2 biggest reasons behind Indonesia's monetary tightening

Inflationary pressures loom in the horizon.

According to DBS,  Bank Indonesia (BI) meets this Thursday and more monetary tightening is to be expected.

DBS noted that over the past few quarters, BI has gradually adopted a tighter monetary stance, initially through macro-prudential measures on credit and more recently, through a 25bps hike in the policy rate and the FASBI deposit rate in June. There are two key reasons for more monetary tightening.

Here's more from DBS:

Firstly, as we have highlighted over the past several months, the current account deficit remains a cause for worry amid a persistent trade deficit as commodity prices stayed lackluster. Concerns about external funding have resurfaced amid speculation of US Fed tapering, resulting in rupiah volatility in recent weeks.

Secondly, inflationary pressures resulting from the average 33% subsidized fuel price hike will be fully reflected in July’s CPI numbers. Notably, headline inflation already pushed up to 5.9% YoY in June and islikely to push past 7% in July.

The need to anchorinflation expectations and ease external stability concerns is likely to prompt another 25bps BIrate hike to 6.25% atthe upcoming meeting.

On the back of potential Fed tapering,there has been upward steepening pressure on the whole yield curve across many Asian economies.

However, Indonesia stands out with bear flattening having taken place in the front end of the yield curve. Notably, the 2Y/5Y spread narrowed from 58bps in early June to 10bps currently as 2Y yields rose more rapidly than 5Y yields.

The flatness of the ID government yield curve in the 2Y/5Y segmentreflects expectations of monetary tightening and we maintain that this segment is likely to stay flattish in the short term.

Beyond the immediate few months, however, 2Y/5Y spreads are expected to increase to 85bps (average of Jan-2010 to Sep-2011).