OF SUBSTANCE AND SPIRIT
Diwa C. Guinigundo
We thought after the BSP delivered a decisive monetary action last Thursday, many market uncertainties would have died down.
On the lighter side, as one broadsheet described the move as “surprised,”the BSP appeared to have done a patellar reflex, or an involuntary response. It was more deliberate, that BSP’s decision to tighten monetary policy by 75 basis points in an off-cycle meeting after two baby steps of 25 basis points each in May and June. It was the correct move.
Monetary tightening was not an interest rate response to cost-push inflation. At the beginning, it was definitely driven by supply factors including high petroleum prices, the disruption of the global value chain and imported inflation on account of unorthodox ultra-easy monetary policy in the US and Europe. With policy reversals across the advanced economies, most local currencies are now crashing in the emerging foreign exchange markets.
But these initial cost-push factors have already triggered second round effects on which the BSP trained its gun. Due to persistently high inflation, both consumption and investment demand could become shaky. Higher wages are now in place in nearly all regions starting June. Transport fares have also been granted provisional increases. Expecting even higher inflation down the road, the BSP was therefore correct in pursuing a tightening mode.
Such a response was data-driven. As early as May, BSP had already estimated that inflation for 2022 would exceed four percent with a big probability of 6.5 percent. The monthly year-on-year inflation has been constantly rising since March 2022. What was actually surprising to us was not the monetary tightening, but the two baby steps instead that the BSP decided to take.
Of course, the BSP fortified those baby steps by a more hawkish forward guidance. It was the market that did not expect to see such an enormous third move. The market should have correctly read that if the public’s inflation expectations were altered, inflation could further blow up.
It was the BSP itself that disclosed during last Thursday’s press conference that their partial survey of private sector economists showed that the mean forecast for 2022 has risen to 5.4 percent from 4.9 percent and to 4.4 percent from 3.9 percent next year during the June survey. The BSP admitted that inflation expectations have been affected.
Only an aggressive tightening could reverse the trend. The market should realize that a restrictive monetary policy was not so much intended to arrest the sharp peso down slide per se as to disabuse market perception that the BSP is not focused on its mandate of price stability. Aggressive tightening should help assure the market that it remains attentive to peso depreciation’s impact on inflation.
Yes, the exchange rate pass through to inflation has dropped over the years since the BSP switched to flexible inflation targeting in 2002. A one-peso depreciation causes 0.042 percentage point of additional inflation in the short run and 0.419 percentage point of additional inflation in the long run. However, if we have a big ₱5 depreciation, for instance, we could still suffer from 0.21 percentage point and 2.1 percentage points in additional inflation over the same periods. These are not trivial amounts.
Some quarters are also afraid that an aggressive monetary action might compromise economic recovery. The broadsheets attributed this to Fitch Solutions’ warning that “too much policy tightening might lead to… hard landing.” Moody’s Analytics echoed Fitch by asserting that “higher rates risk a hard landing if policymakers overcompensate…”
But neither of them suggested a possible path for future adjustments. When is monetary tightening excessive? Yet more tightening appears needed before the real policy rate breaks out of the negative territory. Nominal rate stands at 3.25 percent compared to inflation forecasts of 5.0 percent in 2022 and 4.2 percent for 2023. A prolonged negative real policy rate also poses risks to financial stability.
Our economy is robust enough to accommodate the necessary monetary tightening. Despite all the economic scarring in the last two years, we have the resiliency from policy and structural reforms of the last three decades. We recovered fast in 2021 and the first quarter growth of 8.3 percent was strong.
As proof, the ASEAN + 3 Macroeconomic and Research Office this month raised its growth forecast for the Philippines from 6.5 percent to 6.9 percent this year, the only ASEAN economy to have been upgraded.
Economic commentators should also know that the country’s Phillips curve showing the trade-off between output and inflation has started flattening in 2011 after the Global Financial Crisis. A flatter Phillips curve indicates that economic activity has a smaller effect on inflation. In terms of monetary policy, a central bank maximizes welfare if it responds less to the need to stimulate economic activity and more to inflationary challenge.
Actual experience in 2018 shows that the BSP also turned hawkish starting February 2018 by increasing its policy rate by a total of 175 basis points during the year. With non-monetary support, the BSP managed to pare inflation from 5.2 percent in 2018 to 2.4 percent for both 2019 and 2020. There was little impact on output as real GDP was kept at 6.3 percent in 2018 from 6.9 percent a year earlier, and 6.1 percent in 2019. While the pandemic disrupted the growth momentum at minus 9.5 percent, the recovery was quite strong at 5.7 percent in 2021.
As the Bank for International Settlements (2022) found, the long-term cost of allowing inflation to become entrenched far outweighs the short-term cost of bringing it under control. Consumer welfare directly benefits from a more aggressive monetary policy that aims at inflation control and less aggressive response to output problems.
After all, the primary mandate of central banks particularly the BSP is price stability.