In my previous column (“Demystifying Inflation Figures,” January 11), I explained how the inflation rate published monthly by the government is of relatively little value as an economic indicator.
It can tell families, policymakers and outside analysts what the condition of the economy is in a very general way (“improving,” “getting worse,” or “staying about the same”) if it is looked at over a period of several months or more, but for most purposes it is a poor planning tool.
The one exception to that is monetary policy; through a policy regime known as inflation targeting, the Bangko Sentral ng Pilipinas (BSP)—as do most central banks around the world—relies on the inflation rate to tell them what to do about the country’s money supply. Inflation targeting is regarded as a fad by some economists, but more consider it a best practice; it is widely thought to be a particularly good management tool for developing economies. Inflation targeting is, however, a risky practice in many ways, and there are signs the Philippines might be running into some of the pitfalls of the strategy.
The basic premise behind inflation targeting is based on the quantity theory of money. In noneconomist terms, what that means is that a small amount of inflation is actually a good thing; there is slightly more money in the economy than there are things to spend it on, which encourages productivity as producers of goods and services try to keep up with demand. If there is too much inflation, however, consumers reduce their spending, which leads to a decrease in productivity; less productivity means fewer people employed, which means consumers have even less money to spend, which leads to lower demand. That’s called a deflationary spiral, and it’s not a good thing, so the goal of monetary policy is to maintain a low, stable inflation rate.
Just how much that rate should be depends on a large number of complex factors and a bit of guessing of what will happen in the near future; for the Philippines, the current target is a range between 3 percent and 5 percent.
The BSP has a number of ways to manage the money supply in order to help keep the inflation rate within its target band.
The main tools the BSP uses are primarily the overnight reverse repurchase rate (which has been unchanged for some time at 3.5 percent), along with the overnight lending rate (also steady, for now, at 5.5 percent), and the rate paid on special deposit accounts (SDA), which is now just 2 percent as the BSP has been working since mid-2013 to reduce the size of the SDA portfolio. The BSP can also raise or lower banks’ reserve requirements, and buy or sell government securities as other ways to add or remove money from the financial system.
There are three areas that make inflation targeting challenging, and increase the risk of the central bank getting it wrong. First, policy actions unavoidably work on a considerable time lag. Even the most drastic move the BSP can take—buying or selling government securities—will not have a noticeable effect on prices for several weeks or months, as the change in money supply requires some circulation (in theoretical terms, “velocity,” which describes movement of money through transactions between producers and consumers) to become apparent. If there are strong external shocks to prices—for example things such as catastrophic typhoons, or power generators and distributors conspiring to drive the country to an economic collapse—the monetary policy tools can’t keep up. The BSP generally does a good job of balancing being able to respond quickly to economic changes and allowing enough time for policy changes to have a statistically significant effect (the Monetary Board meets to review policy roughly every seven weeks), but there are times when the policy tools simply cannot be implemented quickly enough.
The second challenge to effective inflation targeting is that it demands that the consumer price index (CPI) be generated and monitored with a high degree of accuracy, and this is one of the two particular areas in which the BSP’s inflation targeting program might cause some worry. As I pointed out in the previous column, there is a possibility that the current CPI model is not completely realistic; besides the unavoidable uncertainty created in extrapolating price data from surveys, the proportional weights assigned to different categories of consumer spending might not accurately reflect actual consumer spending. The potential problem is obvious: If inflation is being miscalculated, then the inflation target will be inaccurate, and central bank management to meet that target may create unintended balances in the money supply. That is not necessarily what is happening in the Philippines now, but the widespread impression among consumers that inflation is actually higher than the published rate suggests the CPI model probably ought to be carefully reviewed.
The third challenge to inflation targeting, and the one where the BSP is most likely running into serious trouble, is that pursuing a policy of inflation targeting and currency exchange rate management at the same time is extremely problematic. Because of the large amount of foreign currency flowing into the country—largely through remittances, with a significant amount added through foreign equity investments—the money supply would increase at an exponential rate if the BSP did not use various means to pull that foreign currency out of the financial system. Doing that, however, alters the value of the peso, and because so much of what money is spent on in the Philippines is imported, removing foreign currency (which lowers the relative value of the peso) actually has an inflationary effect.
The BSP is very nearly in an impossible situation; if it allows the peso to float completely freely, it will likely lose value very quickly, which will lead to inflation. If it exercises some control over the value of the peso in line with its larger inflation targeting responsibilities, a large foreign currency reserve builds up, which is exactly what is happening now; in the past seven years, foreign reserves have quadrupled, and now stand at some $80 billion—money that can’t be cycled into the economy at a rate faster than which it accumulates without creating an inflationary cycle.