macroeconomic analysis series inflation outlook€¦ · inflation will remain higher than 2018...

MACROECONOMIC ANALYSIS SERIES

Inflation Outlook 2019

Key Figures • Headline Inflation (2018)

3.13%

• Core Inflation (2018)

3.07%

• Inflation (2019F)

3.4-3.6%

• Core Inflation (2019F)

3.2-3.4%

• Consumption Growth (Q3 ‘18)

5.01%

• Current Account (Q1 ‘17)

-1.0%

_________

*) Forecast

Researchers

Chaikal Nuryakin

[email protected]

Alvin U. Lumbanraja

[email protected]

Natanael Waraney Gerald

Massie

[email protected]

1

Low Inflation: A New Normal Amid Changing Demographics?

Summary

Despite wide fluctuation of international oil price, slightly higher consumption growth, and rapidly depreciating currency, inflation in 2018 remains remarkably low, with headline inflation at 3.13% (y.o.y) in December 2018. Historically, faster consumption growth drives demand for goods and services and thus tend to push inflation higher. Similarly, without additional fuel subsidy budget, higher oil prices would normally push subsidized fuel prices upward, affecting price of transportation of goods and services and thus increasing prices of most goods and services simultaneously. Also, with more than 90% of imports going towards input and capital goods, depreciating currency would traditionally also accelerate inflation.

We see at least four factors that caused inflation to remain low despite fluctuating oil price and higher economic growth. First, the economy, accelerating though it might be, still seemed to run below its long-run potential. At producers still have plenty of capacity to cope up with rising demand. Second, major infrastructure push by government seem to reduce price disparities between regions and reduce inflationary pressure from volatile goods, particularly perishable food produces that usually drive up inflation. Third, producers and consumers also benefited from government’s decision to hold subsidized electricity and gasoline price even as both oil prices and USD exchange rate rose rapidly in the first half of 2018. Finally, increasing consumer affluence and increasing proportion of older working-age population shift the consumption from nondurable goods (foods and beverages) to durable goods.

Table 1: Inflation Forecast (LPEM FEB UI) 2018 2019 Forecast

Headline Core Headline Core 3.13% 3.07% 3.4-3.6% 3.2-3.4%

The third factor is particularly critical for gauging inflation trajectory in 2019. While geopolitical risks have mostly been priced in, there still remain low-probability-high-impact geopolitical risk that may drive oil prices up, such as possible destabilizing condition in Syria, Iran, and Nigeria, that may constrain oil supply and drive up international crude price. In the event that oil prices rise again in 2019, government’s strategy to put off increases in subsidized fuel price without increasing subsidy allocation will become increasingly untenable for Pertamina’s financial condition. Given the politically sensitive nature of fuel price increases, government should be ready to allocate more contingency budget for fuel subsidies and officially abandon its policy of fixed-amount fuel subsidy in favor of fixed fuel price.

Going forward, there are more downside risk rather than upside risks for inflation, although inflation will remain higher than 2018 level at 3.4-3.6% level. China’s recent decision to revise down its growth outlook to 6.0-6.5%, protracted trade war between China and US, and higher risks of US recession in late-2019 and early-2020 would affect inflation both through lower economic growth and oil price outlook. Aggressive Bank Indonesia’s rate increases following episode of depreciation may also dampen demand for durable goods, thus limiting the extent of short-term pressures on core inflation.




3.13%


3.07%


3.4-3.6%


3.2-3.4%


5.01%


-1.0%

_________

*) Forecast

2

Less Pressure from Staple Items, Slightly Higher Inflation from Consumer Discretionary

In general, we see headline inflation rate to be stable overall in 2018, owing to low and manageable volatile goods inflation in 2018. In particular, the key driver of volatile goods inflation, namely food and fresh produces, saw relatively muted price fluctuations as compared to the previous years. Decline in volatile goods inflation throughout 2018 also contributed to slightly downward trend of headline inflation, despite the fact that y.o.y. core inflation rose from 2.5% in early 2018 to almost 3.1% by the end of 2018.

Figure 1: Inflation Rate (Headline, Core, Volatile, Administered Goods), 2014-2019.

Low inflation rate throughout 2018 is remarkable given the macroeconomic circumstances that usually lead to higher inflation. Inflation remained low throughout 2018 despite the combination of both higher crude oil price, which at its peak rose by more than 25% and briefly hovered at USD80/barrel level, and Rupiah depreciation that at its peak touched 15,200 level (almost 13% from the start of 2018) in the Q3 of 2018. The outsized importance of oil for transportation of virtually all goods and services, and the critical role of imported materials and capital goods for domestic manufacturing, should have caused 2018 inflation to be higher than 3%. This is shown by how relatively stable telecommunication and transportation prices (see Figure 2), which are mostly administered by government. We may also observe the high correlation of volatile and administered inflation, largely channeled by logistic cost (Figure 1).

Figure 2: Inflation Rate by Consumption Type, 2014-2019 (y.o.y)

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Headline Inflation Core Inflation Volatile Goods Administered Goods




3.13%


3.07%


3.4-3.6%


3.2-3.4%


5.01%


-1.0%

_________

*) Forecast

3

Several factors that contributed to lower volatile goods inflation are attributable to various mix of government policies. Infrastructure projects, for example, allow perishable foods to be transported to further places and reduce price differences between region. This partially explains lower volatility for volatile goods inflation in 2018 as compared to larger price swings in the previous years (Figure 1).

