The simplification of the reserve requirement is to be welcomed. But the impact of this on liquidity is likely to be counter-productive. The change will have the effect of freeing up almost Rp 23 trillion, the effect of which in turn is equivalent to increasing the supply of base money (M0) by about 6.6%. But base money has already been growing far too rapidly to be consistent with the current target level of about 5% inflation, which has risen from about 6% in the middle of 2007 to more than 12% in September this year. The new policy is therefore a worrying development. It seems almost certain to generate even higher inflation and more rapid depreciation of the currency. At the same time, the ability of this policy to prevent the emergence of recession is by no means obvious.

Almost everybody who talks about this issue focuses only on the demand side, forgetting about supply. With increased liquidity, individuals and firms have a greater capacity to spend. But firms also have a greater capacity to withhold goods and services from the market in anticipation of being able to push up their prices. If supply curves move upward at about the same rates as demand curves, the result is higher prices with no change in output. The experience of 1998, when inflation surged to over 80% at the same time that output was falling by 13%, provides clear evidence of the wishful thinking that underlies the push for increased liquidity in current circumstances.

Senior deputy governor of BI, Miranda Goeltom, is well aware of the problem, and has announced that BI does not intend to decrease its policy interest rate, which has only recently been increased to 9.5%. But there is an air of unreality about this. How could nominal interest rates possibly be maintained at current levels with liquidity being increased so significantly? Liquidity and interest rates are directly linked. Indeed, if BI were to choose to reduce interest rates, it is precisely by increasing liquidity that this would be achieved. It would simply reduce the quantity of SBIs it issues relative to the quantity maturing, which means that it would be paying out more on maturing SBIs than it would be receiving for issuing new ones.

With liquidity suddenly increasing by a large amount as a result of the change in reserve requirements, the demand for SBIs at current interest rates will increase. If BI issues enough to satisfy this demand, liquidity will return to roughly what it had been previously. If it does not satisfy this demand, it will either need to allow SBI rates to fall, or it will have to ration the demand for SBIs at the auction. In this latter case, a wedge will be driven between money market rates and the official rate, which will only serve to demonstrate that the policy rate no longer bears any relevance to what is going on in the market. BI will be able to pretend that it is still fighting inflation, but the reality is that by adding to system liquidity so significantly, it is encouraging inflation to accelerate even further.

In the near future, expect inflation to accelerate and money market interest rates to decline. But don’t bet on Indonesia avoiding an economic downturn.