Watching Out for Era of High Interest Rates

As expected, the United States Federal Reserve (the Fed) – the US central bank – the raised its benchmark interest rate by 25 basis points (bps) in December. With this increase, the Fed interest rate now falls within the 2.25-2.50 percent range.

The rate hike was the fourth in 2018 and the ninth since 2015, when the normalization policy was implemented. The yearend increase in the Fed interest rate is unlikely to be the last.

Fed Chair Jerome Powell has given strong indications that the Fed will again raise its benchmark interest rate in 2019, albeit at a slower pace. Although President Donald Trump strongly opposes the rate hike, the Fed believes that the ideal benchmark interest rate is around 3 percent. Therefore, the Fed is expected to further increase its benchmark interest rate in 2019 until it touches this figure.

Uncertainty

The Fed\'s measures will certainly have a significant impact on global financial stability, including on Indonesia. So far, global economic players still do not share confidence in the potential impact from the Fed policy. Some economic players believe that the Fed\'s policy is the right step in the midst of the improving US economy. This group is confident that the Fed rate hike will not hamper US business growth and support the steps the Fed is taking.

However, other economic players believe that increasing the Fed rate will be counterproductive to the recovery of the US economy in recent years. The Fed rate hike will increase businesses’ financial burden and cause a decline in productivity. The economic players in this group are responding to the rate hike by withdrawing their capital from the US economy (capital outflow).

Besides the two groups of economic players above, there is still a third group that tends toward caution. They take a “wait and see” approach, postponing business expansion plans until they are sure about the real economic condition they are facing.

The second and third groups are those that President Trump fears most. Trump\'s government must bear extra costs to withstand the possible capital outflow that the two groups could make.

The Trump government must provide "incentives" as compensation for the increased financial burden that businesspeople must bear as a result of the Fed rate hike. Therefore, it is highly understandable that most global economic organizations, including the World Bank, remain concerned about the uncertainty in the global financial condition.

To date, the World Bank still has not changed its 2019 projection of 3.9 percent on global economic growth – growth of only 0.2 percent compared to growth in 2016. Such a low economic growth means that the global economy will not grow more aggressively in 2019 than in previous years.

Impact on Indonesia

The global financial turmoil has a direct impact on the Indonesian economy. As the central bank, Bank Indonesia (BI) will mirror the Fed’s steps to maintain balance in the Indonesian financial system.

Although BI did not follow the Fed rate hike in early December, it raised its benchmark interest rate earlier in a preemptive measure against the expected Fed rate hike. BI’s 7-Day Reverse Repo Rate (7DRRR) is currently at 6.00 percent, the same as the previous month’s level. The Fed rate hike, followed by a similar increase in the BI 7DRRR, marks the beginning of am era of high interest.

The increase in the benchmark interest rate will have a direct impact on bank lending rates. With a benchmark interest rate of 6.00 percent, it will be very difficult for banks to set their lending rates below 10 percent (single digit).

Bank lending rates remain high, and could reach double digits. The high lending rates could cause concern among businesspeople, because the rate hike is not caused by market demand and supply.

The increase in bank lending rates is an anticipatory measure against potential capital outflows of short-term funds, or hot money, due to the Fed rate hike. The increase in BI’s benchmark interest rate will result in increased financial costs that businesspeople must bear. As a result, the Indonesian economy could potentially become a high-cost economy with low productivity.

This phenomenon can be seen from declining growth in bank loans. In 2015 and 2017, the banking industry had a below 10 percent growth in loans.

Loan growth in October 2018 was the same as the figure in October 2017, only 9.54 percent. Cumulative loans grew only 7.02 percent in October 2018 compared to the figure in December 2017.

With an average loan growth of 1.4 percent per month, it would be very difficult to achieve loan growth of above 10 percent by the end of the 2018 fiscal year. The low growth in loans indicates that businesspeople are still refraining from expanding their businesses. Some Indonesian businesspeople are following the wait-and-see approach of global business players until they have regained confidence in the condition of the global and national economies.

The government must therefore watch out for the trend of increased interest rates in the banking industry as a result of the Fed rate hike.

Further, the government must issue a fiscal policy that encourages businesspeople to continue with expansion plans amid this era of high interest rates. If this is done effectively, this era of high interest rates will not have a negative impact on the Indonesian economy. (Agus Herta Sumarto, Lecturer, Economy and Business School, Mercu Buana University; Indef researcher)