Following easing moves by a number of central banks across the globe, Bank Indonesia in February cut its policy rate by 25 basis points to 7.5 percent.

This caught markets by surprise as Indonesia’s macro-rebalancing process is not yet complete and foreign ownership of government bonds had risen from 31.8 percent in June 2013 to 40 percent in February 2014.

The current account deficit adjustment had been marginal, from a trough of 3.5 percent of gross domestic product in the third quarter (on a four-quarter trailing sum basis) to 3 percent in the fourth quarter of 2014, and policy makers still expect the 2015 current account deficit to come in at 3 to 3.1 percent.

Concerns about Indonesia’s monetary policy outlook appear threefold.

Namely, whether the rate cut was too early, if it represents a shift in Bank Indonesia’ focus from macro stability to growth, and if Indonesia would face a repeat of the concerns during the taper tantrums of 2013.

Although the February rate cut was unexpected in terms of timing, we do not think it reflects a shift in Bank Indonesia’s focus from macro stability.

Indeed, the central bank’s reaction function appears to have changed in recent years, with a decrease in the dovish growth slant and an increased focus on macro stability.

Meanwhile, a previously hard-line stance with regards to specific currency levels also appear to have softened.

In this context, we expect macro stability to continue to take precedence over growth for Bank Indonesia, particularly given the still-significant current account deficit and eventual prospects of a US Federal Reserve rate hike.

A focus on macro stability implies two things for monetary policy. First, real policy rates would need to remain above the neutral real policy rate range, of 1 to 1.5 percent indicated by Bank Indonesia, to steer the economy towards a sustainable equilibrium of manageable current account deficits and to attract liquidity.

Second, the differential between Indonesia’s real rates versus US real rates would need to be higher than the 1.2 to 1.8 percent of the past 10 years, when Indonesia was mostly running current account surpluses, as it is now running a current account deficit.

In this context, the extent of disinflation will determine how much Bank Indonesia can ease.

Headline inflation has decelerated from a peak of 8.4 percent year-on-year in December 2014 to 6.4 percent in March 2015, mainly from changes in food and transport segments.

We estimate the figure will normalize to 5.5 percent in the fourth quarter of 2015 and 5.0 percent in 2016.

If we are right, Bank Indonesia would have scope to ease rates by another 50 to 75 basis points without compromising on macro stability.

Based on our rate cut and inflation expectations, the real policy rate would stand at 1.75 to 2 percent in 2016, still above the neutral real policy rate range.

This would also leave the gap between Indonesia’s real rates and those in the US higher than the historical range because we still expect the real Federal Funds Target Rate to stay in negative territory in 2016 despite Federal Reserve rate hikes.

However, the Federal Reserve’s reaction function and market volatility around that will determine Bank Indonesia’s pace and timing of easing.

This is because Bank Indonesia was forward-looking with regard to inflation when it cut rates in February.

The more material disinflation will only occur towards the fourth quarter of 2015, so any aggressive rate cuts by Bank Indonesia before then would compress actual real policy rates.

On the other hand, any earlier-than-expected hike by the Federal Reserve would further reduce the real rate differential between Indonesia and the US, creating potential risks to macro stability and the currency.

So, with Bank Indonesia being averse to currency volatility, we think that it will likely ease only gradually to minimize the risks of a disorderly adjustment in the rupiah.

Risk factors that could affect Bank Indonesia’s policy easing trajectory include commodity price movements, risks to the inflation trajectory, and the timing and pace of Federal Reserve rate hikes.

Meanwhile, currency depreciation remains a necessary development for continued macro-rebalancing, along with tight real rates and structural reforms.

The strong currency trend before the global financial crisis had weakened the non-commodity current account balance in Indonesia and also affected the country’s share of global manufactured exports.

Deyi Tan is an executive director and Asean economist at Morgan Stanley

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