Interest hikes wrong response to cost-push inflation

"What is the lesson in this entire episode?"



In the second (or third, depending on the institution) semester of an economics-degree course a student is introduced to the world of prices, inflation and monetary-authority responses. The teacher discusses with his students the importance of price stability, the causes of price movements upward or downward and the appropriate remedial responses from the national monetary authority, which in this country is the seven-member Monetary Board, the maker of the policies of the BSP (Bangko Sentral ng Pilipinas).

The economics student is taught (1) that upward movements of producer and consumer prices, if not dealt with sufficiently early, can in time become full-blown inflation, (2) that an inflation can be the result either of an upward movement of costs, or a cost-push inflation, or of a rise in the demand for goods and services, or a demand-pull inflation and (3) that the BSP has an array of monetary tools that it can deploy to deal with an incipient inflation.

It is made clear to the student that any anti-inflation strategy decided upon by the BSP will be successful only if the monetary authority has correctly determined the character of the inflation. Is it an inflation of the cost-push variety, or is it a demand-pull inflation? An anti-inflation strategy intended to deal with cost-push inflation will have little or no remedial effect if the inflation that is raging is of the demand-pull variety.

The misdiagnosis of the inflation of 2018 and the consequent wrong choice of anti-inflation strategy has been this year’s big monetary-policy story. As the year nears its end, inflation appears to have moderated—the November inflation rate of 6 percent contrasted with October’s 6.7 percent—but credit for the improvement clearly appears to belong to government instrumentalities other than the BSP.

Anyone reasonably familiar with the structure and workings of the Philippine economy should have known that this year’s inflation was triggered not by forces on the demand side of the economic equation but by forces on the equation’s supply side. There was no surge in demand needing to be tamped down, and there was no build-up of pressure on availabilities of the factors of production. Indeed, the BSP leadership repeatedly assured the Filipino people, the economy was not overheating. The comparatively high employment and underemployment rates reported by the PSA (Philippine Statistics Authority) and private survey institutions hardly indicated overheating.

On the other hand, the excise-tax increases on fuels ordained by TRAIN (Tax Reform for Acceleration and Inflation) were clearly casting a malevolent shadow over consumer prices from Day One of the law’s implementation (January 1, 2018). DOF (the Department of Finance) sought to push the blame toward the agencies responsible for supplying the nation with food—particularly rice, fish and vegetables—despite clear evidence of the inflationary impact of the fuel tax increases or production costs, electricity rates and transportation charges.

Though the ball manifestly was in someone else’s court—DOF’s—the nation’s monetary authority gallantly picked it up, insisting that the continuing rise of the inflation rate above its 2-to-4 percent annual target was a monetary, not a fiscal, problem. In effect, BSP was saying that the inflation was of the demand-pull, not the cost-push kind.

And so it unleashed the weapon in its armory that is intended to quell producers’ and consumers’ spending appetites: interest rate increases. Between May and September, BSP raised its basic lending rate three times, to 175 basis points above its 2009 level. What did those moves accomplish, apart from preventing a further widening of the yield differentials between Philippine and foreign money placements? They made credit more expensive for everyone, in the process raising costs of production, including those of goods intended for export.

In the meantime, the remedial measures adopted by the Duterte administration caused food supplies to increase. The resulting restabilization of food prices validated the position that this year’s inflation has been a cost-push affair.

And the lesson of the entire episode? Interest rate hikes are the wrong response to an inflation rooted in cost-based factors.

Topics: Bangko Sentral ng Pilipinas , Monetary Board , Tax Reform for Acceleration and Inflation , Department of Finance , Philippine Statistics Authority
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