Open Letter on 2006 Inflation
19 January 2007
Her Excellency Gloria Macapagal-Arroyo
President of the Republic of the Philippines
Dear Madame 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 2006 was higher than the Government’s inflation target. With this letter, we also explain the reasons behind our monetary policy decisions, as well as our assessment of the inflation path and policy directions going forward.
What happened to prices in 2006?
There was a brief pickup in inflation during the first quarter of 2006, reflecting mainly the impact of higher world oil prices, the two-percentage point increase in the Value Added Tax (VAT) rate and the earlier removal of certain VAT exemptions in November 2005. Since then, the headline inflation rate has declined steadily, due partly to dissipating pressures from the VAT on the CPI. The impact of the two-percentage point hike in the VAT rate largely resulted in one-off price increases and therefore did not result in a sustained rise in inflation. The recovery of agricultural production also led to a moderation in inflation for food products, which account for a significant share in the CPI basket. Meanwhile, the strengthening of the peso against the US dollar helped keep down the local prices of imported commodities. In particular, the impact on domestic oil prices of increases in world oil prices during the year was mitigated by the continued appreciation of the peso. The substantial easing of world oil prices towards the end of 2006 contributed further to the deceleration in headline inflation.
As a result of these developments, the average inflation rate for 2006 of 6.2 percent was lower than the previous year’s 7.6 percent. Nonetheless, it exceeded the Government target of 4-5 percent, which was agreed upon by the Development Budget Coordination Committee in December 2004. It is important to note, however, that by November and December 2006, inflation at 4.7 percent and 4.3 percent, respectively, had dropped to within the target range for the year.
Core inflation was also on a downtrend through most of 2006 and settled at 5.5 percent, the lowest average rate recorded since 2003. This reflected the absence of broad-based demand pressures on consumer prices.
How did the monetary authorities respond?
The decelerating path for inflation and the expectations of a manageable inflation environment allowed the BSP to keep a steady hand on monetary policy settings. Throughout 2006, the BSP kept its key policy interest rates unchanged at 7.5 percent for the overnight reverse repurchase (RRP) rate and 9.75 percent for the overnight RP rate.
The benign inflation readings also enabled monetary authorities to revive the tiering scheme on banks’ placements with the BSP as a means of encouraging banks to use their excess funds for lending with a view to spurring business activity.
It is worth emphasizing that the deviation of actual inflation from the target in 2006 was due largely to the volatility in world oil prices and significant changes in the tax structure that directly affected consumer prices. Under the inflation targeting framework, these are considered acceptable circumstances under which the inflation target may not be achieved.
What is the outlook for inflation and monetary policy?
For 2007, average inflation is projected to settle within the Government’s target range of 4-5 percent in the absence of further adverse shocks. Limited demand-based price pressures, as suggested by the sustained slowdown in core inflation, and manageable inflation expectations support this outlook. Latest forecasts also indicate that average inflation in 2008 is likely to be in line with the 4.0 percent ± 1 percentage point target.
Nevertheless, despite recent benign readings on the inflation outlook, the BSP remains watchful of the potential risks to inflation. These include the impact on food prices of the El Niño dry spell, upward adjustments in domestic power costs and wages, and volatility in world oil prices. In view of these risks, the BSP remains vigilant against potential second-round effects on price- and wage-setting behavior and possible adverse shifts in the public’s inflation expectations. The BSP will also continue to pay close attention to a possible sustained buildup in liquidity conditions that could lead to price pressures in the future.
The BSP remains strongly committed to achieving the inflation targets over the medium term and stands ready to act against the emerging risks to the outlook for inflation and to inflation expectations. The BSP will also continue to enhance policy transparency and implement improvements in the inflation targeting framework.
For the consideration of Her Excellency.
AMANDO M. TETANGCO, JR.