Why the Bangko Sentral should raise interest rates anew

Last week, the government announced August inflation has soared further to 6.4 percent. Aside from being higher than the 5.7-percent inflation rate for the month of July, it was also significantly higher than the consensus forecast of 5.9 percent. This has brought year-to-date inflation to 4.8 percent.

Even with the significant rise of inflation in August, some economists and market practitioners say they don’t think the Bangko Sentral ng Pilipinas (BSP) will increase benchmark interest rates this September. This is because the inflation surge was largely caused by supply side factors like the shortage of rice and weather disturbances. Therefore, nonmonetary measures are more appropriate to address the issue.

While I agree that supply side factors are largely responsible for the runaway prices of goods and that nonmonetary measures are needed in response, I don’t think the BSP can afford to stay on hold as this would send the wrong signal to investors. Inaction by the BSP will, in turn, result in a weaker peso, higher interest rates and greater volatility in financial markets.

Recall that when the inflation spike first exceeded expectations early this year, the BSP didn’t raise interest rates, saying the situation was not surprising given the implementation of the tax reform program and higher oil prices. It also said the surge was only temporary and that it needed more data to assess whether higher rates were necessary.

Although the BSP finally raised rates by 25 basis points each in May and in June, the impact was mitigated as the central bank also cut banks’ reserve requirements twice by a total of 200 basis points.

The said actions prompted a lot of economists and market participants to think the BSP was behind the curve, raising concerns that inflation would spiral out of control. As a sign of disapproval, market participants sold down Philippine bonds and the peso, causing the 10-year bond rate to jump sharply by 140 basis points to 6.5 percent as of end-June and the peso to depreciate by 6.9 percent during the first half of the year.

Finally, the BSP stepped in and turned more hawkish. It said it would raise rates and temporarily stop cutting reserve requirements to address the higher than expected inflation for the month of July.

Aside from avoiding the possibility of sending the wrong signal to investors, the BSP should raise interest rates anew because of the heightened risk of contagion coming from other economies.

Note that the Indonesian rupiah and the Indian rupee have depreciated by 4.5 percent and 2.8 percent, respectively, compared to their end-July levels. The risk of contagion from the said currencies’ weakness is quite significant since the Philippine economy is very similar to the Indonesian and Indian economies. Aside from being part of the same emerging markets basket in Asia, all three countries enjoy rapid economic growth north of 5 percent. All three also have significant gross international reserves equivalent to 10.1 months of imports for Indonesia, 8.9 months for India and 7.3 months for the Philippines.

However, the main reason why the currencies of all three countries are depreciating is their current account and budget deficits, or the twin deficits. A current account deficit just means a country has more dollars going out than coming in (i.e. more imports than exports), while a budget deficit means the government is spending more than what it is generating in terms of taxes.

As of the end of June, Indonesia has a current account deficit equivalent to 2.4 percent of gross domestic product (GDP) while as of end-March, India and the Philippines hit a current account deficit equivalent to 1.9 percent and 0.6 percent of GDP, respectively. Meanwhile, Indonesia had a budget deficit of 2.9 percent of GDP in 2017 while India and the Philippines had a budget deficit equivalent to 3.3 percent and 2.3 percent of GDP, respectively, during the first half of 2018.

Still, Indonesia and India are somewhat better off compared to the Philippines. Indonesia’s inflation rate was only 3.2 percent in August and 3.2 percent year-to-date, while India’s inflation rate was only 4.2 percent in July and 4.6 percent year-to-date.

If the rupiah and the rupee are currently depreciating despite the fact that inflation is not a problem, and that both countries’ central banks have been increasing interest rates lately to defend their currencies, then the BSP cannot afford to stay put especially with the additional variable that is the rising inflation. If it does, then the pressure for the peso to depreciate would increase, causing inflation to go up further.

Although the BSP cannot address the inflation problem alone, it can’t just wait for the government to address supply side issues. Inflation is currently a problem that needs to be tackled aggressively using both monetary and nonmonetary tools for it to return to the 2-4 percent target range as soon as possible.