Open Letter on 2005 Inflation
25 January 2006
Her Excellency Gloria Macapagal-Arroyo
President of the Republic of the Philippines
Dear Mrs. President,
In line with the BSP’s commitment to promote greater understanding of the monetary policy process under the inflation targeting framework, we submit this open letter to the President and the Filipino public to explain why the actual average inflation in 2005 at 7.6 percent was higher than the government target of 5-6 percent. With this letter, we intend to explain the reasons behind the uptrend in inflation and our corresponding monetary policy decisions. We shall also highlight our continuing efforts to ensure price stability.
What happened to prices in 2005?
The year 2005 saw a continued rise of consumer prices, particularly those for food, energy, and transportation. The higher prices for food items in the first semester were chiefly a result of the adverse effects of the El Niño dry weather on agricultural output, especially on rice and corn production. Meanwhile, the combination of tight worldwide supply, limited spare production and refining capacity and rising global demand drove up world oil prices to historic highs, which led to higher domestic pump prices. This led to adjustments in minimum wages throughout the country, as well as to hikes in transport fares and utility charges beginning in the second half.
Towards the end of 2005, however, inflation slowed down as the impact of the El Niño dry spell on food prices dissipated and world oil prices eased. Nonetheless, food and energy-related items were still the major contributors to inflation during the year. The BSP’s estimates show that of the 7.6 percent inflation rate for 2005, among others, food accounted for 3.0 percentage points; fuel, light and water, 1.3 percentage points; and transport and communication, 1.4 percentage points.
How did the monetary authorities respond?
Monetary policy seeks to respond to demand-side rather than supply-side inflationary pressures. For much of 2005, demand-pull inflation was largely muted, mainly because consumption spending slowed down relative to the previous year. Nonetheless, the BSP decided to raise its policy interest rates in April, September and October 2005 by a cumulative 75 basis points because of the increased risk that the supply shocks, particularly from high oil prices, would generate second-round effects which could lead to even higher inflation.
The BSP also saw indications of a possible deviation from the government targets until 2007, which posed a risk to inflation expectations. Consumers and firms may begin to expect inflation to remain persistently well above the government targets. Higher inflation expectations, in turn, could affect wage- and price-setting behavior and feed into higher actual inflation in the periods ahead. Given the long lags in the effects of monetary policy on inflation and the economy as a whole, we felt it was important to act then to achieve our inflation target for 2006-2007.
The rapid growth in domestic liquidity was also a major reason for the increases in the policy interest rates as well as for the July 2005 hike in reserve requirements of 2 percentage points. The BSP was concerned about the adverse effects of excess liquidity on inflation and inflation expectations, either through increased demand-based pressures on prices or through volatility in the foreign exchange market due to narrowing interest rate differentials. As a result, liquidity growth began to slow down in the latter months of 2005.
Average inflation in 2005 of 7.6 percent exceeded the government inflation target owing mainly to the significant impact of the supply shocks in the first half of the year. It is worth stressing that since the beginning of its adoption of inflation targeting, the BSP has made clear to the public that there are acceptable circumstances under which the inflation target may not be achieved, namely (1) volatility in the prices of agricultural products; (2) natural calamities or events that affect a major part of the economy; (3) volatility in the prices of oil products; and (4) significant government policy changes that directly affect prices such as changes in the tax structure, incentives and subsidies. Two of the four conditions, items (1) and (3), were present in 2005.
What is the outlook for inflation and monetary policy?
Inflation is seen to rise slightly in the early part of 2006 as a result of the VAT rate adjustment, but the continued stability of the peso should help cushion the impact of the VAT. Thereafter, inflation is expected to decelerate as cost-push pressures subside. Nevertheless, average inflation is still expected to exceed the Government inflation target of 4.0-5.0 percent in 2006. Bringing inflation from 2005’s 7.6 percent to 4.0-5.0 percent may represent a significant deflationary move with considerable impact on output growth.
There are other important risks to the outlook for inflation: potential second-round effects from ongoing supply shocks; possible exchange rate movements due to narrowing interest rate differentials and behavior of other currencies; and adverse shifts in inflation expectations.
In view of these risks, the monetary policy stance remains firmly focused on addressing the risks to future inflation, and future policy actions will remain oriented towards achieving the Government’s 4-5 percent inflation target for 2007.
As a complement to monetary action, we will enhance further our representation with other government agencies in support of supply-side intervention measures such as: (1) measures to facilitate distribution of basic goods and services to final consumers; (2) measures on energy conservation and efficiency; and (3) measures to support exploration/use of alternative energy sources. We will also strengthen the communication of our assessment of the outlook for inflation and overall economic conditions and promote greater transparency in the conduct of monetary policy.
For the consideration of Her Excellency.
AMANDO M. TETANGCO, JR.