No Free Lunch

Inflation and BSP’s balancing act

05:38 AM May 11, 2018

Inflation hit a five-year high last month. The year-on-year (Y-O-Y) headline inflation rate was 4.5 percent; that is, for every P100 you spent exactly a year ago, you would now have to pay P104.50. Some analysts are saying that the Bangko Sentral ng Pilipinas (BSP) is “behind the curve,” or is not acting quickly enough to curb inflation. Is it really?

To understand all this talk, some clarifications are in order. First, why is the BSP seen as the main actor here? As our country’s central bank, the BSP has the mission of regulating the supply of money circulating in the economy in order to manage inflation, or the speed at which prices go up. So how does it regulate money supply? The BSP has several tools at its disposal, ranging from drastic to fine-tuning measures, and these include changing the interest rate it charges banks when the latter borrow money from it (which they do all the time).


How does the money supply affect the general price level? Textbook economics teaches us that when there is too much money chasing too few goods, prices will go up. Hence, if the supply of money grows faster than the growth in the amount of goods and services that the money in circulation can buy, expect prices to move up. This growth in goods and services is measured by the growth in gross domestic product or GDP, that familiar figure announced every quarter by our government statisticians (the GDP growth rate for the first quarter of 2018 is in fact due to be announced shortly). This money supply-GDP link drives the “demand pull” side of inflation. But there’s also “supply push” inflation, caused by rising costs of production due to rising oil prices, wages, foreign exchange rates, and yes, taxes—things that the BSP has no direct control over. Still, the BSP can mitigate inflation coming from the cost side to some extent, using its tools to manage the demand side via money supply.

While relative price stability or inflation control is the BSP’s primary mission, its actions affecting money supply also influence GDP growth, which in turn affects the rate at which our economy can generate jobs. Higher interest rates that are associated with tighter money supply tend to dampen growth in the economy. It inhibits borrowing of investible funds by farms and firms to produce more goods and services. It slows consumer purchases of homes, cars and appliances, which are usually bought on financing terms where interest rates are crucial. But it also helps lower the foreign exchange rate, as higher domestic interest rates relative to those overseas can attract foreign funds into the country seeking higher yields on peso-denominated financial investments. In turn, the exchange rate affects costs of production via the cost of imported inputs, and the incomes of families receiving remittances from our overseas workers, among other things. With the economy having so many moving parts all linked to one another, the BSP’s moves on money supply are far-reaching—and they know it.


So is the BSP “behind the curve”? By holding on to interest rates even as inflation appears to be speeding up, is it falling behind in its mission to curb inflation? Upon closer look at the data, I can understand why the BSP has been in no hurry to raise the rates despite the widespread view among financial market analysts that it should’ve raised interest rates much earlier, to arrest inflation and the peso depreciation. BSP Deputy Governor Diwa Guinigundo, an excellent economist, explained it succinctly in a recent interview: the month-on-month (as against Y-O-Y) inflation data actually show real-time price increases to be slowing down since the start of the year! In April, it was only 0.3 percent, down from 0.7 percent in March and 0.8 percent in January. While the rising Y-O-Y rate has been affected mostly by the rise in oil prices since last year (and much less by recent tax increases, as commonly and inordinately blamed), the slowing M-O-M rate should ease worries that the economy is “overheating.” It also suggests that the real time effect of tax increases on cost-push inflation have largely already come in, rising Y-O-Y rates notwithstanding.

I would trust the BSP’s moves. They know what they’re doing.

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