Nestor A Espenilla, Jr: Monetary policy and inflation dynamics
Speech by Mr Nestor A Espenilla, Jr, Governor of Bangko Sentral ng Pilipinas (BSP, the central
bank of the Philippines), at a luncheon meeting of the Rotary Club of Makati, Makati, 14 August
2018.
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Distinguished Rotarians, ladies and gentlemen, good afternoon. Thank you for inviting me to
share the Bangko Sentral's views on the recent developments in inflation. It is my pleasure to join
you today, my second time over a year.
My presentation will be in 3 parts. First, we examine trends in headline inflation with focus on key
drivers behind recent price movements. Next, I will present the BSP's outlook for 2018 and 2019
based on available data and as well as market expectations. Finally, I will discuss the BSP's
policy responses.
The year-to-date (January-July 2018) headline inflation averaged at 4.5 percent year-on-year,
which is above the government's announced target range of 2 - 4 percent for the year. The BSP
continues to see supply-side factors as the main drivers of overall inflation. These supply-side
factors relate to rising international oil prices, higher excise taxes, and weather-related supply
disruptions. These factors are generally considered to be outside the scope of monetary policy.
In this slide, we show the contribution of each CPI subcomponent to overall month-on-month
inflation. Headline inflation fell in month-on-month terms for July 2018. We also see the tapering
off of month-on-month changes of CPI items related to excise tax adjustment in the first five
months.
The month-on-month changes for electricity, tobacco and sweetened beverages are also slowly
tapering off as we pass 7 months of 2018. This supports our view that the impact of excise tax
adjustments are transitory.
Latest baseline forecasts have shifted higher over the policy horizon, suggesting that inflation will
remain elevated in 2018, with the peak occurring sometime in the third quarter, and will revert to
the inflation target of 2-4 percent in 2019.
We have dealt with similar inflation dynamics during supply shocks in the past. Notably in 2008,
international oil prices and food prices increased and inflation averaged 8.3 percent year-on-year
(based on 2006 CPI series) but subsequently dropped sharply to 4.2 percent in the following
year. This is depicted in the right-hand side chart, where actual inflation during this period
showed a hump-shaped path. This shape is similar to the forecasted path for the remaining
2018 to 2019, as shown in the fan chart.
In 2008, the BSP was aware that the initial rise in prices was primarily supply in origin and that
commodity shocks are transitory in nature. Therefore, following an approach consistent with the
widely accepted principle that supply-side developments are best addressed by non-monetary
measures, the BSP kept its policy rates steady. The BSP considered the rise in prices during the
first half of 2008 to be a supply shock episode and accommodated the first-round effects,
allowing them to "pass through" in the form of higher prices.
However, as supply shocks from rising food and energy prices continued over a longer period,
these contributed to second-round effects, affecting the wage and price-setting behavior of
businesses and households by the end of the second quarter. A rise in inflation expectations was
also evident from surveys and financial market data, while the BSP's forecasts showed the risk
of inflation exceeding targets for 2008 and 2009. The BSP responded to these second-round
effects with decisive action and strong anti-inflation pronouncements. It raised key policy rates by
a total of 100 basis points from June to August 2008 while strengthening its anti-inflation
commentary.
Moving back to our current inflation outlook, based on our latest assessment, upside risks
continue to dominate, as the sustained increase in core inflation suggests broadening price
pressures amid resilient aggregate demand conditions.
The following are the key upside risks to the baseline inflation path:
(1) additional wage adjustments;
(2) pending petitions for adjustments in transport fares and electricity rates;
(3) faster-than-expected monetary policy normalization in advanced economies; and
(4) the proposed increase in the NFA's buying price of rice from farmers.
Slower global economic growth due to protectionist policies in advanced economies and
geopolitical tensions along with potential price adjustments from the proposed reform in the rice
industry involving the replacement of quantitative restrictions with tariffs and the deregulation of
rice imports are seen as the main downside risks to inflation.
Meanwhile, the BSP keeps a close eye on developments in the foreign exchange market and
note their potential impact on inflation in the coming months.
Surveys of private sector forecasts as of July show elevated inflation expectations for 2018 but
within target inflation projection for 2019. Private sector expectations range from 4.2 - 4.5
percent (based on BSP and AP Consensus) in 2018 and 3.6 - 3.9 percent in 2019.
The increase in inflation expectation of private sector economists is attributed to higher
projections to volatile global oil prices, a weaker peso, and the transitory effects of recent tax
measures on the prices of domestic goods and services.
As an inflation-targeting central bank, our decisions on the monetary policy stance are
datadependent and guided by our inflation forecasts over a given policy horizon. As a matter of
discipline, we refrain from reacting to short-term market fluctuations or commentaries but
instead focus on obtaining comprehensive information and making reasonable assumptions
about the future.
In responding to the recent uptrend in inflation, the BSP follows the standard approach among
central banks in responding to supply-side factors. In a supply shock episode, central banks
would typically not react, as these historically tend to be transitory or short-lived in nature, but
remain vigilant and undertake action against incipient signs of second-round effects.
This was the case early this year when economic data indicate the country's inflation
environment was driven by supply-side factors and our forecast continued to show inflation
upticks as transitory and moderating within the target in 2019. Thus, adjustment in policy rate
was not yet warranted.