Figure 3: Inflation Rate and Relative Change in USD/IDR, 2014-2019.

Other price-controlling policies, however, come with its fair share of unintended consequences. Officially, current administration has never abandoned its policy of fixed fuel subsidy (i.e. letting fuel price flows while subsidizing fixed amount of Rupiah per liter). However, the reality is that price per liter of Premium (RON 88 gasoline) and Solar (subsidized diesel fuel) remained unchanged since April 2016, despite the fact that the price was set when Brent crude oil was $40/barrel and the price has increased by more than 100% at 2018 peak. In effect, government of Indonesia forced Pertamina to shoulder some of the price differences between Government’s official subsidy budget and the retail price, thus jeopardizing the state of Pertamina’s finance and distort the budget allocation. Additional measure of direct price control of key food-related commodities also created further distortion in the market for food commodities.

Figure 4: Inflation Rate and Relative Change in Oil Price (Brent), 2014-2019.

While government policies have kept volatile goods inflation at relatively manageable level and exert significant downward trend on headline inflation, higher GDP growth counteracted the trend of downward inflation by exerting pressure on price of durable goods. Consumption growth prompted core inflation to steadily rise from 2.58% in February 2018 to 3.07% in December 2018. This trend coincided with steadily higher GDP growth in second half of 2018; we see consumption

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Inflation Change in Oil Price (Brent, Relative to Jan 14)




3.13%


3.07%


3.4-3.6%


3.2-3.4%


5.01%


-1.0%

_________

*) Forecast

4

growth to be solidly above 5.1% in Q4 2018 and prompted by higher growth food consumption and also discretionary items such as transportation, communication, restaurants, and hotels.

Figure 5: Core Inflation Rate and Consumption Growth, 2014-2019.

On the other hand, there are growing risks that upward trajectory of inflation may be offset by lower durable goods consumption. To offset Federal Reserves’ steps to tighten USD interest rate, Bank Indonesia compensated by proactively raising interest rates more steeply than Federal Reserves. As the result, demand for goods that are more likely to be purchased through loans, such as housing and vehicle, tend to drop following steep increase in interest rates. This is evidenced by lower housing component of GDP growth in Q3, from 4.84% in Q2 to 4.01% in Q3 following rise in benchmark interest rate.

Slightly Higher Inflation in 2019, More Downward than Upward Risks

Going forward, we estimate inflation to slightly increase o 3.4-3.6% in 2019, with core inflation increasing to 3.2-3.4%. Our estimates are based on three key macroeconomic assumptions. First, we assume that US economic growth has peaked in late-2018, and thus Federal Reserves will not hike interest rate much further, which makes Rupiah likely to stay below 14,000 level. Second, we also assume that combination of reduced China and US economic growth due to trade war and more US shale capacity coming online following increase in oil price will causes oil price to move relatively sideway in 2019. Lower oil price will also reduce the necessity to raise subsidized fuel price, thus removing most of upward risks for oil price in our baseline scenario. We also assume that if Federal Reserves stop hiking interest rate, Bank Indonesia will compensate by cutting benchmark interest rate, thus driving more durable goods consumption in the second half of 2018.

Impact of higher interest rate on inflation is also driven by the fact that as demographic structure shift towards more working-age population, consumers as a whole tend to shift their consumption basket to incorporate more durable goods consumption. As the result, relative demand for nondurable goods may slightly recede and become slightly less of a concern for inflation going forward, and prices of durable goods may grow in importance as factors driving inflation. While this may not be readily captured by current CPI methodology, we expect lower benchmark interest rate, coupled with relaxation of credit requirements for vehicle credit and residential mortgages will stimulate demand for durable goods purchases in 2019, pushing core inflation slightly higher to our expected rate.

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Consumption Growth Core Inflation




3.13%


3.07%


3.4-3.6%


3.2-3.4%


5.01%


-1.0%

_________

*) Forecast

5

We see several downward risks for inflation going forward. First, if inversion of US yield curve really foreshadows recession and that probability US recession in second half of 2019 is high, Federal Reserves would start to compensate by starting to cut interest rate and prompted capital outflow from US much like what happened after US started Quantitative Easing in 2009. In such scenario, we expect Rupiah to appreciate considerably and reduce prices of imported raw materials in Rupiah, thus reducing inflation. This scenario of US recession is also higher as (1) US government is in shutdown and Congress is in gridlock, thus slightly reducing confidence in US prospect and (2) protracted trade war between US and China would reduce US domestic demand. Second of lower global growth would also affect Indonesia inflation indirectly through oil price, as lower oil price is closely associated with lower inflation in the past.

However, there are also low probability of upward risks for inflation. While geopolitical risks such as tension between Qatar and other Gulf producers or chaos in Venezuela have mostly been priced in at current market price, there still remain low-probability-high-impact geopolitical risk that may drive oil prices up. We see possible destabilizing condition in Syria (especially after US decided to pull out of Syria), Iran, and Nigeria (potential riot surrounding this year’s election) that may constrain oil supply and drive up international crude price. Additionally, the ability of OPEC to successfully constrain supply of oil and hold oil price at around $80/barrel would pose serious fiscal challenges. Given that whoever wins the election will enact some form of price adjustment for oil price after the election, as the timing would be the most feasible politically, the magnitude of the fuel price and electricity price increases will be the key risk of inflation in 2019.

macroeconomic analysis series inflation outlook€¦ · inflation will remain higher than 2018...

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