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Inflation Targeting: The BSP's Approach to Monetary Policy

The Inflation Target

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Inflation Targeting: The BSP's Approach to Monetary Policy

Download Primer on Inflation Targeting

  • The primary objective of the BSP's monetary policy is “to promote price stability conducive to a balanced and sustainable growth of the economy” (Republic Act 7653). The adoption of inflation targeting framework of monetary policy in January 2002 is aimed at achieving this objective.

  • Inflation targeting is focused mainly on achieving a low and stable inflation, supportive of the economy’s growth objective. This approach entails the announcement of an explicit inflation target that the BSP promises to achieve over a given time period.

    • The Inflation Target

    The government’s inflation target is defined in terms of the average year-on-year change in the consumer price index (CPI) over the calendar year. The inflation targets have been set at 4 ± 1 Percentage Point for 2013-2014 and at 3 ± 1 Percentage Point for 2015-2016.

    Consistent with the inflation targeting framework, the Monetary Board announced in July 2010 the BSP’s shift to a fixed inflation target for the medium term of 4 ± 1 percent for 2012-2014. The shift to a fixed medium-term inflation target from a variable annual inflation target was approved by the Development Budget Coordination Committee (DBCC) on 9 July 2010 under DBCC Resolution No. 2010-3.

  • The BSP has a number of monetary policy instruments at its disposal to promote price stability. To increase or reduce liquidity in the financial system, the BSP uses open market operations, accepts fixed-term deposits, offers standing facilities and requires banking institutions to hold reserves on deposits and deposit substitutes.

1. Open Market Operations

Open market operations are a key component of monetary policy implementation. These consist of repurchase and reverse repurchase transactions, outright transactions, and foreign exchange swaps.

Repurchase and reverse repurchase transactions are carried out through the repurchase (RP) facility and the reverse repurchase (RRP) facility of the BSP. In a repurchase or repo transaction, the BSP buys government securities from a bank with a commitment to sell it back at a specified future date at a predetermined rate. The BSP’s payment to the bank increases the latter’s reserve balances and has an expansionary effect on liquidity. Conversely, in a reverse repo, the BSP acts as the seller of government securities and the bank’s payment has a contractionary effect on liquidity. RP and RRP transactions have maturities ranging from overnight as well as two weeks to one month. The interest rates for the overnight RRP and RP facilities signal the monetary policy stance and serve as the BSP’s primary monetary policy instruments.

Outright transactions refer to the direct purchase/sale by the BSP of its holdings of government securities from/to banking institutions. In an outright transaction, the parties do not commit to reverse the transaction in the future, creating a more permanent effect on money supply. The transactions are conducted using the BSP’s holdings of government securities. When the BSP buys securities, it pays for them by directly crediting its counterparty’s Demand Deposit Account with the BSP. The transaction thus increases the buyer’s holdings of central bank reserves and expands the money supply. Conversely, when the BSP sells securities, the buyer’s payment (made by direct debit against his Demand Deposit Account with the BSP) causes the money supply to contract.

Foreign exchange swaps refer to transactions involving the actual exchange of two currencies (principal amount only) on a specific date at a rate agreed on the deal date (the first leg), and a reverse exchange of the same two currencies at a date further in the future (the second leg) at a rate (different from the rate applied to the first leg) agreed on deal date.

2. Acceptance of fixed-term deposits

The BSP also accepts deposits from banks. The Special Deposit Accounts (SDA) facility consists of fixed-term deposits by banks and by trust entities of banks and non-bank financial institutions with the BSP. It was introduced in November 1998 to enable the BSP to expand its toolkit in liquidity management. In April 2007, the BSP expanded access to the SDA facility by allowing trust entities to deposit in the SDA facility in order to better manage liquidity in the face of strong foreign exchange inflows.

3. Standing Facilities

The BSP extends discounts, loans and advances to banking institutions in order to influence the volume of credit in the financial system. Rediscounting is a standing credit facility provided by the BSP to help banks meet temporary liquidity needs by refinancing the loans they extend to their clients. The rediscounting facility allows a financial institution to borrow money from the BSP using promissory notes and other loan papers of its borrowers as collateral. There are two types of rediscounting facilities available to qualified banks: the peso rediscounting facility and the Exporters’ Dollar and Yen Rediscount Facility (EDYRF) which was introduced in 1995.

4. Reserve requirements

Reserve requirements refer to the percentage of bank deposits and deposit substitute liabilities that banks must keep on hand or in deposits with the BSP and therefore may not lend. Changes in reserve requirements have a significant effect on money supply in the banking system, making them a powerful means of liquidity management.

Reserve requirements apply to peso demand, savings, time deposit and deposit substitutes (including long-term non-negotiable tax-exempt certificates of time deposit or LTNCTDs) of universal banks (UBs) and commercial banks (KBs) and may be kept in the form of cash in vault, deposits with the BSP and government securities.

Required reserves consist of two forms: regular or statutory reserves; and liquidity reserves. Deposits maintained by banks with the BSP up to 40 percent of the regular reserve requirement are paid interest at 4 percent per annum, while liquidity reserves are paid the rate on comparable government securities less half a percentage point. The use of liquidity reserves help to reduce bank intermediation costs since they are paid market-based interest rates. In March 2006, the Monetary Board began to require banks to keep liquidity reserves in the form of term deposits in the reserve deposit account (RDA) with the BSP instead of government securities bought directly from the BSP.

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