ON Thursday, as is their wont, the Bangko Sentral ng Pilipinas (BSP) announced its inflation estimate for October, seeing prices up by between 0.1 and 0.9 percent. The BSP usually gives a prediction about a week before the official consumer price index figures are released; October’s data is due out on November 5.
October’s inflation rate will be below 1 percent for the fourth straight month, and while the costs associated with the onslaught of Typhoon Lando earlier this month will have kept prices from falling into deflationary territory, they are coming perilously close to crossing the zero percent threshold.
In our meeting with BSP governor Amando Tetangco Jr. last week, he seemed thoroughly unperturbed by the likelihood of a virtually flat inflation rate, and suggested that any action the BSP deems necessary to arrest the slide would be mild at best.
Of course, as a central banker, Tetangco is naturally unflappable, but his perspective does make a valid point; the tools the central bank uses to manipulate the consumer price index—adjustment of its key interest rates, banks’ required reserves, and the money supply through currency market intervention—work on a very fine scale, where a small change of even a fraction of a percent moves billions of pesos.
That leaves the BSP with a very narrow margin for error, and as a consequence, decisions on monetary policy adjustments are approached in an extremely conservative way. This is true anywhere; the US Federal Reserve, for example, has waffled for months about raising its interest rates, not wishing to upset what it perceives so far as being a generally good trajectory for the US economy.
Even so, one has to wonder if the BSP may have waited too long to act. With the economy in fairly good shape but under pressure from the slowdown in China, among other things, superlow inflation—or worse, deflation—is particularly unhelpful. To explain why that is so, allow me to update an earlier (June 9) discussion of the relevance of inflation to the economy:
Superlow inflation is generally bad for the economy as a whole, and despite its immediate effect on price, ultimately bad for consumers as well. Indeed, it keeps prices from increasing at an uncomfortable rate, but such benefits lose value over time because superlow inflation retards wage growth.
Prices affect business revenues more quickly than changes in volume; in most cases—gas prices are a good example—the increase in volume does not compensate for the price drop.
Thus, if prices are not increasing, neither will there be a need to raise wages, and of course if wages do not increase, consumer spending is unlikely to grow either. Consumption growth will, given enough time under these conditions, slow or perhaps, even reverse into a decline, which aggravates the problem by driving prices even lower as producers try to attract waning demand.
Another factor that drives demand lower is that when prices decrease over a period of time, consumers tend to hold back on purchases—particularly larger purchases like homes or cars—in the expectation of even lower prices in the near future.
Second, wage costs are subject to something called the ‘money illusion.’ When demand declines—which is what is happening in the Philippines now, as indicated by not only the low inflation rate, but also by lower GDP growth over the first half of the year—employers seek to cut costs by cutting payroll costs. The ‘illusion’ is that those costs are inversely proportional to demand, i.e., rise as demand falls, which is usually not the case, but for companies that have to take relatively quick action to keep their finances in order, trying to convince them to be patient is difficult. When inflation is higher, the solution is relatively painless; wage increases are simply kept smaller than the inflation rate.
But if inflation is too low, the only option for the employer is to directly cut wage costs, which usually means cutting jobs, or delaying hiring, because cutting wages is generally frowned upon. The effect of all that is to further reduce consumer demand; fewer people working means fewer people able to spend.
Since this is all very elementary to central bankers, their monetary policy is designed to strike a balance between letting prices rise at a useful rate—enough to maintain wage growth—without letting them become so high that they significantly drive up the cost of basic necessities; this formula allows consumers some measure of disposable income, which is the main driver of the consumption component of the economy.
The rule of thumb is that an inflation rate of about 2 percent is healthy for an economy, but that benchmark is somewhat arbitrary, so second-guessing the BSP’s perspective on how low inflation should be allowed to go is something that should be done with a great deal of caution.
Nevertheless, one has to assume that the lower limit is very near; the BSP has progressively lowered its inflation targets throughout the year, and there simply isn’t much room left until the CPI slips into unequivocally harmful negative territory.