Definition of Inflation
Inflation is a general increase in prices of goods and services over a period of time. Deflation is the opposite, namely a general decrease in prices over time.
Inflation is calculated by BPS-Statistics Indonesia using SEKI-IHK data. Higher prices of one or two goods do not count as inflation unless the increase expands or raises the prices of other goods.
Measuring CPI
Based on the Classification of Individual Consumption by Purpose (COICOP), the Consumer Price Index (CPI) is divided into the following seven categories:
1. Foodstuffs;
2. Processed Food, Beverages and Tobacco;
3. Housing
4. Clothing
5. Health
6. Education and Sport
7. Transportation and Communication
Data for each group is collected through the Cost of Living Survey (SBH).
Disaggregation of Inflation
In addition to the COICOP categories, BPS-Statistics Indonesia also publishes inflation based on other categories known as an inflation disaggregation. Inflation is disaggregated in order to produce inflation indicators that depict the influence of fundamental factors.
In Indonesia, CPI inflation is disaggregated as follows:
1. Core Inflation, namely the persistent component within inflation movements, which is influenced by economic fundamentals, including:
- Supply-demand interaction;
- External environment: exchange rate: international commodity prices, inflation in trading partner countries;
- Inflation expectations amongst merchants and consumers.
2. Non-core inflation, namely inflation components with higher volatility due to the influence of non-fundamental factors. The components of non-core inflation are as follows:
- Volatile Foods: VF inflation is predominantly influenced by shocks in the foodstuffs’ category, such as harvests, natural disruptions or domestic and international food price developments.
- Administered Prices: AP inflation is mainly influenced by government price policy on subsidised fuel, electricity rates, transportation fares and so on.
Determinants of Inflation
Inflation is driven by supply-side pressures (cost-push inflation), demand-side pressures (demand-pull inflation) as well as inflation expectations. Cost-push inflation factors include exchange rate depreciation, the impact of inflation in other countries, especially trading partners, higher administered prices as well as negative supply shocks due to natural disasters and disruptions in the distribution chain.
On the other hand, demand-pull inflation factors include high demand for goods and services relative to supply. In a macroeconomic context, demand-pull inflation is a condition illustrated by real output exceeding potential output or aggregate demand exceeding economic capacity. Meanwhile, inflation expectations are affected by the behaviour of the public and economic actors in terms of taking economic decisions based on expected inflation. Therefore, inflation expectations are adaptive or forward looking.
This is reflected in the formation of prices at the producer and merchant level, particularly during the approach to a festive period (Eid-ul-Fitr, Christmas and New Year), and in the determination of the provincial minimum wage (UMP). In general, although the availability of goods is considered adequate to cope with higher demand, the prices of goods and services during festive periods tend to increase beyond typical supply-demand conditions. Likewise, when new provincial minimum wages are set, merchants tend to raise prices despite only a moderate impact on demand.
Importance of Price Stability
Low and stable inflation is a prerequisite for sustainable economic growth that will ultimately ameliorate public prosperity. Controlling inflation is, therefore, critical considering that high and unstable inflation has an adverse socioeconomic impact.
First, high inflation persistently erodes real income over time, leading to a deterioration in living standards and adversely affecting all, particularly those towards the bottom of the pyramid.
Second, unstable inflation creates uncertainty amongst economic actors in terms of their ability to make decisions. Empirical experience shows that unstable inflation undermines public decision-making in terms of consumption, investment and production, thus impeding economic growth.
Third, a higher rate of domestic inflation compared with neighbouring countries will lead to uncompetitive domestic interest rates and intensify currency pressures on the rupiah.
Fourth, the importance of price stability in relation to financial system stability (reference).
Through its mandate as stipulated in the Bank Indonesia Act, Bank Indonesia's overriding objective is to create and maintain rupiah stability. Rupiah stability contains two salient aspects, namely stability in relation to goods and services, which is reflected in the interest rate, as well as stability against other currencies that is reflected in the exchange rate against foreign currencies.
Formulation of a single objective explicitly clarifies the targets to be achieved by Bank Indonesia and also delineates Bank Indonesia's responsibilities. Consequently, attainment of the single objective is simple to measure. In pursuit of its goal, Bank Indonesia understands that stimulating economic growth and controlling inflation must be aligned for optimal and sustainable results in the long term.
Inflation Control
Bank Indonesia monetary policy aims to manage price pressures from aggregate demand (demand management) relative to supply-side conditions. Monetary policy does not respond to transient inflation spikes caused by temporary shocks that will fade over time.
Meanwhile, inflation is influenced by supply-side factors and shocks, such as global oil price hikes, failed harvests and floods. Based on the weights in the CPI basket, the components of inflation influenced by supply-side factors and shocks are represented by volatile foods and administered prices, accounting for around 40% of CPI.
Similarly, Bank Indonesia's ability to control inflation is comparatively restrained in the event of major shocks, such as during the fuel price hikes in 2005 and 2008, which triggered significant inflation spikes.
Considering that inflation is influenced by shocks, attainment of the inflation target requires cooperation and coordination between the Government and Bank Indonesia through integrated macroeconomic policy, encompassing fiscal policy, monetary policy and sectoral policy. Furthermore, the vulnerability of inflation in Indonesia to supply-side shocks necessitates a specific policy response.
At the technical level, coordination between the Government and Bank Indonesia is facilitated through establishment of a Coordinated Inflation Target Setting, Monitoring and Control Team (TPI) in 2005. The members include Bank Indonesia and relevant government ministries, including the Ministry of Finance, Ministry of Home Affairs, Ministry of Trade, Ministry of Agriculture, Ministry of Transportation, Ministry of Energy and Mineral Resources, National Development Planning Agency, Coordinating Ministry of Economic Affairs, Ministry of Public Works and Housing, Ministry of State-Owned Enterprises, Cabinet Secretary and National Police of the Republic of Indonesia.
Acknowledging the importance of such coordination, TPI was expanded to the regional level in 2008. Moving forward, the Government and Bank Indonesia expect more effective coordination with the support of the central and regional TPI in the pursuit of low and stable inflation towards sustainable economic growth.
Setting the Inflation Target
The inflation target is the rate of inflation that must be achieved by Bank Indonesia in coordination with the Government. In accordance with the Bank Indonesia Act, the inflation target is set by the Government. Pursuant to a Memorandum of Understanding (MoU) between the Government and Bank Indonesia, the inflation target is set for the upcoming three years through a Minister of Finance Regulation (PMK). Based on PMK No. 101/PMK.010/2021, dated 28th July 2021, concerning the Inflation Target for 2022, 2023 and 2024, the Government set the inflation target for 2022-2024 at 3.0%, 3.0% and 2.5% respectively within a ±1% corridor.
Bank Indonesia expects the inflation target to be used as a benchmark for businesses and the public when conducting economic activities moving forward, thereby maintaining low and stable inflation. One inflation control measure to ensure low and stable inflation is to anchor public inflation expectations to the target corridor.
The inflation target is published on the official Bank Indonesia website as well as the websites of other government institutions, including the Ministry of Finance, Coordinating Ministry of Economic Affairs as well as the National Development Planning Agency. Prior to promulgation of Act No. 23 of 1999 concerning Bank Indonesia, the inflation target was set by Bank Indonesia. Since then, however, the Government has been responsible for setting the inflation target in order to strengthen the credibility of Bank Indonesia.
