Mizuho daily – Adaptive, not rational and Bank Indonesia’s constrained status quo

By Vishnu Varathan, Head, Economics & Strategy, Asia & Oceania Treasury Department, Mizuho Bank, Ltd.,

Adaptive, Not Rational

It is not entirely clear whether markets reacting to additional Pfizer doses for Europe to push the EUR up above 1.20, while USD generally loses ground on vaccine catch-up trades elsewhere, is a reflection of adaptive or rational expectations.

The key difference between adaptive and rational expectations, as defined by economics, is  adaptive expectations is self-reinforcing, being based on updated, but historical information.

Whereas rational expectation couple human rationality with updated information; therefore allowing for “Bayesian updating” that reiterates conditional probabilities as necessary.

The trouble is that unpacking this is fraught with definition ambiguity. One may argue that adaptive expectations must bet on ever-rising cases in to a subsequent wave; but this is patently false as we are programmed (even without “Bayesian updating”) to expect a peak of the cycle.

So, a case can be made that correlating  increased more vaccine availability with getting Covid under control is but a version of adaptive expectations.

In contrast, not factoring  in human complacency and virus mutation is a lapse of rational expectations.

India’s experience with its deadly “second wave” is a cautionary tale in this regard. Therefore, by extension, a straight-line selling of USD on vaccine positives outside of US also smells more like an adaptive reflex than a rational, considered position.

To be honest, your scribe doesn’t know better. But aggressively pursuing USD weakness (sub-108 USD/JPY, AUD toward/past 0.748 and USD/SGD below 1.33) probably cannot be declared the epitome of rationality; and at the very least must concede lapses into adaptive reflex.

Bank Indonesia: Constrained Status Quo

Bank Indonesia is set to keep policy on hold. To be sure, this is not a comfortable extension of policy pause to assess the recovery, and as a lead up to timing normalization further out.

Instead, this is a an uncomfortable compromise at the current constrained status quo; albeit with a distinct dovish bias that underscores desire for more policy support in favour of boosting economic recovery and jobs as adverse impact from Covid lingers.

But risks to rupiah stability necessitate an inconvenient restraint.  Especially as signs of stress on IDR in recent weeks raise the stakes of putting through more easing at this juncture. In particular, President Jokowi’s backing of the Bank Indonesia Bill, which is deemed to dilute the central bank’s independence in favour of leaning into the MoF’s fiscal stimulus efforts despite the stretched fiscal position, compromises BI’s rupiah stability mandate. And not merely because the BI Bill requires adding an employment and growth mandate to BI’s policy objectives.

Critically, it fails to consider the negative perceptions on central bank independence and the tension, if not outright clash, between the various policy objective.

Mainly because;

1) there is no clear-cut Taylor rule equivalent that Bank  Indonesia has a precedent of being able to adhere to, which is imperative to establish policy credibility, and;

2) pre-existing debt monetization risks being compounded by growing dangers of the BI bill being seen as a subordination of BI to the MoF.

And Bank Indonesia cannot afford another leg of wobbles in the IDR as rupiah stability policy objectives cannot be perceived to abandoned; even if the government’s growth and pro jobs targets are co-opted by the central bank.

After all, it is one thing to supplement policy targets (although this will require adequate policy framework strengthening), but quite another to supplant existing (rupiah) objective.

With rupiah remaining vulnerable, despite a weaker USD trend last week, Bank Indonesia cannot bank on pulling off RBI-type QE; not for now.

A far more constrained status quo will have to be accepted as the trade-off for wider policy (and rupiah) stability.

Source: Mizuho Bank Ltd