Overheating

There is a downside to rapid economic expansion. Improperly managed, an extended period of rapid growth could lead to what economists call “overheating.”

Fear of an overheating economy was one of the reasons cited for the substantial drop in the Philippine Stock Exchange Index (PSEI) last Wednesday. The other reason cited was fear of the consequences on the Philippine economy of the outbreak of a trade war between the US and China. Both countries are our major trading partners.

Overheating happens when there is too much money chasing too few goods in an economy. This happens when growth in production capacity lags behind the pace of economic expansion. Its most reliable indicator is rising inflation.

Since the start of this year, our inflation rate has indeed picked up. This has been induced by rising oil (and then rice) prices, the devaluation of the peso and the effects of new excise taxes. Our money managers confidently predicted the inflation rate should soon settle down. By the second half of the year, declining inflation should bring us to within target range.

To be sure, the excise taxes (such as the one imposed on fuel products) will have a single-shot effect on inflation. Since they are not increased every month, it should not be feeding inflationary tendencies in a sustained way.

Nevertheless, one uninitiated senator tried to gain political points in aid of his reelection by calling for the withdrawal of TRAIN. That will not reduce inflationary pressures. The excise taxes have already taken their inflationary toll. Henceforth the prices of commodities will move according to the dictate of other factors.

If we withdraw TRAIN now, that will only increase the likelihood of a large budget deficit. Now this is truly inflationary. A large budget deficit will increase speculation against our currency and cause a chain of events that will lead to chronic inflation.

Another similarly uninitiated senator, also seeking reelection made a similarly pointless proposal to delay introduction of the newly designed coins because they might cause confusion. Even if we delay the release of the new coins, however, they will still cause the same confusion. The timing of the release, therefore, has no bearing on whatever confusion they might potentially cause. But we digress.

Last month, the year-on-year inflation rate was calculated at 3.9 percent. This is at the upper end of the BSP’s target range. Our monetary managers expected to rein in the inflation rate in the succeeding months.

Then the rice supply problem happened, thanks to the gross mismanagement of the NFA. Rice pricing began to be volatile, rising significantly across varieties of the commodity. The lower the family income, the greater the percentage of income is spent to purchase rice. The inflationary consequence of rising rice prices is clear.

Over the next two months or so, some experts are now expecting the inflation rate to rise further to between five percent and six percent. That is way beyond the tolerable range. But since fuel prices have risen as well and there is little indication that fresh supplies of cheap rice will be available, it is hard to argue against the forecast of higher inflation.

It will not help our inflation-fighting efforts that Saudi Arabia wants to push up oil prices back to the $100-per-barrel level. But with lingering concerns in the Middle East, neither is it likely that oil prices will climb down to the $45-per-barrel range.

Since oil prices push up the inflation rate everywhere else, we are likely to see monetary authorities fight back inflation the only way they can: by jacking up interest rates. Oil might be pushing the global economy towards a higher interest rate regime.

In our case, the Monetary Board maintained a dovish stance for months. Notwithstanding market expectations for an increase in policy rates, the Monetary Board kept them steady for months.

Not only that, the BSP actually announced its intention to reduce reserve requirements for the banks. That would likely increase money in circulation, fueling the inflationary tendencies. That move never materialized. Considering the inflation numbers, the proposal will remain shelved for a long while.

There is reason for the reluctance to increase policy rates. Our government is currently maintaining an 80-20 policy on public borrowings, preferring to source financing from the highly liquid domestic market. If we raise domestic interest rates, government financing will become more expensive.

But the peso’s exchange rate has come down far enough and inflation forecasts have risen far enough.  The situation seems ripe for the Monetary Board to adjust policy rates upwards.

The market seems to have already discounted that. This is one of the reasons our stock market has been declining. When interest rates are jacked up, money tends to move toward fixed rate instruments and away from lackadaisical equities.

There is a price to pay for increasing policy rates. It will dampen investment activity because money will cost more. It will eventually slow down our pace of growth.

There are, unfortunately, no painless choices to be made.

To date, our economic managers have been gung-ho about exceeding the seven percent threshold in GDP growth. That will create jobs and lessen poverty, but it will also require our people to bear a higher inflation burden.

It is more politically palatable to have a lower inflation rate. It produces less discontent.

But we will have to understand that reining in inflation will mean reining in our growth rate. We simply cannot have our cake and eat it too.