Taming inflation

(Part II)

 As I said in last week’s column, the main task of the Bangko Sentral ng Pilipinas (BSP) is to maintain relative price stability in the Philippine economy. Such was the justification of the BSP’s move to raise the lending rates incrementally from May up to the present.

During this period and in each month successively and incrementally, Philippine interest rates went up from a level of two percent (in April) to 3.75 percent (by August).

In sum, the base lending rate in the country rose by 1.75 percentage points within a four-month period.

Inflation-fighting anchors. The central bank’s function is to maintain price stability. This is mainly done by regulating the volume of credit and money supply in the economy. There are two important ways for central banks to manage price stability.

(1) The lending rate. The main policy tool for this is to influence the cost of money, which is the interest rate. The higher the rate of interest, the more likely it is possible to reduce the demand for money and credit, and hence to reduce inflationary pressures.

There are different ways to influence the interest rate. One of the simplest methods is to simply set the rate that banks can charge for overnight lending. This rate then guides the level of rates for all types of lending, including that of rewarding those who save through the deposit rates.

In most economies, all these rates are competitively set among banks and lending institutions. The BSP usually sets the main interest rate (which is the lending rate) and the interest rate on deposits. In August, the lending rate is set at 3.75 percent and the deposit rate at 2.75 percent (or one percent lower than the lending rate).

(2) What other important central banks do. Central banks of smaller economies like the Philippines monitor carefully what other central banks do in the face of problems like inflation.

Because of the global impact of the American economy, the most-watched and influential of the central banks is the Fed (the US Federal Reserve System). The BSP does this closely, as it also examines what other central banks do in relation to the policies set by the US Fed.

In the current inflationary situation, the Fed, since early this year, had triggered several acts to raise the interest rate for the US economy. The US Fed had initially signaled a slow, incremental rise of interest rates as it had earlier predicted a longer period of very low interest rates.

This changed abruptly in May  when the Fed raised the interest rates by a large jump in basis points. This change in stance was instigated by the unexpected surge in the American inflation.

During these months, American economic recovery was strong, thus fueling price increases. Moreover, the Russia-Ukraine war, starting in February, drove up global prices of oil, gas, food, and other commodities. Further abetting inflation were the US and NATO sanctions that constricted financial and trade flows on global transactions to punish Russia.

Between May, June, and July, the Fed raised interest rates from a low level of 0.25 percent to one percent in May; to 1.75 percent (June); and to 2.5 percent (July). Thus, during this period, the US Fed raised interest rates in the US by a total of 2.25 percentage points.

The Fed’s action for August is yet to be announced. If the Fed raises interest rates, there will be further pressure on other countries, including the BSP to increase interest rates if only to keep in pace or not fall behind too.

One of the major consequences of the US Fed move was to strengthen the US dollar against most global currencies. A rise in US interest rates attracts global funds to move toward the US from their current locations. In the global capital market, other central banks also would seek to strengthen their economic defenses. This explains in part the depreciation of the peso.

BSP MOVES. The BSP raised the lending rate by 0.25 percentage points each in the month of May and June. Such decisions were gentle compared to the American changes.

But in July, the BSP decided to raise the rate by 0.75 percentage points, followed by a 0.50 percentage points increase in mid-August. That the Philippine authorities raised their rates much higher two months later indicates that the earlier policy responses appeared inadequate in their judgment.

As a result of these decisions, Philippine interest rate increases tracked below the rise in US interest rates: US rates rose by a total of 2.25 percentage points compared to 1.75 percentage points for Philippine interest rates.

By these increases in the interest rates, the Philippine interest rate differential over the US rate remains still higher than the US rate. In August, Philippine benchmark interest rate is 3.75 percent and the US is 2.5 percent (meaning, Philippine interest rates are higher by 1.25 percent over the US rate; for those mystified by these numbers, the arithmetic is 3.75 = US rate plus 1.25).

Before May, however, the Philippine interest rate differential was higher than the US rate. The Philippine interest rate then was 2.5 percent and the US was closer to zero, at 0.25 percent. Hence, the interest rate differential has been reduced. It was then by 2.25 percent over US rates.

Yet, as capital is scarcer in the Philippines than in the US (a capital-rich country), Philippine interest rates need to be higher than in the US to attract foreign capital. The recent policy decisions will reduce the effective interest rates between the two countries so that capital flows into the poorer country could be adversely affected.

The judgment as to whether the recent moves of the BSP to tame inflation are enough still has to be tested against further developments.

But some favorable developments have recently eased the pressure on oil and food prices at the global front. Energy prices have recently fallen and food grain that had been trapped in Ukraine have moved out to world markets. Yet, the end of the Ukraine war does not appear on the horizon.

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