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An Open Letter to the President: "Why Actual Average Inflation was Lower than the Inflation Target in 2003?"


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

Dear President Arroyo,

In order to promote greater understanding of the monetary policy process under the inflation targeting framework,  the BSP submits this open letter to the Filipino public to explain why the actual average inflation in 2003 at 3.1 percent is lower than the government target of 4.5-5.5 percent.  This is in consonance with the BSP’s continuing efforts to clarify the reasoning behind and the results of its decisions with regard to monetary policy.[1] 

Monetary policy typically operates with a lag, so that policy actions undertaken during a particular year would exert most of their impact on the economy only after some time lag which, in the case of the Philippines, is estimated to be about two years.  This implies that the actions of the BSP at any given time are always based on its assessment of the outlook for inflation and output two years ahead. 

In 2002, the outlook for inflation in 2003-2004 was not particularly bright due to a host of factors, including the impact of El Niño on food prices, the possibility of sizeable adjustments in utility charges, and later, the uncertainty over the impact of the US-Iraq war, ensuing movements in oil prices as well as the possibility of foreign exchange market volatility. All these factors posed significant risks to the inflation outlook and the pressures from them subsided materially only during the second quarter of 2003. 

Such an outlook was the main reason why the Government in 2002 chose to keep the inflation target of 4.5-5.5 percent for 2003,  even as the average annual inflation settled at only 3.1 percent in 2002.  The monetary authorities felt that the target would not only take full account of the risks to the inflation environment but also provide the BSP with sufficient flexibility in carrying out its monetary policy.  The BSP also believed that,  at this early stage of inflation targeting,  it is important to set inflation targets that are achievable in order to help establish policy credibility and set the stage for a gradual decline in inflation beyond the medium-term towards the 0-3 percent range,  in line with the targets used by other inflation-targeting countries.  A below-target inflation rate would then represent a movement towards a desired low level of inflation without any undue risk of deflation, and thus should be viewed as a generally positive development.

The low-inflation environment in 2003 may be traced largely to the absence of significant demand-driven pressures that could pull up consumer prices as well as  the easing of cost-push inflationary risks. Despite robust consumption activity, demand-side pressures on consumer prices remained subdued in 2003 because of continued soft spots in overall demand,  as reflected by the presence of unused capacity in the economy and the mixed trends in economic indicators.  Unused productive capacity is indicated by soft labor market conditions (unemployment rate of 10.1 percent as of October 2003) and moderate capacity utilization in key areas such as manufacturing (78.9 percent as of October 2003).  Equally important, the supply-side risks to future inflation have largely tapered off, particularly with the abatement of the El Niño phenomenon and the downtrend in international oil prices from their peak levels in March.

At the time the 2003 average inflation forecasts were set by the BSP in the closing months of 2002, the perceived risks were higher and therefore the target was considerably higher than what turned out to be the actual rate of  3.1 percent for the whole of 2003.  These perceived risks to inflation were also the main reasons why the stance of monetary policy emphasized caution in the easing of BSP policy interest rates. Given generally supportive monetary conditions, the BSP, therefore, felt that leaving policy rates unchanged was sufficient to support the pace of economic activity.  The evolution of the BSP’s assessment of future inflation was constantly communicated to the public, along with the resulting monetary policy stance, through publications such as our quarterly Inflation Report,  the published highlights of Monetary Board discussions on monetary policy, and press communications on monetary policy actions.  These information  and other materials are also available on our website. 

Looking ahead to 2004,  the expected path for inflation continues to be favorable.  Current levels of employment and manufacturing capacity utilization continue to support a moderate path for inflation over the BSP’s two-year policy horizon.  Inflation should see a moderate increase in 2004-2005 as GDP growth strengthens, aggregate demand conditions improve, and planned adjustments in tariff rates and power rates exert a modest cost-push influence on consumer prices.  Average headline inflation is thus expected to lie within the range 4-5 percent,  in line with government inflation targets. 

At the same time,  the downside risks for the overall strength of economic activity—based on the recently observed slowdown in money and credit demand, the restrained pace of bank lending, and the generally uneven trends in economic data—pose a challenge to policymakers’ ability to preserve the ongoing stimulus to economic activity without any undue risk of demand-pull inflation. 

Monetary authorities will therefore ensure carefully that the macroeconomic environment remains conducive to credit demand and investment activity while helping guard against potential risks to price stability. The monetary policy stance will continue to recognize the liquidity needs of economic growth while emphasizing the need for caution in order to help keep in check any possible vulnerabilities in the system that could arise from renewed volatility in the foreign exchange market, excessive debt accumulation by both the private and public sectors as well as any possible build-up in asset price inflation.

We conclude this report 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.

Respectfully yours,


Rafael B. Buenaventura       
Bangko Sentral ng Pilipinas

9 January  2004


[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.