Monetary policy beyond low inflation

In response to the COVID-19 pandemic, central banks around the world have been experimenting with unconventional policies. Normally, standard macroeconomic models prescribe substantial policy rate cuts during economic downturns to provide cushions to the economy. But central banks cannot always adhere to this prescription.

The United States Federal Reserves (Fed), for example, cut its policy rate by the average of 5.5 percent during recessions since 1957. But the Fed Funds Rate (FFR) was already at 1.75 percent in February 2020. So it had to be set at minus 3.75 percent to follow the historical patterns.

As setting negative rates is equal to taxing deposits, it can prompt fund owners to withdraw money from the banking system and to hoard cash instead. Hence, contrary to the normal nexus where a lower interest stimulates the economy, rate cuts below zero can discourage economic activities and introduce a deflationary spiral.

At this point, the Fed is arguably facing the zero lower bound (ZLB) on nominal interest rates. It prevents the central bank from lowering the FFR below the bound in response to adverse pressures to the economy. The ZLB is also known as the effective lower bound (ELB) since the bound can be nonzero.

In a way, Indonesia might be facing an ELB near the 4.5 percent if Bank Indonesia (BI) cannot make further cuts without causing capital to leave the financial system at large scales. Nevertheless, BI is living in a world where its peers are facing ELBs.

A world wherein inflation is the least thing to worry about. In fact, they are struggling to push inflation up to avoid deflationary pressures on future welfare.

Facing the ZLB, some major central banks dare to explore the negative-rate territory. The Fed, on the other hand, is visibly reluctant to experiment with negative rates. When the FFR hit zero in early March 2020, the Fed relaunched at full force the GFCera assistance with additional variants. It prefers large-scale easing to negative rates by rolling out facilities known by their cryptic acronyms, e.g. CPFF, MMLF, PMCCF-SMCCF, and TSLF.

Casual onlookers might be surprised to learn that as well as holding mortgage-backed securities, the Fed is now purchasing speculative-grade securities, exposing its balance sheet to unchartered territory. Risks related to BI’s sovereign-grade securities purchases in the primary market are practically nothing to the Fed’s recent undertakings.

Balance-sheet risks aside, the Fed has the opportunity to cushion the historic impacts of the pandemic by supplying the equally unprecedented assistance. BI, in contrast, might envy that privilege, thanks to Indonesia’s chronic lack of financial deepening.

The Indonesian capital market capitalization to gross domestic product (GDP) ratio has never reached 50 percent, even during booms. Private bonds represent less than 20 percent of tradable bonds. Securitizations and derivatives are exceptionally limited to the extent BI must even provide foreign exchange forward services. Hence, not many channels for those US-style interventions are available.

But lack of financial sophistication is not always an issue to BI’s policy implementations. BI had once created its own instruments to support its policies. Transitioning from direct monetary control to open market operations in 1984, BI issued own securities: BI Certificates (SBI) and BI Money Market Commercial Papers (SBPU).

Likewise, BI could again create new type of instruments to facilitate more active interventions to show that BI is willing to safeguard the economy — quoting Mario Draghi — “whatever it takes.”

On a related note, consistent with Hal Hill’s contemporaneous analysis in 1999, recent episodes of sudden capital flows reversal, roller-coaster fluctuations of the rupiah, and other factors attributed to the 1997-1998 crisis are still yet to create another catastrophe.

These factors compounded the impacts of the crisis but could not sufficiently explain how the phenomenon took place. In The Indonesian Economy in Crisis, Hill identifies “domestic policy mismanagement which culminated in a total loss of confidence in the [New Order] regime” as the primary cause of the 1997-1998 crisis.

The free floating of the rupiah was not a problem. In fact, substantial depreciations were expected to strengthen the currency through improvements in net exports. It became a consequential problem when investors bet that BI had to persist in appreciating the rupiah and wasted its reserves since most cross-border borrowers at the time, who typically had strong connections to the first family, did not hedge their exposures. BI’s intervention bands were akin to free hedging services.

Closing of ailing banks would not invite panic if the criteria for closure were well-articulated and no president’s sons or pals interfering with financial oversights. Also, international assistance could be more potent if the palace was not flip-flopping on agreed commitments or suddenly toying with a currency board system proposal, damaging partners’ trust.

The COVID-19 pandemic has opened another front for the Indonesian authorities to test their capability in safeguarding financial stability. So far, they seem to command the field. They are well equipped to stabilize the currency, anchor expectations or maintain discipline. But they will need more public support should the productivity shocks become more severe and if the ELB becomes binding. This would be a completely new policy arena.

The strategy in that terrain might sound too bizarre to most domestic audience. The central bank must conduct massive monetary easing while the fiscal authority has to implement expansionary budget, naturally requiring major debt issuance.

Uproars and public resistance are very much expected if the rationale is not properly conveyed. However, reluctance to commit to such endeavors might erode their credibility, a key feature in preventing economic crises.

All in all, maintaining confidence in the economy requires the authorities to act and the general public to trust; it takes two to tango.

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An executive of Bank Indonesia, currently pursuing a master's degree in systemic risk at the Yale School of Management. The views expressed are his own.

Disclaimer: The opinions expressed in this article are those of the author and do not reflect the official stance of The Jakarta Post.