Macro Strategy

After the Hike, What’s Next

 

  • BI’s 50 bps hike signals stronger IDR stabilization focus, tighter FX controls, elevated short end yields, and targeted growth support.
  • Current episode appears defensive and FX-driven, contained inflation limits hike risks as govt keeps fuel prices unchanged.
  • We highlight the key factors behind BI’s rate hike decision and revise our scenario band, with 10Y yields at 6.7% to 7.3%.

 

Stability Moves To The Fore. Bank Indonesia raised its policy rate by 50 bps to 5.25%, higher than the market consensus of 5.00%. The decision reinforces BI’s stronger focus on IDR stability, while also acting as a pre-emptive step to manage inflation risks from global commodity price volatility. We highlighted 4 key points for the latest BI’s measures:

 

  1. BI’s assessment of IDR pressure is broadly aligned with our view, as the pressure reflects both structural and seasonal factors. On the structural side, geopolitical tensions and higher commodity prices have strengthened the global “higher for longer” interest rate narrative, especially in the US. This has pushed US Treasury yields higher and supported a stronger USD. On the seasonal side, FX demand from dividend repatriation, the Hajj season, and external debt repayments has added further pressure on the IDR.
  2. To further strengthen FX stability, BI also announced that starting in June, the threshold for cash FX purchases without underlying transactions will be lowered to USD25k. This follows the previous reduction from USD100k to USD50k, which had already lowered average daily spot transactions to USD62mn in April to May, from USD78mn in 1Q26. This measure signals BI’s continued effort to manage FX demand more tightly.
  3. Concurrently, BI emphasized that stability remains the current priority, while support for growth will continue through more targeted measures. These include relaxing Macroprudential Intermediation Ratio requirements and expanding KLM incentives. The objective is to encourage banks to diversify funding beyond deposits through bond issuance, while also broadening financing beyond bank loans through corporate bond purchases.
  4. Going forward, BI reaffirmed its commitment to IDR intervention, including through SRBI as the core of liquidity operations. As a result, SRBI yields are likely to remain elevated to preserve the attractiveness of local assets and support foreign inflows. BI is also likely to continue its operation twist strategy in the SBN market, keeping short end yields elevated to attract inflows, while purchasing longer tenor bonds to stabilize long end yields and maintain liquidity in the financial system. This also allows BI to recycle IDR liquidity absorbed through SRBI back into the market through SBN purchases.

 

What’s Next? The latest rate decision raises the next important question: will BI continue hiking rates? In our view, the current situation appears more similar to past isolated hike periods rather than a full tightening cycle.  The key difference is inflation, especially given the government’s current stance to keep subsidized fuel prices unchanged. Unlike past full tightening cycles, which were driven by both IDR pressure and high inflation, the current episode still appears mainly defensive and FX-driven, with inflation relatively contained. The key risk lies in the government’s fiscal capacity to keep fuel prices unchanged, especially if the ongoing peace talks fail to progress and oil prices remain elevated.

 

Under its mandate, BI is responsible for maintaining IDR stability through two main channels: price stability and exchange rate stability. This is implemented through a Flexible Inflation Targeting framework, while still taking into account financial stability and economic growth.

 

On the inflation side, BI monitors headline CPI against its target band, but places greater emphasis on core CPI as a cleaner measure of demand-driven inflation pressure. On the currency side, BI closely tracks the USDIDR level and exchange rate volatility, commonly measured using the 20-day standard deviation.

 

Our assessment of BI’s historical reaction function, using monthly data since 2016, suggests that BI reacts most aggressively during periods of FX stress and tighter global financial conditions. This is reflected in the significance of IDR stress episodes, changes in US Treasury yields, and periods of disorderly IDR depreciation. Historically, BI’s tightening response can be grouped into two main types.

 

Full Tightening Cycles: 2018 and 2022. These episodes were driven by simultaneous pressure on inflation, the IDR, and global financial conditions, especially during aggressive Fed tightening.

 

In 2018, the Fed raised rates by a cumulative 100 bps, while the DXY rose above 96 from around 90 earlier in the year. Global liquidity also tightened due to ECB tapering, higher oil prices, trade war tensions, and spillovers from EM stress, including Turkey. As a result, IDR weakened from around 13,700 to nearly 15,000, while annualized volatility rose to 7 to 9%. Although CPI remained relatively contained at around 3.2%, BI still responded with 175 bps of rate hikes over seven months to stabilize the currency.

 

The 2022 cycle was more aggressive because inflation and FX pressures intensified at the same time. Inflation rose above 5%, pushing the inflation target gap to around 1.5 to 2.0 ppt. Brent crude stayed above USD100/bbl for five consecutive months after the Russia, Ukraine war, while the Fed raised rates from 0.25% to 4.5% during the year. This pushed the DXY to 114, compressed yield spreads, and triggered consistent net outflows from SBN. In response, BI delivered 225 bps of rate hikes across six consecutive meetings.

 

Isolated Hikes: 2023 and 2024. These episodes were more defensive in nature. BI raised rates mainly to stabilize the IDR, while inflation remained under control.

 

In October 2023, BI raised rates by 25 bps as USDIDR approached 15,800 and the 2Y Indonesia, US yield spread narrowed to 1.5%, the tightest level in the dataset. Another 25 bps hike followed in April 2024, when USDIDR breached 16,000 and annualized IDR volatility rose to 8%. However, neither episode developed into a full tightening cycle. BI later began cutting rates in September 2024.

