Philip and the Phillips curve

Published July 7, 2022, 12:05 AM

by Diwa C. Guinigundo


Diwa C. Guinigundo

Two days ago, the Philippine Statistics Authority announced that inflation further escalated to 6.1 percent for June 2022. This was the fourth consecutive month of inflationary trend after peaking last year at 4.4 percent in August 2022. There is nothing new in the story except that such a trend begs for a more aggressive monetary policy. And the BSP, hopefully next month, will not disappoint.

Ever the pragmatic economist that he is, BSP Governor Philip Medalla was recently quoted by Bloomberg saying: “If we see that the exchange rate is overshooting too much, and that selling foreign exchange (FX) will not make the problem go away, we would clearly consider may be increasing policy rates by more than our planned 25 basis points.”

That was really a good policy statement coming from the BSP head.

For there is no other option but to be more decisive. Yesterday, he was quoted to have already admitted that “this year, sad to say, the average inflation will, in all likelihood, breach the national government’s target of 2-4 percent by quite a bit.”

His reference to a possible overshooting of the exchange rate should disprove the perception that he and the BSP appear indifferent to the dynamics of the exchange rate. People love to quote that rhetorical question Philip spewed out at about the time he was designated as BSP governor: “W ho cares about the exchange rate?” Philip could be flippant, but certainly, he knows fully well that inflation is also driven by the peso’s exchange value.

We import fuel, food, and raw materials so that every time the peso weakens against the US dollar, they become more costly in peso. Over time, we see commodity prices going up as reflected by the inflation rate. But we hear consumers’ complaint about the rising cost of living, the demand for higher wages getting more deafening. What started as cost-push is now getting to be more pervasive, pushing up demand pressure and motivating higher inflation expectations.

At the same time, he must have recalled previous staff presentations before the Monetary Board that the so-called exchange rate pass-through has declined over the years after the BSP transitioned from monetary aggregate targeting to flexible inflation targeting in 2002. That means the exchange rate could depreciate as much as the market would allow, but the impact on inflation will be far from one-to-one. Part of the reason is the discipline and transparency of monetary policy that translates into greater predictability. The BSP has become credible in delivering price stability.

Policy-wise, therefore, it makes sense not to rely so much on working on the exchange rate to promote price stability. After all, the flexibility of the exchange rate allows it to help stabilize the macroeconomy and afford some independence to monetary policy.

Of course, when the peso depreciation becomes excessive, there is always a scope for the monetary authorities to do some preemptive measure lest the huge adjustments in the peso-dollar rates translate to imported inflation and dis-anchor inflation expectations.

My good friend former Finance Undersecretary Romy Bernardo will be the first one to argue that because domestic inflation also climbs with the peso depreciation and the BSP has reasonable amount of FX reserves, the BSP can exercise the flexibility to minimize the sharp volatilities in the exchange rate.
This is where the BSP governor must be coming from when he announced that if selling FX does not work to prop up the peso, he would consider tightening monetary policy beyond the normal size of policy rate adjustment.

Obviously, Philip realizes that there might be limited success in the initial reduction in the balance sheet of the BSP. The huge monetary expansion during the pandemic armed the banks and the general public with sufficient peso liquidity to buy FX and in the process weaken the peso. If market rates continue to mimic the BSP’s low policy rate, mopping up operations through the use of BSP’s own securities and deposit facilities will have very limited bite.

With inflation raging, the only way to mop up the enormous domestic liquidity is by jacking up interest rate. This should be an effective counterweight to what many market players are doing. They have been increasing their exposure to FX assets, while foreign investors are leaving for other markets. Give the market reason to hold on to their peso assets.

More important, doing more than the usual 25 basis points will send a strong signal to the market that the BSP is serious in taming inflation and in the process temper inflation expectations. Inflation expectations after the BSP switched to flexible inflation targeting has been more forward, rather than backward, looking. Forecasts breaching the official target tend to push them up.

Finally, who has not heard about the observed flattening of the Phillips curve, that which relates unemployment (output) and inflation, in the Philippines?

While more decisive monetary action, even as it shocks output as feared by many, will not necessarily translate into large reduction in inflation, not doing it is more costly. On the downside, if inflation is above target, as we are having now, bringing inflation down to the target level of 2-4 percent in the next two years or so would entail a greater sacrifice of output.

Philip is undeniably aware that a flattening Phillips curve demands a strong commitment to price stability and to ensuring that inflation remains within target. The stakes are high, both in terms of rising inflation and a bigger sacrifice of output. Yes, he may be flippant, but Philip knows his monetary economics really well.