Nevertheless, recognizing increasing volatilities in world oil prices and interest rates, the BSP
adjusted monetary conditions by adjusting auction volumes and allowing the term deposit facility
(TDF) rates to rise, creating an effective tightening in the market. This allowed the BSP a channel
to provide guidance to short-term market interest rates which have firmly anchored to the BSP's
interest rate corridor.
Starting in Q2 2018, the Monetary Board (MB) noted that latest baseline forecasts have shifted
higher over the policy horizon. Upside risks also continue to dominate the inflation outlook.
Meanwhile, inflation expectations remain elevated. Therefore, in response to dynamic economic
and market conditions, the BSP raised the policy interest rate by 25 basis points each on 10 May
2018 and 20 June 2018 and by 50 basis points on 10 August 2018.
In the latest policy meeting, the MB noted increased risk of inflation exceeding the target in 2019.
Thus, a stronger monetary action is necessary to rein in inflation expectations and prevent
sustained supply-side pressures from driving further second-round effects, even as we expect
average inflation to ease to within the inflation target of 2-4 percent in 2019.
Overall, the three rate hikes are meant to signal the BSP's strong commitment to ensuring
macroeconomic stability and will help reduce further risks to inflation, including those emanating
from ongoing normalization of monetary policy in advanced economies and its impact on the
foreign exchange market, and bring inflation toward a target-consistent path over the medium
term.
Favorable conditions arising from sustained domestic growth suggest that the economy can
accommodate monetary policy tightening. It should be noted that the Philippine domestic
economy has experienced sustained expansion for the past 78 quarters (or a period of more
than 19 years).
In 2017, the domestic economy posted an annual growth rate of 6.7 percent. This growth has
been increasingly broad-based, thereby providing more opportunities across all segments of
society.
In the first half of 2018, output grew by 6.3 percent year-on-year on higher government spending
as well as capital formation, supported by resilient domestic demand.
In the meantime, the overall external position of the domestic economy remains resilient,
supported by sustained foreign direct investments, overseas Filipino (OF) remittances, and
business process outsourcing (BPO) receipts. These provide additional buffers to the domestic
economy.
Our external debt metrics have also improved as external debt to GDP ratio continues to decline.
Gross international reserves of US$76.9 billion as of July 2018 remain more than adequate,
covering 7.4 months of imports of goods and payments of services and income.
Meanwhile, on the current account, two factors are motivating the modest shortfall. One is the
surging growth of the Philippine economy which requires higher imports of capital goods like
machineries and equipment and the other is the continued softness of the global economy
particularly in 2015-2016.
The current account shortfall indicates that the economy is, on a net basis, importing what is
required to continue its expansion. Our imports are mostly comprised of capital goods, raw
materials, and intermediate products which together account for more than 80 percent of total
imports.
The peso also continues to be flexible and has maintained its external price competitiveness
against baskets of currencies of all trading partners and trading partners in advanced and
developing economies.
The BSP likewise strongly supports the carefully coordinated efforts of the National Government
(NG) to further temper the potential adverse impact of inflation on households via the full
implementation of various safety-net programs (e.g., targeted cash transfers, Pantawid Pasada
program, etc.)
All of this is by the way of saying that when it comes to responding to inflation, monetary policy is
not the only game in town; non-monetary intervention can go a long way towards addressing
inflation pressures especially in the face of strong supply shocks.
Ladies and gentlemen, our recent policy actions demonstrate our strong resolve to ensure
inflation returns to target by 2019. We have likewise demonstrated that with the development of
auction-based instruments complementing our policy rate, the BSP has expanded its option for
maintaining firm monetary control.
We continue to pursue refinements in our monetary operations. This includes shifting reliance
on reserve requirements to more market-based instruments. To date, we have reduced reserve
requirement ratio (RRR) by 200 bps, an operational adjustment to promote market development.
I reiterate that the RRR cuts are not intended to be expansionary. Data suggest we were able to
neutralize the immediate liquidity impact through open market and FX operations. Following the
cuts, the level of domestic liquidity actually grew at a slower rate. M3 expanded by 11.7 percent
year-on-year (y-o-y) in June 2018, slower than the 14.3-percent growth rate in the previous
month.
We are ready to continue reducing the RRR next year as inflation returns to target based on our
latest forecast. Ultimately, the goal is to reach single-digit RRR at the end of my term. This can
be pursued without compromising effective monetary control.The Philippine economy remains
resilient supported by its strong fundamentals. Prospects for the domestic economy continue to
remain favorable as domestic growth fundamentals are expected to remain intact. Private
demand is expected to remain firm, aided mainly by sustained remittance inflows and a
manageable inflation environment.
At the same time, macroeconomic stability will be supported by strong policy response in terms
of fiscal policy (i.e., tax reforms), monetary policy, and flexible exchange rate policy. The policy
agenda of the government to strengthen both hard and soft infrastructures supported by the
increase in revenue from tax reforms is expected to further increase the country's potential
output.
Equally important are the strong buffers in place which continue to support the positive outlook on
the macroeconomy. Sufficient capitalization of the Philippine banking system along with a
comfortable level of gross international reserves provides buffers to mitigate shocks.
In closing, let me emphasize that while the recent inflation outturns are underpinned by factors
outside the scope of monetary policy such as higher global oil prices, weather-related supply
disruptions, and increased excise tax, the BSP stands firm in its intent to take immediate and
appropriate measures to ensure that the monetary policy stance continues to support the BSP's
price stability objective.
Thank you for your attention!