Posted on Tuesday, October 7, 2003

Can inflation be managed properly?

By Lawrence Chin, Researcher
 
(Conclusion)
 
Deflation or disinflation?

IT is important for the Bangko Sentral ng Pilipinas (BSP) to explain its plan of action to reduce inflationary pressures (when actual inflation exceeds the target) and deflationary pressures pressures (when actual inflation is below the target), said Dr. Pon­ciano S. Intal Jr., an economics professor at the De La Salle University.

In the case of the Philippines, the inflation target set for 2002 and 2003 is in the range of 4.5 to 5.5 percent. However, the actual inflation rate of the country has been around 3 percent in the past 21 months. 

In response, BSP Deputy Governor Amado M. Tetangco Jr. cautioned against the use of the word “deflation.” He explained that deflation could only exist when the prices of goods fall along with industry output leading to an economic recession. With this definition, the country has never experienced deflation as industrial production grew with the gross domestic product (GDP) posting a 4.6-percent increase last year.

Instead, the country experienced “disinflation” or the reduction of prices coupled with a growth in industrial output, he averred. 

Although the annual inflation for last year was at 3.1 percent the BSP has decided to maintain its original inflation target for 2003. Both Tetangco and National Economic and Development Authority (NEDA) Secretary Romulo L. Neri have expressed confidence in BSP Governor Rafael B. Buenaventura’s decision to maintain the 4.5 to 5.5-percent target this year as a conservative measure considering the severe acute respiratory syndrome outbreak, the Gulf War, and other political noise during the start of 2003.

According to Neri, it is important to have a leeway for inflation so that the government can stimulate the economy a bit. Also, in case of supply shocks (like for foreign crude oil) the government need not tighten the money supply to keep inflation at 3 percent since the target is 4.5 to 5.5 percent. 

Setting the target

Considering Buenaventura’s decision, one wonders if the target is determined arbitrarily. The truth is, the inflation target is mathematically derived using macro-economic data including inflation figures. Central banks using inflation targeting have a choice between “headline inflation” or “core inflation.”

Currently, the BSP uses headline inflation or the inflation you read from newspapers. Core inflation, meanwhile, is headline inflation less energy and food – the volatile items of the consumer price index (CPI), the basis for computing inflation.

Inflation is influenced by internal and external factors. Internal factors are those that can be managed by monetary policy. While external factors include events that monetary policy could neither anticipate nor address like the effects of an international oil price hike or a devastating typhoon.

In managing inflation, however, the government can approach the problem through monetary policies (demand-side), or by addressing the supply situation of goods (supply-side) like in cases where there is a supply-shock caused by calamities leading to higher prices.

With core inflation, policy makers could focus on the demand-side inflation and respond accordingly with the appropriate monetary policy using tools such as rate adjustments for bank reserve requirements and re-discount rates along with government securities.

Neri and Tetangco believe that core inflation is the ideal basis for an inflation targeting policy because it removes distractions that the BSP cannot address anyway. Next year, the BSP will shift to core inflation in setting its inflation targets after refinements have been introduced to its mathematical models, said Tetangco. 

However, Intal believes otherwise and claims that headline inflation is more appropriate and acceptable to the country.

“People won’t understand why you are excluding food and energy in your inflation target because those are the most important to their welfare. For an American, those are just 10 percent of his budget. But for a Filipino those represent 60 percent of his budget.”

He explained further that since food is removed from the equation in core inflation, wage increase becomes the major source of pressure. In the Philippine context food accounts for 50 percent of the budget so a price hike will trigger labor groups to ask for a wage increase. Hence, headline inflation is more appropriate in the country than core inflation, said Intal.

Considering the possibility of managing inflation from the supply-side, the BSP needs to coordinate closely with other members of the Philippine government’s macro-economic team like the Department of Finance, Bureau of Internal Revenue, Bureau of Customs, the Department of Agriculture, etc., in order to reduce inflation by addressing supply shortfalls.

In fact, the low inflation experienced by the Philippines was partly due to the improved performance of the agriculture sector, according to Intal. He attributes the robust agricultural performance this year to good weather and the success of the Agriculture and Fisheries Modernization Act (AFMA). 

The government’s investments in agriculture have paid off, paving the way for a bumper rice, corn, and sugar harvest with the propagation of high yielding crop varieties, he explained.

AFMA has made it possible for local farmers to produce corn cheaper than imported stock. Moreover, the country could export sugar next year, he said.

Experts agree that the best way to address supply-shock inflation like oil price hikes is to refrain from using monetary policy. “It is better to just let a supply-shock ride by than to use monetary tools to control inflation that may lead to a recession.” attested Neri.