Open Letter on 2008 Inflation
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 2008 average inflation of 9.3 percent was higher than the Government’s target range of 3.0-5.0 percent.
The Government’s target for 2008 was agreed upon by the Development Budget and Coordination Committee (DBCC) on 29 November 2006 and announced on 14 December 2006. It was reflective of the BSP’s forecasts at that time, which showed a generally declining path for inflation over the next two years, with average inflation expected to fall within the target range of 4.0-5.0 percent for 2007 and 3.0-5.0 percent for 2008. This outlook was influenced by benign inflation trends during the second half of 2006, driven mainly by lower oil prices, a stronger peso and generally stable food prices.
In this letter, we will also explain the thinking behind our monetary policy decisions during 2008, as well as our assessment of the inflation outlook and policy directions for 2009 and 2010.
What happened to prices in 2008?
The Philippine inflation environment in 2008 turned out to be more challenging compared to the BSP’s assessment two years earlier. Price pressures in the first half of the year had intensified more than first anticipated, principally due to the big surge in the international prices of oil and food. Thus, instead of the expected steady decline towards the target range, inflation climbed sharply from 4.9 percent in January to peak in August at 12.4 percent. Then, as international commodity price pressures receded, inflation fell quickly, consistent with the temporary nature of commodity shocks. Inflation stood at 8 percent by December, bringing the full year average to 9.3 percent. Under the inflation targeting framework, there are predefined conditions that may cause actual inflation to deviate from the target. These include volatile movements in the prices of certain food and fuel products. If these price shocks were excluded, inflation would have averaged lower at 6.2 percent for 2008.
The surge in oil and food prices was a global phenomenon and affected not only the Philippines but also most countries worldwide. In fact, because of the magnitude and the unexpected nature of the global shocks, both inflation targeting and non-inflation targeting central banks alike breached their respective 2008 inflation targets.
A confluence of global and supply-side factors resulted in these unanticipated movements in commodity prices. First, the inherent volatility in commodity prices was magnified by adverse weather conditions and speculative activities in global commodity markets as the US dollar weakened. Second, world oil prices became highly volatile due to low global production capacity, tight refining capacity and increasing demand from emerging market economies, while food prices soared because of the strong demand for commodities used in bio-fuel production as well as rising fuel and fertilizer costs. All these translated to unprecedented increases in domestic rice prices as well as the pump prices of fuel.
The role of food and fuel prices should be stressed at this point. Food accounts for almost half of the Philippine CPI basket, while fuel accounts for almost another 10 percent. Therefore volatilities in international food and oil prices pose huge risks to our inflation path. In addition, tests of persistence have shown that commodity inflation in the country tends to be protracted, with food more so than fuel. Thus, increases in rice and fuel prices are particularly virulent as these figure prominently in Filipino consumers’ expectations and could lead to clamors for upward adjustments in wage and transport fares.
How did the monetary authorities respond to emerging challenges to the inflation outlook over the policy horizon?
The BSP calibrates monetary policy prudently, mindful of the inflation dynamics in the Philippines.
In this situation, the BSP was aware that the initial rise in prices was primarily supply in origin and that commodity shocks are transitory in nature. Therefore, following an approach consistent with the widely accepted principle that supply side developments are best addressed by non-monetary measures, the BSP kept its policy rates steady. The BSP considered the rise in prices during the first half of the year as a shift in relative prices and accommodated such first-round effects, allowing them to “pass through” in the form of higher prices.
However, as supply shocks from rising food and energy prices continued over a longer period, these contributed to second-round effects, affecting the wage and price-setting behavior of businesses and households by the end of the second quarter. A rise in inflation expectations was also evident from surveys and financial market data, while the BSP’s forecasts showed the risk of inflation exceeding targets for 2008 and 2009. The BSP responded to these second-round effects with decisive action and strong anti-inflation pronouncements. It raised key policy rates by a total of 100 basis points from June to August while strengthening its anti-inflation commentary.
The inflation outlook started to improve in September, with the decline in international commodity prices. Monetary authorities, however, took the view that with the domestic elevated core inflation readings still rising, there were still price pressures in the pipeline. The weaker peso also posed an upside inflation risk. Hence, the Monetary Board, during its October and November policy meetings opted to keep policy rates steady to ensure that inflation and inflation expectations were kept at bay. Meanwhile, to address any possible tightness in financial markets as a result of the global financial turmoil, monetary authorities implemented preemptive measures aimed at providing adequate market liquidity and ensuring the orderly functioning of the financial system.
In December, the inflation outlook further improved, showing a decelerating path over the policy horizon with average inflation falling within the target range in 2010. This outlook reflected the significant fall in the November inflation and the sharper-than-expected slowdown in global economic growth. Given the downside risks associated with the declines in commodity prices, the fall in inflation expectations, and the slowdown in economic activity, the Monetary Board decided to reduce key policy rates by 50 basis points during its 18 December policy meeting.
What is the outlook for inflation and monetary policy?
Latest baseline forecasts of the BSP show a deceleration in the inflation path; the annual average inflation may settle within the target range of 2.5-4.5 percent in 2009 and 3.5-5.5 percent in 2010. The positive developments in the prices of commodities and the recent string of low inflation numbers should significantly relieve inflationary pressures and keep the public’s inflation expectations well anchored. Moreover, prospects of weaker world economic activity are expected to dampen demand, reducing price pressures. Under this scenario, the BSP will continue to carefully consider opportunities to ease monetary policy, mindful of any potential tightening credit conditions.
We assure the President that the BSP will remain focused on achieving the country’s price stability objective while providing an environment that ensures sufficient liquidity to support the economy’s growth requirements.
For the consideration of Her Excellency.
AMANDO M. TETANGCO, JR.
26 January 2009