Price and Demand Weakening
The increase in the price of an item has a limit. If it rises above the ability to pay, the customer will stop buying and switch completely to another alternative.
The impact of rising prices can be described in two ways, namely the substitution effect and the income effect. The most extreme impact is the loss of demand, or demand destruction, due to the substitution effect and income effect, which makes consumer goods no longer unaffordable.
The increase in the price of an item has a limit. If it rises above the ability to pay, the customer will stop buying and switch completely to another alternative. This is a mechanism that prevents price increases from developing into hyperinflation.
This principle is used by monetary authorities around the world to cool an overheating economy, through disinflationary policies in various instruments. As an authority, they also have the ability to take anticipatory action (to move ahead of the curve).
Changes in behavior
As a result of the Russian attack on Ukraine, the price of West Texas Intermediate (WTI) oil jumped to US$123 per barrel. The WTI oil price then fell to $99 per barrel but the uncertain geopolitical situation brought it back to about $107 per barrel. Other factors holding WTI oil prices in the range of $100-110 per barrel are concerns about the impact of the lockdown in China and the potential for a recession in the United States.
It seems that traders on the futures exchange are starting to understand that demand will automatically fall if the oil is no longer affordable. However, speculators still need a price fluctuation to make a profit. The effect of this change in behavior is that the oil market fluctuates in a narrower price range, compared with the beginning of the Russia-Ukraine conflict.
The remaining group (34 percent) would not likely change their vehicle use habits until the price reached $5 per gallon.
Even so, the price range is still unable to lower for fuel oil in the US. At the gas station level, the average fuel price jumped to $4.37 per gallon or $1.19 (about Rp 17,255) per liter. The results of a survey released by Maru Public Opinion at the end of April showed 66 percent of US vehicle owners had made or would make, a significant change in their vehicle use habits if the price at the gas pumps escalated from the national average price of $4.37 per gallon. The remaining group (34 percent) would not likely change their vehicle use habits until the price reached $5 per gallon.
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The increase in fuel prices, coupled with an increase in the price of daily necessities by 10.8 percent in April, caused inflation in the US to remain high at 8.3 percent the month, after reaching a peak of 8.5 percent in March.
Paradoxically, demand destruction was needed to reduce inflationary pressures even though the result was negative growth of minus 1.4 percent in the first quarter of 2022.
However, the US central bank considered inflation was still too high so it had to raise interest rates by 50 basis points on 4 May. This move was accompanied by a reduction in securities holdings by $95 billion per month.
Another anecdotal case of habit change occurred in the United Kingdom caused by the Russia-Ukraine conflict and economic sanctions against Russia that sent energy and food prices soaring.
A YouGov survey at the end of April showed that 14 percent of the 10,674 respondents had reduced the frequency of their daily meals from three times to less. If they still ate three times a day, they reduced the portion. To save on electricity and gas bills, some people had also turned to frozen ready-to-eat food because cooking their own food has become expensive.
Mudik and economic growth
The sharp increase in the number of people going to their hometowns for mudik (exodus) to celebrate Idul Fitri in early May occurred because the traditional homecoming had been held back for two years due to the pandemic. The supporting factor was the price of fuel, which had not yet entered the demand destruction zone. According to toll road operator Jasa Marga, the number of vehicles using the toll roads reached a new record high of 1.7 million vehicles during 22 April-1 May, or 9.5 percent higher than the figure before the pandemic.
Meanwhile, the durable purchasing index in March showed a declining trend, an indication that an increase in savings was taking place for the homecoming trips.
From a financial point of view, the community seemed to have prepared for mudik several months in advance. According to Bank Indonesia (BI), the proportion of savings increased from 15.9 percent in March to 16.4 percent in April. Meanwhile, the durable purchasing index in March showed a declining trend, an indication that an increase in savings was taking place for the homecoming trips.
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By the time the Idul Fitri public holiday ended on May 8, as many as 46 percent of the homecomers were estimated to have not returned, thus potentially increasing the impact of the mudik on economic growth. The latest data published by Statistics Indonesia (BPS) shows that economic growth in the first quarter of 2022 reached 5.01 percent on an annual basis, not much different from 5.02 percent in the fourth quarter of 2021. This is an indication that the long-term equilibrium growth path is almost achieved, or has even been reached again.
With such a growth base, the above spending pattern does not appear to have created excessive inflationary pressure on the demand side. April inflation was recorded at 3.47 percent, up from 2.67 percent the previous month. Inflationary pressures came more from the production sector and imported inflation, where food, beverages and tobacco accounted for 46 percent, followed by the transportation sector with 29 percent.
The inflation rate is still in the range of 3 plus/minus 1 percent so it can still be checked by controlling the liquidity without having to raise the benchmark interest rate. The thing to watch out for is imported inflation originating from both commodity prices and the strengthening of the US dollar, which has caused the weakening of the rupiah. Currently, the dollar index has already reached 104 as a result of the Russia-Ukraine conflict, the rise in the United States Federal Reserve’ interact rate and the lockdown in China.
ARI KUNCORO, Rector of the University of Indonesia.
(This article was translated by Hendarsyah Tarmizi)