working Paper.

in ation component is split into the two elements, thatis the deterministic trend and the stochastic trend. Thedeterministic trend is represented by a long-term trendwhich is linear. The stochastic trend is the accumulationo shocks that are permanent in nature which will a ectin ation 3. It can be said that the stochastic trend has acorrelation to in ation which tends to have a high level o persistency.

The results o the calculation o data or the permanentin ation component show that the lowest level whichcan be reached is around 5.3%, occurring in the postcrisis period, during the second quarter o 2003 until thefrst quarter o 2004. In the pre crisis period permanentin ation tended to be above its long-term trend (Chart 1),while in the post crisis period permanent in ation tendedto be below the long-term trend (Chart 2). This signalsthat the stochastic trend is lower in the post crisis period.

This result is in line with research fndings which indicate

that the degree o persistent in ation in Indonesia isdeclining urther. Studies carried out using the simpleauto-regression model have ound that in the period1990-2006 the level o persistency in Indonesia actuallyexperienced a change rom over time 4. The study showsa decline in the degree o persistent CPI in ation, rom0.27 in the pre crisis period to 0.12 a ter the crisis. Thechange in the degree o persistent in ation was alsoconfrmed by the results o estimating rolling regressiono the persistency coe fcient. Lower persistent in ation implies that i there areeconomic shocks, in ation will return more quickly to itsaverage level. From the aspect o controlling in ation, thelower persistent in ation will also make it easier to reducein ation, because the peoples tendency to anchorin ationary expectations to the past will lessen.

The results o the research which confrm that a

3 A shock which is transitory in nature in cumulative terms willdisappear.

4 Yanuarti, Tri (2007), Has Ination Persistence in IndonesiaChanged?, Bank Indonesia Working Paper.


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permanent in ation component in Indonesia is still airlyhigh remains as an obstacle in e orts to reduce in ationto a lower level. The continuing high level o permanentin ation component indicates the presence o moreundamental problems in regard to the phenomenono in ation in Indonesia, especially matters that arerelated to productivity, e fciency, and the structure o the economy. The close connection between in ationand economic productivity and e fciency implies that

dis-in ationary policy needs to always be adoptedin consideration o the principals o gradualism andbalance. Monetary policy which is excessively tightwhen economic productivity and e fciency is low cancontribute toward the recession. In contrast, monetarypolicy which is too loose, will only lead to in ator andnot pro-poor economy. The close connection betweenin ation and structural aspects also implies that or acredible process o de ation then good coordinationbetween the government and Bank Indonesia is deemedimportant.


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In ation Targets or the Years 2008-2010

Low and stable in ation is a precondition or increasedprosperity and the basis or balanced economic growth.In line with Act No. 23/1999 concerning Bank Indonesiawhich was being superseded by Act No 3/2004, BankIndonesia is tasked with achieve and maintain thestability o rupiah exchange rate. Based on the Acts(explanation o article 10 clause 1a), the in ation targetis determined by the Government a ter coordinating withBank Indonesia. In turn, the in ation target is used byBank Indonesia as the basis in ormulating and carryingout monetary policy by taking into account the stability o the fnancial system and the overall economy.

Based on the decision by the Minister o Finance No.399/ KMK.011/2004 dated 6 September 2004, thein ation targeting period is fxed or 3 years, while thetype o in ation targeting used is the yearly CPI. In thisdecision the in ation target or the years 2005-2007 wasalso agreed, which was 6%1% or 2005, 5.5%1% or

2006, and 5.0%1% or 2007. Later, the governmentand Bank Indonesia agreed to revise the target on 17March 2006. The in ation target or 2006-2008 was

agreed at 8.0%, 6.0%, and 5.0%, respectively, witha deviation o 1%. Subsequently, at the beginningo 2008, the government set the new in ation targetsor the period 2008-2010, that is o 5.0%, 4.5%, and4.0%, respectively, with deviation o 1% throughthe decision o the Finance Minister No.1 year 2008(Chart 3). In general, the in ation target is set by takinginto consideration the in ation projection and the policieswhich need to be taken such that the in ation target isrealistic.

The determination o in ation target is needed as are erence or each player in the economy in takingeconomic decisions, including or the government andBank Indonesia in ormulating the appropriate policies.

The setting o a lower in ation target demonstrates thegovernments commitment to continue the disin ationprocess on a gradual basis such that domestic in ationwill be relatively similar to in ation rates in other countries

in the region. The in ation target is also expected tobecome anchor in the ormation o in ation expectationso each economic player ( orward looking). This isseen to be important given the role that in ationaryexpectations have in orming in ation.

The Government is well aware that such a goal requirescommitment and hard work rom various parties takinginto account Indonesias historically high in ation onaverage. Based on historical data over the last 30 years,the lowest in ation on average occurred in the post-

crisis period edging down at 7.12%, a level o in ationwhich was still airly high (Chart 4). Nonetheless, theachievement o lower in ation than the historical averageis not impossible given that in the years o 1992, 1996,and 2003, in ation had reached around 5%. In each o those three years, the achievement o low in ation wasunderpinned by the act that non- undamental actorswere under control that is volatile ood in ation (Chart3) and administered prices. Aware o the various actorsthat a ect in ation, which not only cover monetary policy


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yet also cover policies on production and distribution,the government has decided to orm the CoordinatingForum to Control In ation aside rom strengthening o theexisting teams such as the In ation Control Team and theCoordinating Team to Stabilize Basic Foodstu Prices.

PeriodDevaluation(1979-1984)

Be ore Crisis(1985-1997)

Crisis(1998-1999)

A ter Crisis(2000-2007)

Mean (%, yoy) 14.49 7.94 41.02 8.81 7.12*

* Increasing Fuel Price Impact

It is expected that these orums will be able to monitorthe undertaking o activities involved with controllingin ation. This orum is directly chaired by the Minister orthe Economy, with the permanent members being theFinance Minister, the Governor o Bank Indonesia, andthe Minister o Trade.

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