In the implementation of monetary policy, Bank Indonesia applies an Inflation Targeting Framework (ITF). ITF is a framework of publicly announcing an inflation target corridor and adjusting monetary policy to achieve that target as part of the commitment and accountability of the central bank. In practice, ITF is implemented using a policy rate as a signal of monetary policy and the interbank rate as the operational target. The Inflation Targeting Framework was formally adopted by Bank Indonesia on 1st July 2005, replacing base money as the target of monetary policy.
Based on experience from the Global Financial Crisis in 2008/2009, an important lesson that emerged was the need for adequate central bank flexibility in response to more complex economic developments and a stronger financial sector influence on macroeconomic stability. Consequently, Bank Indonesia strengthened the ITF framework through its evolution into Flexible ITF.
Flexible ITF was developed around the core elements of the existing Inflation Targeting Framework (ITF), including a publicly announced inflation target and forward-looking monetary policy, namely monetary policy oriented towards achieving the inflation target in future periods due to the time lag effect of monetary policy.
Public accountability of monetary policy remains an inherent element of Flexible ITF. Flexible ITF was developed based on the following five core elements:
- Inflation targeting as the fundamental strategy of monetary policy.
- Integration of monetary and macroprudential policies to strengthen policy transmission and maintain macroeconomic stability.
- The role of exchange rate and capital flow policies to support macroeconomic stability.
- Strengthening policy coordination between Bank Indonesia and the Government to control inflation as well as maintain monetary and financial system stability.
- Strengthening the policy communication strategy as a policy instrument.
Why Flexible ITF?
The Global Financial Crisis that occurred in 2008-2009 forced central banks to rescue the economy and maintain financial system stability. Furthermore, policies that focused solely on ITF implementation were no longer considered sufficient due to the narrow monetary policy mandate of maintaining inflation in line with the target corridor, which was insufficient to maintain overall economic system stability.
The role of the financial system in the economy is increasing, with the impact of financial system instability becoming more significant. This is reflected in the massive recovery costs and far-reaching impact of the Global Financial Crisis in 2008/2009. Such conditions raised awareness of the critical central bank function to maintain financial system stability. Consequently, ITF implementation to maintain price stability was necessary but not sufficient.
After the Global Financial Crisis, however, growing demand emerged for central banks to strengthen financial system stability in order to ensure macroeconomic and financial sector stability. To that end, successful ITF implementation required support of a macroprudential regulatory framework. Therefore, Bank Indonesia evolved ITF into Flexible ITF by strengthening its mandate to maintain price stability and support financial system stability.
How is Flexible ITF Applied?
The overriding objective of ITF and Flexible ITF are the same, namely to control inflation. Notwithstanding, a nascent dimension that emerged from the Global Financial Crisis was the central bank’s integrated role to maintain financial system stability, while achieving the price stability mandate. The embodiment of Flexible ITF is the flexibility to integrate monetary and financial system stability through a policy mix of monetary, macroprudential, exchange rate and capital flow instruments, while strengthening the institutional arrangements in order to optimise the role of policy coordination and communication.
In accordance with the inflation targeting strategy, Bank Indonesia announces the inflation target for a specific future period. The inflation target is set by the Government in coordination with Bank Indonesia for the upcoming three years through a Minister of Finance Regulation (PMK). Bank Indonesia regularly evaluates whether the inflation projections remain in line with the target corridor set. The projections are based on several models and the various information available that depict inflation conditions moving forward as the basis for the monetary policies instituted. This is due to the implications of the time lag effect of monetary policy, with the monetary policy target thus based on future inflation projections. Efforts to achieve the target are implemented through a policy mix response based on transparency and accountability.
Bank Indonesia regularly reports the implementation of its duties to the People’s Representative Council (DPR) and also the Government. Furthermore, Bank Indonesia also routinely publishes assessments of the latest inflation conditions and outlook moving forward, the decisions taken as well as future policy direction to maintain inflation in line with the target (forward guidance). This is not only done under the auspices of transparency, yet also an important aspect of strengthening Bank Indonesia credibility to ensure policy effectiveness.
To strengthen the effectiveness of monetary policy transmission, Bank Indonesia set the BI 7-Day (Reverse) Repo Rate as the policy rate on 19th August 2016, representing the monetary policy response signal in terms of controlling inflation in line with the target corridor. Use of BI7DRR as the reference rate is part of Bank Indonesia's monetary policy reformulation.
Previously, Bank Indonesia had used the BI Rate as the reference rate, equivalent to a 12-month interest rate in the term structure of monetary operations. Through the BI7DRR, however, the tenor of the monetary instrument was shortened to 7 days, which is expected to accelerate monetary policy transmission and steer inflation towards the target corridor.
There were three main objectives of monetary policy reformulation. First, strengthening the signal of monetary policy direction. Second, strengthening monetary policy transmission effectiveness through its impact on interest rate movements in the money market and banking industry. Third, accelerating financial market deepening, particularly in terms of transactions and formation of the interest rate structure in the interbank money market for tenors of 3-12 months.
