CME INVITES BANK INDONESIA TO BE PRUDENT ON INTEREST RATE CUTS TO AVOID AN UNSUSTAINABLE RECOVERY PATH
Friday, 19 February 2021: Bank Indonesia (BI) has cut its benchmark interest rate for the sixth time since the beginning of COVID-19, bringing it to a record low in an attempt to support the economic recovery. The recent decision brings the central bank’s seven-day reverse repo rate down 25 basis points (bps) to 3.5 percent, the lowest level since the rate was introduced in 2016.
The Center for Market Education (CME, www.marketedu.org) invites the Indonesian central bank to be prudent with further moves in the same direction. Indeed, if it would work perfectly as described by textbooks — lower the rate to stimulate the economy and raise it to cool down prices — monetary policy would be an easy tool, and we would not experience economic crises. However, central bank actions are based on past information (and information always evolves), and it takes time for such actions to produce effects (and the bigger the time lag, the bigger the evolution of the context).
“It is important to understand that monetary policy is a signal more than an objective fact. By lowering the interest rate, the central bank wishes to communicate that more financial resources have been made available for investment (or that borrowing money is cheaper). Its effects on the real economy are not automatic as we are used to think. As a signal, monetary policy needs to be interpreted by economic agents and its consequences will depend on such interpretations” – commented Dr Carmelo Ferlito, CEO of the Center for Market Education.
One potential interpretation is that more financial resources are available — or that “money is cheaper” — and this would eventually call for more investment (which may be also bad investments). However, this is not the only possible interpretation. Market players may think that the central bank is worried about the present status of the economy and therefore may become even more conservative and hold back. In a nutshell, the economy is made by billions of individual actions linked by signal interpretations; in such a system, nothing is automatic and the result of an action is open-ended by nature.
When we believe that the interest rate is the main driver for investment, we are disregarding the basic fact that entrepreneurial decisions are mainly driven by profit expectations. It is enough to look at the mixed results produced by quantitative easing in Europe: If businesspeople do not expect a bright future, no matter how low the interest rate is, they simply do not invest.
Dr Ferlito added that further cuts may push inflationary tendencies. “In fact, from the inflation perspective, at the moment we experience contending trends: the Covid-19 crisis pushes for prices to go down, while the different fiscal stimuli push in the opposite direction. If inflationary tendencies would prevail, purchasing power would be compromised during an already difficult moment. On the contrary, now we need purchasing power to be restored and saving to be rebuilt in order to grant the creation of funds available for investment”.
The CME added that too low an OPR could eventually incentivize malinvestment (bad investments), because investments are done than would not be done in different circumstances (they would have been done only because “money is cheap” and therefore they would move the economy toward an unsustainable path).
While the Indonesian economy struggles on the way to recovery, and Indonesia played a smart game in the FDIs match, it is important that the seeds are planted for a sustainable recovery, which means a recovery which is not inflated by artificial credit but supported by restored purchasing power and new savings necessary to finance sustainable investments.
About CME: The Center for Market Education (CME) is a boutique think-tank based in Kuala Lumpur, Malaysia. As an academic and educational institution, CME aims to promote a more pluralistic and multidisciplinary approach to economics and to spread the knowledge of a sounder economics, grounded in the understanding of market forces. In order to do so, CME is not only involved in academic initiatives, but it organizes seminars, webinars and tailor-made economics classes for students, journalists, businesspeople and professionals who wish to better understand the relevance of economics for their daily lives and activities. Economics matters and needs to be presented in a fashion in which the link with reality is clearly visible. In this sense, we look not only at theoretical economics but also at policy making, with an emphasis on the unintended consequences generated by political actions.