OFFICIALS of the National Economic and Development Authority (NEDA) and the Bangko Sentral ng Pilipinas (BSP) were all smiles last week when it was announced that the Philippines’ headline inflation rate in May dropped to the lowest it has been since 1995.
Dragged by declines in housing, utilities, fuels and communications costs, May’s inflation rate was just 1.6 percent, at the very bottom of the BSP’s target range, and 0.6 percent lower than the 2.2 percent inflation rate recorded in April. Year-on-year, inflation was almost 65 percent lower than the 4.5 percent rate measured in May 2014.
That’s good news, right? Well, maybe not.
To be sure, an inflation rate of 1.6 percent is not necessarily bad on its own, but as part of a trend should be considered a warning sign. Since a high point of 4.9 percent in August of last year, with the exception of a tiny 0.1 percent bump in February, inflation has declined month after month. That suggests that the BSP’s efforts to keep inflation within a low target range (for 2015, between 2.0 and 4.0 percent) might have been overdone, and the economy has fallen into a deflationary spiral. As we have observed in the US and Europe over the past couple of years, perniciously low inflation is difficult to reverse, and can have a dragging effect on the entire economy.
There are three basic reasons why superlow inflation is bad for consumers and the economy as a whole. First, it retards wage growth. In general, prices affect business revenues more quickly than changes in volume, and if prices are not increasing, neither are the financial resources needed to increase wages. If wages do not increase, consumer spending power does not expand, and consumption growth slows or even reverses to a decline, which in turn, drives down prices even further.
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 the slowing of GDP growth over the last two quarters—employers seek to cut costs by cutting payroll costs (The ‘illusion’ is that those costs are inversely proportional to demand, which is not always the case, but convincing businesses of that is next to impossible). If 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. No employer in his right mind would consider actually cutting wages, and so the only other option, cruel though it may be, is to cut jobs. That also reduces demand by reducing consumers’ spending power, and consequently lowers prices even more.
Finally, persistently decreasing inflation can slide into actual deflation. Falling prices paradoxically reduce consumer demand, particularly for big-ticket purchases like homes or cars. If prices are steadily declining, consumers tend to wait on purchases on the assumption that prices will be even more attractive next month or next quarter. They will be, because falling demand will force prices lower, but in the meantime, consumer spending power, because of the first two reasons explained above, is being reduced at the same time.
None of this is a mystery to the BSP or any other central bank, so what they attempt to do is to maintain inflation at a level that encourages wage growth and the resulting higher consumer spending without letting prices for basic necessities rise too much. After all, if consumers are obliged to spend most of their income on food, housing, and utilities, they will have little left to purchase things that have a bigger positive effect on the economy such as houses, cars, and new smartphones.
The consensus among central bankers is that an inflation rate of about 2 percent is close to a perfect balance, but they consistently miss that mark, perhaps due to the dubious justification, or to be more accurate, the lack of justification for that figure. Back in the late 1980s and early 1990s the Reserve Bank of New Zealand became the first central bank to actively engage in inflation targeting, and determined that 2 percent inflation was the appropriate benchmark. The BNZ’s plan worked; New Zealand’s economy quickly improved, and as a result, central banks and economic planners elsewhere made the assumption that the 2-percent mark must be the magic number. What worked for New Zealand, however, does not necessarily work elsewhere, which is why inflation targeting has had mixed results in most places, including the Philippines.
What the BSP should do now, while the inflation rate is not yet dangerously low, is to arrest its slide by lowering its benchmark interest rates from their current 4 to 6 percent range.
Analysts’ views on whether or not that will happen are divergent, and as a result not particularly helpful in divining what the near future holds for the economy; a recent thumbnail survey of banks by The Manila Times found UK-based banks guessing the BSP will do exactly that, while banks in Singapore see the BSP’s current rates being held through the rest of this year. With Mayvelin U. Caraballo