In practice, monetary policy reformulation upholds four salient principles. First, reformulation does not change the monetary policy framework as Bank Indonesia continues to apply flexible ITF. Second, reformulation does not change the current monetary policy stance. Third, reformulation ensures the policy rate is reflected in monetary instruments and is transactable with Bank Indonesia. Fourth, determination of the operational target based on various considerations can be influenced by the policy rate. Consistent with the second principle, reformulation does not change the current monetary policy stance because both the BI Rate and BI7DRR are part of the same term structure with regards to guiding inflation towards the respective target.
The implementation of Flexible ITF also aims to achieve financial system stability. To that end, Flexible ITF implementation is supported by the application of macroprudential policy. Macroprudential policy focuses on the interactions between financial institutions, markets, infrastructures and the broader economy, including measurement of future potential risk. Such policy aims to prevent systemic risk that could trigger a financial system crisis due to macroeconomic conditions. An in-depth explanation of macroprudential policy is available at the following link: (Link ke kebijakan makroprudensial).
Flexible ITF implementation is also supported by exchange rate policy. Bank Indonesia institutes exchange rate policy in order to manage rupiah exchange rates in line with the currency's fundamental value and market mechanisms. Furthermore, exchange rate policy aims to reduce shocks that emerge from a demand and supply mismatch in the foreign exchange market through selling intervention in the spot market, Domestic Non-Deliverable Forwards (DNDF) market an FX futures market as well as through purchases of tradeable government securities (SBN) in the secondary market. This strategy simultaneously maintains exchange rate stability an adequate rupiah liquidity.
The various aforementioned policies are strengthened through policy coordination with the Government, particularly on the supply side. Government policy is predominantly oriented towards maintaining affordable prices, uninterrupted supply and distribution as well as effective communication in order to stabilise food prices and control inflation. Policy coordination between Bank Indonesia and the Government to control inflation has been strengthened through the establishment of a National and Regional Inflation Task Forces (TPI). In addition, policy coordination also reinforces financial system stability. Through the Financial System Stability Committee, Bank Indonesia in conjunction with the Ministry of Finance, Indonesian Financial Services Authority (OJK) and Deposit Insurance Corporation (LPS) determine which coordination measures are necessary and provide recommendations in terms of monitoring and maintaining financial system stability.
The overriding objective of monetary policy is to create and maintain rupiah stability, as reflected by low and stable inflation. To that end, Bank Indonesia sets the BI 7-Day (Reverse) Repo Rate as the main policy instrument that influences economic activity, with inflation as the ultimate goal. The process of setting the BI7DRR to achieving the inflation target is transmitted through various channels with a time lag.
Adjusting the BI7DRR to influence inflation is known as the monetary policy transmission mechanism. This mechanism shows how Bank Indonesia policy, through adjustments to monetary instruments and the operational target, influences various economic and financial variables before ultimately affecting inflation. The mechanism works through interactions between the central bank, banking industry and financial sector, as well as the real sector. Adjustments to the BI7DRR influence inflation through various channels, including the interest rate channel, credit channel, exchange rate channel, asset price channel and expectations channel..
In terms of the interest rate channel, adjustments to the BI7DRR influence deposit rates and lending rates in the banking industry. Bank Indonesia can utilise tight-bias monetary policy by raising interest rates, which impacts aggregate demand and alleviates inflationary pressures. In contrast, reducing the BI7DRR will lower lending rates thus increasing corporate and household demand for loans. In addition, lower lending rates also reduce the cost of capital for investment in the corporate sector, thus stoking consumption and investment activity and stimulating the economy..
Adjustments to the BI7DRR can also influence the exchange rate through the exchange rate channel. A hike in the BI7DRR, for example, would increase the differential between interest rates in Indonesia and other countries. A wider interest rate differential would attract non-resident investors to place capital in financial instruments in Indonesia seeking a higher rate of return. In turn, the foreign capital inflow would trigger rupiah appreciation, leading to cheaper imports and more expensive, or less competitive, exports from Indonesia, thus stimulating higher imports while simultaneously reducing exports. Consequently, rupiah appreciation would ease inflationary pressures.
The impact of changes in interest rates on economic activity also influences public inflation expectations through the expectations channel. Lower interest rates stimulate economic activity an increase inflation, with workers thus anticipating higher inflation and, hence, demanding higher wages. Producers subsequently pass on the cost of higher wages to consumers by raising prices.
The monetary policy transmission mechanism is characterised by a variable time lag. The time lag associated with each transmission channel is different. Under normal conditions, the banking industry will respond to increases/decreases in the BI7DRR by raising/lowering interest rates. Notwithstanding, if the banking industry detects higher risk in the economy, the response to a downward BI7DRR movement is slower. In addition, in the case of banking industry consolidation to increase capital, lower lending rates and increasing demand for loans do not necessarily increase bank lending in response. On the demand side, consumers may not necessarily respond to lower lending rates in the banking industry through higher demand for loans if the economic outlook is weak. Therefore, the effectiveness of monetary policy transmission is affected by external conditions, the financial sector and banking industry, as well as the real sector.
