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Why was Actual Inflation in 2004 Higher than the Government Target? An Open Letter to the President


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

Dear President Arroyo, 

In line with the BSP’s continuing efforts to promote better public understanding of the monetary policy process under the inflation targeting framework,  we submit this open letter to explain to you and the Filipino public why the 2004 average inflation rate of 5.5 percent was higher than the government target of 4-5 percent.  With this letter, we hope to clarify the reasons behind such inflation development and the results of our decisions with regard to monetary policy and what we intend to do to ensure price stability.[1] 

What happened to prices in 2004 

The year 2004 generally saw rising prices for key goods and services, particularly food, fuel, and transport. Higher prices for food items such as fish and corn have been the result mainly of supply constraints.  Higher meat prices were a result of consumers buying fewer poultry products due to the avian flu scare. Meanwhile, global demand and supply factors raised international oil prices to unanticipated levels.  The higher cost of imported oil in turn has led to increases in domestic pump prices which led to hikes in transport fares and power rates.  Thus, as we have emphasized in our public statements on the monetary policy stance, a good part of the uptrend in inflation may be traced directly to higher prices of specific food items and the worldwide increase in petroleum prices.  The BSP estimates that food and energy items accounted for about 4.0 percentage points of the 5.5 percent average inflation rate in 2004.

What were the reasons for the inflation uptrend? 

The factors that drove food and energy prices to higher levels in 2004 are no doubt supply-side shocks.  These are events or disturbances that either cause increases in the cost of producing goods and services or reduce the supply of the same goods and services available in the economy.  The worldwide increase in oil prices that fed into higher cost of transport services and other goods as well as the spate of typhoons and domestic supply constraints that affected the availability of certain food products may be characterized as supply shocks.  Such shocks are typically associated with the form of inflation known as cost-push inflation, which involves a rise in the general price level resulting from an increase in the cost of production. 

The other form of inflation, demand-pull inflation, was generally absent in 2004.  Demand-pull inflation refers to a rise in the general price level resulting from an excess of total demand expressed in terms of higher spending.  It typically occurs when total demand for goods and services exceeds total supply. This type of inflation happens when there is excessive growth in aggregate demand and the economy is operating at or near full employment.  By and large, there has been a relative absence of demand-driven pressures on consumer prices in 2004.  Overall demand conditions have remained uneven despite robust consumer spending and continued improvements in other demand indicators.  In particular, growth in bank loans and the money supply continued to be modest, while unemployment remained at double-digits, suggesting that the economy continues to operate way below its full productive capacity.  Under such conditions,  the likelihood that expanding aggregate demand would lead to sustained consumer price increases was relatively low.

In essence, therefore, the inflation uptrend in 2004 may be characterized as a predominantly supply-side phenomenon, arising in large part from a series of supply-side shocks to the economy.  This is a crucial point because monetary policy generally seeks to respond to demand-side inflationary pressures rather than supply-side pressures,  since monetary policy affects inflation mainly by influencing the demand side and supply-side pressures are often driven by factors that are outside the control of the central bank.  For example, higher policy interest rates tend to reduce bank lending and investment spending, which is a component of aggregate demand.  Changes in policy rates as a rule cannot directly affect the cost of production inputs. 

How did the monetary authorities respond? 

Given the supply-side nature of inflation in 2004,  the BSP opted to maintain its monetary policy settings.  This essentially meant leaving the monetary stance unchanged (where the policy interest rates were maintained but  the liquidity reserve requirements were raised by 2 percentage points in February as a preemptive measure against the inflationary impact of volatility in the foreign exchange market). 

However, the BSP also actively supported the use of non-monetary government intervention measures to address more directly the supply-side risks, particularly in the case of food prices.  For this purpose, the BSP coordinated with government agencies such as the Department of Agriculture (DA) and the Department of Trade and Industry (DTI) in identifying measures to fill the gaps in domestic food supply, such as encouraging the timely importation of meat and corn.  Meanwhile, the efforts of the Department of Energy (DOE) focused on public information dissemination regarding energy consumption and facilitating access by major users to petroleum products (e.g. transport groups) through discount schemes.  These non-monetary measures were only partly successful.  They produced encouraging results for food prices,  but were less effective in the case of petroleum prices.  Part of the reason was that, unlike other Asian countries such as Thailand, Malaysia and Indonesia, the Philippines currently does not have in place a system of government subsidies for petroleum products because of a deregulated domestic oil industry that employs market-based pricing for fuel.  Most important, the Philippines has limited fiscal resources. 