 

The key difference was inflation. In both 2023 and 2024, headline inflation stayed below 3%, while core inflation continued to decline toward below 2%. This allowed BI to treat the hikes as temporary defensive moves rather than the start of a prolonged tightening cycle

 

 

Key Factors Behind the Rate Decision: Our View. Based on our regression analysis, there are several indicators for BI rate movement:

  1. The strongest predictors of a BI rate hike are price-related indicators, particularly headline inflation, the gap versus BI’s inflation target, and oil prices as signals of global supply shocks.
  2. This is followed by short-end UST yields, narrowing ID-US yield spreads, and DXY, which increase hike probability by reducing the attractiveness of IDR assets and raising exchange rate pressure.

This pattern is also consistent with BI’s communication. In 2022, BI justified hikes using both inflation and IDR stability concerns, while in 2023 and 2024, the decisions were framed mainly as pre-emptive measures to stabilize the IDR without significant inflation concerns.

As such, in our view, the May 2026 hike fits the isolated-hike pattern more closely, mainly underpinned by several indicators:

  • Headline CPI stood at 2.42%, core CPI at 2.44%, and the inflation target gap remained zero, representing the most benign inflation backdrop among past hike episodes.
  • DXY stood at 98-99, well below the 105–114 range seen during full tightening cycles.
  • The sole stress point was IDR: the currency averaged 17,500 in May and volatility spiked sharply to 6.2%. This mirrors the isolated hike template of 2023–2024, where currency stress drove the decision without corroboration from inflation.

 

The current hike appears more consistent with a stabilization-oriented adjustment rather than the beginning of a prolonged tightening cycle in to 2018 or 2022. Our analysis shows that when inflation remains within BI’s target band, the probability of a follow-on hike in the subsequent month falls to just 3.2%. Nonetheless, current IDR pressure may prove more persistent than in prior stabilization episodes due to growing concerns surrounding fiscal discipline and policy uncertainty under the new administration. This is consistent with our earlier report, “The Currency Conundrum,” where we argued that recent IDR weakness increasingly reflects a structural repricing of Indonesia’s equilibrium exchange rate rather than merely cyclical external volatility.

 

At the same time, the current global backdrop remains significantly different from the aggressive Fed tightening cycles seen in 2018 and 2022. Market expectations are still largely for the Fed to remain on hold, although some expectations have recently shifted toward the possibility of a 25 bps hike either later this year or in early next year. This contrasts with the 2018 and 2022 periods, when the Fed was implementing a clear and aggressive tightening cycle.

 

Scenario Band Revision. In our report “The Next Constraint” (27th April) we shifted our scenario band by moving our earlier pessimistic scenario into the base case. Since then, conditions have rapidly approached our pessimistic scenario, with USDIDR even surpassing our assumption under that scenario, while the 10Y INDOGB yield remains below our projected level. Given the recent shift in macro conditions and monetary stance, we have revised our key macro assumptions toward a more cautious scenario.

  • Our baseline now is for BI to hold the rate at 5.25% through year-end, with IDR at IDR 17,500/USD while foreign ownership in the SBN market is maintained near the current level of around 12.5%. This implies a 10Y INDOGB yield of around 6.9%.
  • Under a more pessimistic scenario, we see the possibility of another 25 bps BI rate hike, particularly if USDIDR approaches the next psychological level of 18,000, potentially triggering further foreign outflows and pushing 10Y yields closer to 7.3%.
  • On a more optimistic case, if global and domestic market conditions improve and policy focus shifts back toward growth support, we see room for BI to eventually return to our previous baseline path, with rates adjusted back to 4.75% and potentially driving 10Y yields back closer to 6.6%.

 

Capital Market: Rising Yield Continues. The bond market remained under pressure as UST yields moved higher over the week. The 10Y UST yield rose by 10 bps w-w to 4.56, while the 2Y UST yield increased by 15 bps w-w to 4.13%. In the domestic market, the 10Y INDOGB yield also edged higher by 4 bps w-w to 6.74%. Indonesia’s 5Y CDS widened by 8 bps w-w to 92 bps, indicating some increase in sovereign risk premium. Meanwhile, the DXY was broadly flat, rising only 0.03% w-w to 99.32. Despite the stable DXY, IDR weakened by 1.40% w-w despite BI’s 50 bps rate hike, closing at IDR17,709/USD.

 

  • Fixed Income Flows. Foreign investors recorded a weekly net outflow of IDR1.18 tn from the SBN market (data as of 19 May), bringing total foreign holdings to IDR867tn. On MTD basis, foreign flows remained slightly positive at IDR0.37tn. Among domestic investors, banks posted sizable net outflows of IDR81.19tn w-w (MTD outflow IDR57.66tn). In contrast, Bank Indonesia, excluding repo transactions, recorded net inflows of IDR96.78tn w-w (MTD IDR63.02tn), indicating continued support in the SBN market. Mutual funds added modest net inflows of IDR0.32tn, while insurance and pension funds recorded combined net inflows of IDR12.53tn on a w-w basis.
  • Equity Flows. The JCI dropped sharply by 8% last week, briefly falling below the 6,000 level. On a YTD basis, the index has declined by 29%, significantly underperforming regional peers. Foreign outflows also continued for the eighth consecutive week, with foreign investors withdrawing IDR1.7tn last week, bringing MTD outflows to IDR6.7 tn.

 

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