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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 4.0 percent ± 1 percentage point for 2014 and at 3.0 percent ± 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 4.0 percent ± 1 percentage point 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.

  • To achieve the inflation target, the BSP uses a suite of monetary policy instruments in implementing the desired monetary policy stance. The reverse repurchase (RRP) or borrowing rate is the primary monetary policy instrument of the BSP. Other monetary policy instruments include (a) increasing/decreasing the reserve requirement; (b) encouraging/discouraging deposits in the special deposit account (SDA) facility by banks and trust entities of BSP-supervised fnancial institutions; (c) adjusting the residscount rate on loans extended to banking institutions on a short-term basis against eligible collateral of banks' borrowers; and (d) outright sales/purchases of the BSP's holding of government securities.
  • 1. Open Market Operations

Repurchase and reverse repurchase transactions are carried out through the reverse repurchase (RRP) facility and the repurchase (RP) facility of the BSP. In a repurchase or repo transaction, the BSP buys government securities (GS) 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 for the GS 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 GS and the bank’s payment to the BSP has a contractionary effect on liquidity. RP and RRP transactions have maturities ranging from overnight up to 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 (DDA) 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 DDA 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 and trust entities. 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.

Subsequently, the BSP implemented various adjustments in its SDA facility. In July 2012, funds from foreign sources were prohibited from being placed in banks' SDA facility to help avoid the situation where BSP's instruments for OMO become the recipient of capital inflows. 1 Also, the spread on SDA rate over RRP rate was reduced to 1/32nd of a percent to fine-tune insrtruments' pricing consistent with the decline in global interest rates. Further fine-tuning of the operation of BSP's monetary policy tools involved the removal of the term premium in the SDA facility in January 2013 and the cumulative reduction in SDA rate (total of 150-bps) from January to April 2013. Finally, in May 2013, the BSP decided to limit the access to the SDA facility to legitimate trust arrangements.2

3. Rediscounting

The BSP extends discounts, loans and advances to banking institutions in order to influence the volume of credit in the financial system. 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. In August 2013, the BSP restructured the rediscounting window to align it further with the BSP's market-based monetary operations framework and with the international central banking practice of scaling down directed credit operations. 3

Under Circular No. 806 series of 2013, two separate rediscounting windows were established, namely: (1) the Rediscounting Window I (RW I) for universal and commercial banks (U/KBs); and (2) the Rediscounting Window (II) for thrift banks (TBs), cooperative banks (coop banks), and rural banks (RBs). Banks will be able to access RWs I and II on an open-volume basis consistent with the objective of reorienting the BSP rediscounting window as a regular liquidity standing facility. In the RW I, the rediscount rate was aligned with the lending rate under the BSP RP facility plus the appropriate term premium to encourage banks to exhaust other possible sources of funding before trying to access the central bak rediscounting window. Meanwhile the interesrtrate in the RW II is pegged to the overnight RRP rate plus a term premium. TBs will have access to the RW II until November 2018, while coop banks and RBs will have access to the RW II until November 2023. By November 2023, the RW II will no longer be operational and all banks shall have access only to RW I.

4. Reserve requirements

Reserve requirements refer to the percentage of bank deposits and deposit substitute liabilities that banks must set aside in deposits with the BSP which they cannot lend out, or where available through reserve-eligible government securities. Changes in reserve requirements have a significant effect on money supply in the banking system, making them a powerful means of liquidity management by the BSP.

Reserve requirements are imposed on the peso liabilities of universal/commercial banks (UBs/KBs), thrift banks (TBs), rural banks (RBs) and cooperative banks (Coop Banks), and non-bank financial institutions with quasi-banking functions (NBQBs). Reservable liabilities include demand, savings, time deposit and deposit substitutes (including long-term non-negotiable tax-exempt certificates of time deposit or LTNCTDs)

The existing reserve requirement ratios vary across bank types and liabilities. The current headline reserve requirement ratio of 20 percent is imposed on certain liabilities of UBs/KBs and NBQBs. Previously, the eligible forms of compliance to the reserve requirements included banks' deposits in their demand deposit account (DDA) with the BSP, reserve-eligible government securities, and vault cash. Effective on the reserve week beginning on 6 April 2012, the BSP excluded vault cash (for banks) and demand deposits (NBQBs) as eligible forms of reserve requirement compliance. 4 At the same time, the BSP unified the existing statutory reserve requirement and liquidity reserve requirement into a single set of reserve requirement as well as discontinued the renumeration of the unified reserve requirements.

 

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1 BSP Memorandum No. M-2012-034 dated 13 July 2012
2 BSP Memorandum No. M-2013-021 dated 17 May 2013
3 Circular No. 806 and 807 series of 2013, both dated 15 August 2013
4 Circular No. 753 dated 29 March 2012

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