A misplaced sense of urgency on inflation

Ben D. Kritz

Ben D. Kritz

When the Monetary Board next meets on June 19, most analysts expect that it will raise its benchmark overnight borrowing and lending rates, which stand at 3.5 percent and 5.5 percent respectively, in response to the latest inflation figures which showed a 4.5-percent increase in May.

The Bangko Sentral ng Pilipinas (BSP) has not, of course, come right out and said it will raise its rates, but following increases in banks’ reserve requirement ratios at the last two Monetary Board meetings with statements like “the room to keep rates steady has narrowed,” and that the BSP “will not hesitate to adjust policy settings,” if it senses inflation targets are at risk are fairly clear signals of its intentions.

So far, only one major analyst, Singapore-based DBS, has forecast that the BSP will keep rates steady this time; the consensus among everyone else is that, at a minimum, the rates will go up by 25 basis points, with some bookmakers suggesting the reserve ratio could very well be raised again as well.

While the BSP has not generally adhered to the same low, short-term standards that characterize the rest of the Aquino Administration’s approach to handling money, the sense of urgency caused by the most recent inflation report might be misplaced, and the BSP should strongly consider the advice of noted University of the Philippines economist Ben Diokno to leave well enough alone (see “Anti-inflation measures could be harmful to economy—economist,” in the June 6 edition of the Times).

Diokno’s argument is that raising interest rates to curb inflation will also curb lending and investment, which is the wrong way to handle the Philippines’ much bigger problem of unemployment. What he is describing is actually a well known principle in economics: higher inflation, at least to a certain point, corresponds to higher demand for labor at the trade-off of lower real wages (the model that explains this is called the Phillips Curve, for those who’d like to brush up on their basic economics), and it happens partly because the real interest is lower than anticipated when inflation is higher than expected; in short, borrowers gain at the expense of lenders.

The one glaring problem with Diokno’s thesis is that while it is supported theoretically, it hasn’t been reflected in the Philippine reality. Inflation has increased by a rough average of 0.16 percent per month over the last year, yet every indication is that unemployment has increased at the same time, bucking the model. During that time, the BSP has kept its benchmark interest rates stable; the suggestion is, then, that acting to curb inflation by raising rates most likely will not have as much of an impact on employment as Diokno fears, and may very well have no impact at all.

Apart from that, though, Diokno’s suggestion is worth following for two reasons. First, the inflation rate over the past couple of years, even now when it is almost two percentage points higher than it was at this time last year, has been comfortably low, and has not fallen outside its target range to any significant degree for any significant length of time.

Yes, there are critics (present company included) who make the case that the price basket weights probably need to be updated and that the real inflation rate might be considerably higher than what it is believed to be, but that is another issue; according to the current benchmarks, Philippine inflation is not—or at least not yet—a serious problem.

The second reason came out of Europe last week, when the European Central Bank (ECB) announced a couple of moves aimed at heading off deflation in the Eurozone; cutting its overnight deposit rate to -0.10 percent, and trimming both its refinancing and marginal lending rates as well. It will take some time for the impact of the ECB’s move to be felt here in Asia and the effects are forecast to be moderate, but generally favorable nonetheless; regional bond markets should benefit as an increased money supply in Europe drives bond yields there lower, and regional currencies will appreciate with respect to the euro, which is a benefit to import-dependent countries like the Philippines. A stronger peso will help to reduce inflation with no help from the BSP, but there is a downside: the prospect of greater liquidity in the Eurozone means that regional economies could see their foreign reserves increasing; while that is good news for countries that need to build up their reserves, that could be problematic for the Philippines, whose gross international reserves are already at or slightly over what is probably a reasonable limit.

The upshot of all this is that there is a real possibility that a move now by the BSP to curb inflation might not have any effect at all; inflation may be reduced by a small amount, and then promptly gain again through an influx of fresh hot money, in which case all the BSP will have accomplished is to dampen lending with higher interest rates—in other words, a net negative as far as the wider economy is concerned. Whether or not that has any impact on jobs, the implication is that Dr. Diokno is still right: adjusting interest rates with an eye toward controlling inflation is not a good idea right now. The next policy meeting after June 19 is on July 31; waiting that long to see what effect economic decisions elsewhere actually have, instead of just guessing at them, is probably a prudent move.



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