As early as August 2004, it became clear that actual inflation in 2004 would likely deviate from the target. Inflation-targeting central banks respond typically to deviations of forecasted inflation from the inflation target either by: (1) adjusting the monetary policy lever so that actual inflation is brought towards the target, or (2) in case of a breach because inflation is driven by factors beyond the control of monetary authorities, issuing an explanation to the public on why the target was not achieved.  Since the outlook for inflation environment and demand conditions did not support monetary tightening, the BSP took the latter route.    

When the BSP’s inflation forecasts started to show strong indications of a potential breach of the inflation target in 2004 and 2005,  the BSP also set about informing the public of the prospective breaches through press releases, the Inflation Report,  press conferences and public briefings.  Communications with the public  concerning the monetary stance emphasized the predominant role of supply-side factors—which cannot be curbed by monetary action—in the inflation outlook and noted that overall economic conditions do not warrant a tightening of monetary policy settings through an increase in BSP policy interest rates.  In addition, the BSP sent a letter to the President on 3 September 2004 apprising Her Excellency of the inflation developments, outlining the reasons behind the rising inflation and indicating the measures being undertaken by the BSP and other government agencies to mitigate the impact of higher inflation.

We wish to emphasize that the breach of the inflation target was caused by factors that were largely beyond the control of monetary policy and thus the overshooting was not a result of an error in policy judgment.  Monetary authorities chose not to respond to the supply-side shocks because (1) the resulting pressures were not susceptible to monetary action; (2) BSP forecasts indicated that inflation would subside by 2006; and (3) there were downside risks to the overall strength of economic activity.  Moreover, an increase in policy rates would have had a limited impact in containing price pressures since these emanated mainly from supply factors and the full impact of monetary policy action on inflation is felt only after 15‑21 months.

We also wish to note that the existing monetary policy framework of inflation targeting allows sufficient flexibility for the BSP to deal with unforeseen developments or shocks to prices by providing for a clear definition of the acceptable circumstances under which an inflation-targeting central bank may fail to achieve its inflation target.  In so doing, it also recognizes the limits of the effectiveness of monetary policy under such circumstances.  The array of acceptable circumstances include: (a) movements in prices of agricultural products; (b) natural calamities; (c) movements in international oil prices; and (d) changes in government administrative measures.  The use of such exemptions to the inflation target is consistent with international best practice in monetary policy among central banks. 

What is the outlook for inflation and monetary policy? 

Recent data for both headline and core inflation continue to suggest increasing price pressures over the near term.  However,  the expected path for inflation over the policy horizon is hump-shaped. Average headline inflation is expected to overshoot the 4.0-5.0 percent inflation target for 2005 but should ease back toward the same range target in 2006. This is wholly in accordance with past experience concerning episodes of food- or oil-driven supply-side inflation, during which headline inflation tended to quickly revert to manageable levels after a brief upsurge.  It should be noted that easing conditions in world energy markets have already led to a downward shift in the expected inflation path, particularly in the months leading to 2006.  Nevertheless, supply-side factors are expected to continue to be the principal source of risks to the inflation outlook.  Such risk factors primarily relate to a sustained rise in world oil prices, which will feed into the cost of producing other goods and services.

The prevailing assessment of price and output conditions supports keeping present policy settings unchanged, but also argues for the continued readiness of authorities to undertake any necessary policy action ahead of time against inflation pressures.  The readiness to act will be particularly important in guiding and preventing unfavorable shifts in the public’s inflation expectations in the event that the rising pattern of commodity prices persists over the near term, and if exchange market pressure develops during the period.  At the same time, direct action against supply-side risks should remain a key policy priority, and all potential avenues for non-monetary intervention in the supply and delivery of affected commodities should continue to be explored and pursued accordingly. 

We conclude this letter by assuring the President and the Filipino public that the Bangko Sentral shares the strong commitment of the Philippine Government to reforming the Philippine economy and leading it further on to the path to long-term economic development.  We have made it part of our mission to contribute to the balanced and sustainable growth of the Philippine economy through both the promotion and maintenance of price stability and the effective supervision over financial institutions under our jurisdiction. 

For the consideration of Her Excellency.


[1]  The explicit requirement for the BSP to explain publicly any deviation from the inflation target began only with the formal implementation of the inflation targeting framework of the BSP in January 2002.  Although the modified monetary targeting approach employed by the BSP in the years prior to 2002 allowed for the use of publicly disclosed government inflation targets,  there has been, until recently, no formal requirement for explaining deviations from  the target.