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ECONOMIC UPDATE - Monetary Review - The game changer

Fed becomes more dovish

The Federal Reserve (Fed) is no longer in any rush to raise US interest rates. Fed proved its dovish stance after it cut its FFR hike projection in 2019 from 50 bps to no hike at all. Moreover, Fed plans to end its tapering off policy in September. It will start reducing the cap on Treasury securities monthly redemptions from the current USD30 bn to USD15 bn in May.  The move denotes Fed’s concern of US slowdown risk in 2019. Fed also revised PCE inflation projection to 1.8% YoY (vs 1.9% YoY in Dec meeting), unemployment rate to 3.7% (vs 3.5%) and GDP growth at 2.1% YoY (vs 2.3% YoY).


How trade war to affect Fed’s decision?

We noted three major factors that restrain US economic growth and inflation recently: 1) US – China trade war; 2) Fed’s monetary tightening policy and 3) declining tax cut effect. From those 3 factors we have mentioned, trade war has the highest uncertainty. Fed’s policy has turned dovish in March meeting and declining tax cut effect has been priced in by Fed and investors. Trade war will become the key as different outcomes may lead to different Fed’s monetary stance. If a trade deal to lift up previous tariff sanction is reached, it may give a boost to US and China economic. However, better economic outlook can be seen as an opportunity for another FFR hike cycle even though we see the maximum magnitude will only be at 25 bps in 2020. On the other side, if trade deal is not achieved and even both countries add new tariff sanctions, it will lead to even lower growth and FFR cut opportunity will start to emerge.


How trade war affect Indonesia’s CAD and BI’s policy rate decision?

Previously, we expect CAD to reach 2.8% of GDP due to trade war impacting global slowdown in 2019. How trade war ends will affect both China and US, leading to sluggish Indonesia’s export demand and CAD. Non oil and gas export to US and China reached 25% proportion, making their growth strongly affect Indonesia’s export. Then, how will it impact the BI’s policy rate decision in 2019? The main reason of BI maintaining policy rate is because of external stability, mainly from CAD and capital flow due to global volatility. Better CAD will lead to better balance of payment (BoP) and more stable Rupiah which will open opportunity of policy rate cut in 2019-2020. On the other hand, high CAD will lead to sluggish BoP and more volatile Rupiah which will make central bank to maintain high policy rate or even raise it if necessary. We will follow our base case as stated below.


Base case: Trade war ends with peace, BI cut rate 50 bps in 2019 and 75 bps in 2020 (page 5 onwards)

Our base case assumes there will be a trade deal between US and China that will alleviate previous tariff sanction burden from both countries. Slowing down economies in both countries (mainly China) will give a pressure to both countries to settle their differences immediately. In this base case, China’s growth should reach above 6.2% and favor Indonesia’s export demand. We revised our CAD forecast back to 2.5% of GDP. Healthier CAD and less global volatility will bring Rupiah to Rp13,980 in 2019 average, bringing confidence for BI to cut policy rate by 50 bps in 2H19. However, better US macroeconomic figure (growth, inflation and unemployment rate) may lead to another FFR hike. In our opinion, Fed will raise FFR by only 25 bps in 2020 in order to maintain inflation on target at 2.0% YoY. On Indonesia’s side, we believe BI will still continue rate cut of 75 bps in 2020 as the CAD will be healthier at 2.2% of GDP in 2020 and Rupiah will still remain below Rp 14,000.


Alternative case: more severe trade war, no rate movement in 2019 (page 7 onwards)

The alternative case contains the risk of trade deal failure that leads to another tariff increment. Higher tariff will drag down the growth forecast of China and US to below 6.0% YoY and 2.0% YoY, respectively. On this case, Indonesia’s export can be hurt significantly as its main export destination’s demand will decline and CAD will remain high at 3.0% of GDP. As the consequences, we see Rupiah will move around Rp 14,329 in average and Rp 14,550 in YE 2019, preventing BI to cut the rate in 2019. However, sluggish US growth will encourage FFR cut of 50 bps in 2020. We see BI to follow Fed’s movement by higher magnitude of 100 bps due to: 1) sluggish growth at 4.8% YoY; 2) Low inflation at 2.0% - 2.5%; 3) Healthier CAD at 2.5% of GDP due to lower domestic demand. Other risks to our call can be seen in page 8.