Feedback Corner

Monetary Policy

Open Letter to the President

Open Letter on 2007 Inflation

14 January 2008

Her Excellency
Gloria Macapagal-Arroyo
President of the Republic of the Philippines
Malacañang, Manila

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 2007 average inflation of 2.8 percent stood lower than the Government’s target range of 4.0-5.0 percent. Through this letter, we also explain the thinking behind our monetary policy decisions during the year, as well as our assessment of the inflation outlook and policy directions for 2008 and beyond.

The 2007 target was established in December 2005 when oil prices where surging and there were serious threats to inflation from the supply side. At the time, the peso was only beginning to firm up while market sentiment was generally uncertain given the difficult fiscal position.

What happened to prices in 2007?

Price and monetary conditions improved beyond our initial assessment two years back. Headline inflation eased significantly in 2007, supported by generally stable prices for major food items. Food inflation went down significantly from 5.5 percent in 2006 to 3.3 percent in 2007 as prices of all major food items showed modest movement, including rice, even as this commodity recorded higher prices in the second half of 2007. Agricultural production was also boosted by the quick response by the Government to mitigate the impact of the dry spell in the second half of the year. With the two percent adjustment of the Reformed Value Added Tax (RVAT) in February 2006, the fiscal balance bounced back and reversed negative market sentiment resulting in significant capital flows and peso appreciation. The peso appreciation moderated supply-side pressures resulting from higher import prices. In particular, the firm peso mitigated the impact on domestic oil prices of increases in world oil prices during the second half of 2007. The rise in utility rates was also tempered by the strengthening of the peso which allowed downward adjustments in the foreign exchange component of billing rates.

Demand-driven pressures on consumer prices also turned out to be limited in 2007 as evidenced by the slowdown in core inflation to 2.8 percent from 5.5 percent in the previous year. One of the reasons is that wage adjustments in 2007 were lower than what were originally estimated. The accelerating growth of domestic liquidity in the first half of 2007 had been addressed adequately by a package of quick-acting monetary measures implemented in May 1/.

It is important to stress therefore that the perceived risks on inflation were higher two years earlier than what actually materialized in 2007. To a large extent, the cautious monetary stance taken then contributed to the muted demand pressures and anchored the market‘s inflation expectations.

As a result of these developments, inflation averaged 2.8 percent for 2007, lower than the previous year’s 6.2 percent. This was also well below the 4.0-5.0 percent target range for 2007 and the lowest annual average in 21 years.

How did the monetary authorities respond to emerging challenges to the inflation outlook over the policy horizon?

In 2007, domestic price developments and demand conditions remained consistent with the BSP’s expectations of a generally benign inflation outlook for the medium term. Demand indicators reflected modest demand growth, which exerted limited price pressures. Inflation expectations remained well anchored while liquidity growth had been decelerating, reflecting the impact of the monetary measures implemented by the BSP in previous years through increases in the policy rates and in May 2007 through a broadening of the scope of BSP’s open market operations. As a result, the benign inflation outlook and limited demand-side pressures provided scope for monetary policy easing in the second half of 2007. The Monetary Board cut policy rates four times in 2007 in view of favorable inflation readings. Key policy rates were reduced in July, October, November, and December 2007 by a total of 225 basis points for the overnight borrowing facility, and 250 basis points for overnight lending facility. Moreover, the Monetary Board anticipated that amid expectations of slower US and global growth, an accommodative stance could provide support to sustained economic growth.

What is the outlook for inflation and monetary policy?

With these measures undertaken in 2007, headline inflation is expected to be within the 4.0 percent ± 1.0 percentage point target in 2008. Limited demand-based price pressures, as suggested by the stable trend in core inflation in 2007, and manageable inflation expectations support this outlook. Latest forecasts also indicate that average inflation in 2009 is likely to be within the 3.5 percent ± 1.0 percentage point target.

We assure the President that the BSP is closely monitoring developments that could pose upside risks to the inflation outlook, including emerging trends in global commodity prices, to ensure that the monetary policy stance remains consistent with the economy’s momentum for sustained non-inflationary growth. The BSP remains strongly committed to achieving the inflation targets over the medium term and stands ready to act against any emerging risks to the attainment of these targets.

For the consideration of Her Excellency.

Very respectfully,



1/ The Monetary Board approved new monetary measures effective 10 May 2007 which included allowing trust departments of banks to deposit with the BSP; and allowing special deposit account (SDA) placements of banks to be deemed as alternative compliance with the liquidity floor requirements for government deposits.