WHEN Indonesia’s National Statistics Bureau announced that the country’s annual inflation last month grew to an unexpected high of 4.53 per cent, some economists warned that the economy might be overheating.

The economy is “growing above its sustainable rate largely as a result of an overly loose monetary policy”, Credit Suisse economist Robert Prior-Wandesforde said in a research note. His comments echoed recent declarations by the International Monetary Fund, which has been arguing that Asian nations should prepare to “shift gears” and tighten monetary policy as their economies strengthen and inflationary pressures rise.

Such concerns, however, can be exaggerated. After all, current inflation is well within Bank Indonesia’s target of 3.5 per cent to 5.5 per cent for the year. It is also well below historical averages. Year-on-year inflation reached 12 per cent in late 2008, for example, and was as high as 7 per cent as recently as February last year before falling to 3.56 per cent in March this year.

Domestic demand is closely watched in Indonesia because it accounts for 54 per cent of the economy. It has also been the main driver of economic growth since the global downturn began in 2008. The fact that the jump in inflation last month was largely driven by higher food prices, including meat, dairy products, fruit and fish, also has political implications.

Not all of the inflation in recent months was domestically generated, however. Weaker trade figures are partly responsible for a decline in the value of the rupiah, suggesting that imported inflation has been adding to the problem. The currency declined by 2.9 per cent against the greenback in the three months ended last month, its worst quarter since 2009.

The trade deficit in May was almost US$490 million (S$622 million), far above the median US$128 million surplus forecast by nine economists polled by Dow Jones Newswires.

The economy is set to face even more inflationary pressures in the coming weeks with the beginning of a new school term and the Muslim religious festivals of Ramadan and Eid Al-Fitr.

That said, there are good reasons for expecting inflation to remain under control in the second half of the year. One of these is the fact that much of the inflation earlier this year was linked to a transitory phenomenon – the expectation that the government would increase the price of subsidised petrol. Speculation led to shortages and a subsequent rise in the cost of transportation that ultimately proved unwarranted when Parliament scrapped the subsidy reduction plan in late March.

Given the high cost of the fuel subsidies, Parliament’s decision could seriously damage Jakarta’s fiscal position. However, it has helped ensure inflation remains muted for the remainder of the year.

Inflation will also be held in check by a rise in domestic food production. Higher yields and an increase in planted areas are expected to lift rice and corn production, for example. White sugar production is also expected to exceed last year’s output as a normal dry season helps increase extraction rates.

Most economists believe that Bank Indonesia, the central bank, will avoid responding to higher inflation by raising interest rates. For some time now, the monetary authorities have sought to sustain economic growth and contain inflation without raising the benchmark interest rate, which has remained steady since a cut in February. Instead, Bank Indonesia has been looking at other approaches, including tighter lending regulations aimed at preventing the development of property bubbles.

In the medium and long term, however, Indonesia will have to deal more directly with underlying structural problems. The oil subsidy is unsustainable. It will eventually have to be reduced significantly if the nation is to have any realistic chance of paying off its debts and allocating badly needed funds to infrastructure, education and health. Inevitably, this will involve higher inflation, at least initially.

More also needs to be done to encourage Indonesians to consume a greater variety of foods instead of focusing on a small range of staples that carry increasingly high prices. According to the International Rice Research Institute, Indonesia’s per capita rice consumption stands at 139kg per year, among the highest in the world. But the country has not been self-sufficient in rice since the 1980s, when farmland was used to build housing estates for a larger, more urbanised population.

These are long-term issues, of course. They are not the sort of things that any hand-wringing about the relationship between inflation and the country’s allegedly loose monetary policy will resolve.

(C) Singapore Press Holdings Limited