High Inflation, high interest rates: looming recession?

Inflation means a general increase in prices and fall in the purchasing value of money. It involves goods and services becoming more expensive over a certain period of time. Compared with the inflation rate in October 2021 at 4 percent, it has almost doubled to 7.7 percent in October 2022, which has been the highest in 14 years.

In effect, inflation operates much like a regressive tax in that it negatively impacts income distribution and imposes a greater burden on the poor and low-income earners. For consumers, it means that with the same amount of income or salary, they would be able to purchase less due to price increases in goods and services. For low-income earners, they are more vulnerable because they are typically the first to lose their jobs if the government tries to control inflation that will slow down the economic activities. The slowing down of economic activities typically means less income for companies which, in turn, leads to layoffs or freeze hiring.

Aside from increasing government debt, which is seen to hit P14.63 trillion ($256.67 billion) by end of 2023, and depreciating peso, which may breach P60 against US dollar as the trade deficit widens, inflation in the country is one of the top priorities of the Marcos administration. The inflation rate is likely to rise further in the last two months of the year, according to the Philippine Statistics Authority (PSA).

What causes inflation?

Over the longer run, economists think the price level is ultimately a function of the amount of money in the economy relative to the items that money can buy. But, over shorter periods, as evidenced by the experience of the past year and a half, supply and demand of goods and services can play a big role.

Supply shocks are those that disrupt production or raise production costs. Examples of these are high oil prices, natural disasters or other similar factors. This causes what is called a “cost-push” inflation, where the inflation is caused by a disruption to the supply.

Expansionary policies can also affect inflation. Examples of these include the lowering of interest rates and increasing government spending. While these policies tend to improve economic growth, it could put a strain on the country’s resources and cause “demand-pull” inflation. Demand shocks, like stock market crashes, may do the same.

Finally, another cause is the subjective concept of “expectations.” If people expect prices to go higher, they naturally include these expectations whenever they’re negotiating their wages, prices, rents or other factors.

Why increase interest rates?

We are raising interest rates because inflation is too high. High interest rates means higher borrowing costs. It encourages people to save money to earn higher interest rates and discourages people from borrowing money because of the higher financing costs. In effect, it cools down the economy and eases demand pressures.

In the Philippines, the Bangko Sentral ng Pilipinas (BSP) has the mandate to implement monetary policy, e.g., increase interest rates, while the government has responsibility to adopt fiscal policy, e.g., cut government spending in addressing inflation and ensuring economic growth. The BSP is an independent monetary authority mandated to ensure price and monetary stability while the Department of Finance (DOF) is part of the economic team of the President that is responsible for the formulation and administration of fiscal policies, and the management of financial resources, including, among others, taxes and debts.

It is important to distinguish monetary policy from fiscal policy, and also to realize how these policies can complement and help each other in addressing economic issues like high inflation. To address high inflation, the President must focus on fiscal policy as part of his socioeconomic agenda, starting with the rationalization of government budget to cut unnecessary spending (i.e., confidential and intelligence funds). He must also prioritize economic stimulus for the agriculture sector to increase productivity, lower food prices and increase exports —which will also improve trade deficit and improve peso valuation against the dollar.

Are we in a recession?

The government appears to have a positive outlook on the economy. In a press release on Oct. 20, National Economic and Development Authority (Neda) chief Arsenio Balisacan stated that the government has developed a plan to manage “the economic risks brought about by high inflationary pressures, the Russia-Ukraine conflict, global supply disruptions, and recessions.”

Citing a World Bank report, he stated that the Philippines is slated to grow by 6.5 percent in 2022 and by 5.8 percent in 2023. It likewise relied on a report by the Asian Development Bank, which stated similar prospects.

The International Monetary Fund (IMF) similarly agrees with these figures. In its 2022 World Economic Outlook, the IMF projects that the Philippines would grow its gross domestic product by 6.5 percent in 2022 and 5 percent in 2023.

In another World Bank report, senior economist Kevin Chua stated that the Philippine economy is expected to recover in 2022 to 2023 following the deep recession in 2020.

Filipinos, however, seem to disagree. In its Consumer Pulse Study, TransUnion noted that most Filipinos (76 percent) believed that the Philippines was already in a recession or would enter one by the end of 2023.

Moreover, data from the PSA show that the unemployment rate has been on a steady decline over the past year (from 8.9 percent in September 2021 to 5 percent in September 2022). However, the same report also showed that the underemployment rate has increased since June 2022.

Aside from consumers losing purchasing power, which hurts the poor more disproportionately, inflation can cause a painful recession due to sustained increase in interest rates resulting in a slowdown of the economy, thus increasing unemployment and job losses. While no policymaker would want to see job losses, the government must address inflation now before it becomes so much higher that would need even more painful measures to tame it. This herculean task of addressing high inflation with the least possible job loss is the main task of the BSP using monetary policy tools.

This caveat on looming recession and stagflation (or inflation with stagnation) is the reason why addressing high inflation requires a whole-of-government approach —with the BSP on monetary policy, and the DOF and Congress on fiscal policy (i.e., whether to increase taxes and/or cut government spending). This issue will be the subject of my policy memo as a final requirement for API 121 course (Recession, Growth and Macroeconomic Policy) at the Harvard Kennedy School under Prof. Karen Dynan. The same will be published and forwarded to the Philippine Congress and the economic managers of the Marcos administration for appropriate action before the year ends. INQ

This article reflects the personal opinion of the author and not the official stand of the Management Association of the Philippines or MAP. The author is MPA/Mason Fellow at the Harvard Kennedy School. He is a member of the MAP Tax and Ease of Doing Business committees and chief tax advisor of the Asian Consulting Group. Feedback at [email protected] and [email protected].