Conflicting signals?


With lower inflation forecasts for 2023 through 2025, the Bangko Sentral ng Pilipinas (BSP) Monetary Board decided to take a pause in its series of monetary tightening that started last year. This means its policy rate, based on the overnight reverse repurchase facility (RRP), was kept at 6.25 percent as well as the overnight deposit and lending facilities maintained at 5.75 percent and 6.75 percent, respectively.

There is no dispute that the BSP has very good reason for its decision. The outlook for 2024 and 2025 inflation appears benign even as the year-to-date average this year at 5.5 percent continues to breach the 2-4 percent inflation target. This forecast plus an inflation path that promises to achieve within-target rates later this year notwithstanding what it observes as persistent price pressures and predominance of upside risks justify “a pause in the monetary tightening cycle.”

What is more reassuring is to read in the BSP’s Monetary Policy Report for May 2023 that it is prepared “to resume interest rate action as necessitated by the potential upside risks in the near term, in keeping with the BSP’s primary mandate to ensure price stability.”

By underscoring its readiness to resume its cautious policy, a pause could simply indicate the monetary authorities’ decision to be patient with the inflation data to establish a more definitive downtrend. Price pressures remain while upside risks are more preponderant.

Thus, we find it difficult to reconcile current market talks about a possible reduction in the required reserve ratio (RRR) from the current level of 12 percent with a policy pause. A pause is a cautious stance, reducing the required reserve ratio is expansionary monetary policy. Therefore, sending conflicting signals when RRR is reduced at this time of calibrated cautiousness is unavoidable.

Monetary conditions have changed since 2018 especially at the height of the pandemic in 2020. There was no complicating inflationary spiral in 2019 and 2020 when RRR was slashed by as much as 200 basis points to mitigate the economic lockdown. But since then, both headline and core inflation rates have climbed to dizzying levels, prompting the BSP to jack up interest rates to their all-time highs and reverse its expansionary open market operations. The national government itself paid back its emergency advances.

What does one expect from a reduction in RRR?

RRR is primarily a prudential measure against the possibility of the banks running short of liquidity when there is market distress. Lower RRR means the BSP requires a smaller percentage of the banks’ deposits and deposit substitutes that should be kept with the BSP. The banks would therefore command bigger loanable funds but less reserves in case of bank distress.

RRR, by its effect on both the supply of money and market interest rates, is also a monetary policy tool. In the recent past, a change in the RRR was described as an operational adjustment to facilitate the BSP shift to market-based instruments for managing domestic liquidity such as the term deposit facility and the BSP securities. But with lower RRR, no matter how it is called, banks would have more money at their disposal for lending, or for taking a position in the foreign exchange market. These possible outcomes are bound to ultimately bring down market interest rates and a weaker peso.

On hindsight, the BSP lowered the RRR during the pandemic because the policy rate had reached a historic low of two percent. With the prospect of a deep recession, the only option available to the monetary authorities to further help business with more and cheaper credit was to bring down the RRR. This infused the system with additional liquidity without directly easing interest rates.

One unwanted consequence was that real policy rate ended up negative. If sustained over a prolonged period, risks might be mispriced and financial stability issues could emerge. In addition, conditions for complying with the RRR were relaxed during the pandemic by qualifying even banks’ lending to small and medium enterprises (SMEs). With such relief measure expiring in the middle of the year, the BSP believes this could amount to rate tightening.

But sustained cautiousness is precisely what a pause should signal to the market. Keeping interest rate steady after raising it up by 425 basis points remains restrictive in the face of easing inflation, so restoring the usual condition for RRR compliance only secures the inflationary downtrend because price pressures and upside risks continue to be real.
Timing of any RRR adjustment is therefore crucial lest conflicting signals are triggered.

Finally, the BSP has been quoted in the past as hoping that the RRR adjustment would encourage “the banks (to) waive all fees on small transactions when people make bank-to-bank payments. We’re literally bribing the banks to subsidize the small transactions.” This is quite unexpected. With all these digitalization initiatives, we thought over time digitalization would have brought down the banks’ cost of doing business and therefore, the financial benefits could have started cascading to their individual and corporate clients.

But based on the banks’ actual disclosure, their transfer fees through digital channels to the BSP as of end-April 2023 remained nearly unchanged. We observe that more medium-sized but digitally equipped banks charge less than their bigger counterparts.

To settle all these market talks about RRR, we should be assured by what BSP Governor Philip Medalla declared last March 2023 that “any adjustment in banks’ RRR will be done once domestic inflation rate is on sustainable downward path.”

Or we can just mimic Odysseus who asked his men to stuff their ears with beeswax, and bind him in the mast of their ship. This worked and the sirens’ song failed to bewitch them.