The BSPs Conduct of Monetary Policy

Director Economic and Financial Learning Center University of the Philippines Manila 13 July 2011

ZENO RONALD R. ABENOJA

OUTLINE
A. Introduction B. Inflation and Price Stability C. Monetary Policy and Inflation Targeting D. Inflation: Recent Trends and Outlook Inflation: E. Contemporary issues in Monetary Policy

OUTLINE
A. Introduction B. Inflation and Price Stability C. Monetary Policy and Inflation Targeting D. Inflation: Recent Trends and Outlook Inflation: E. Contemporary issues in Monetary Policy

The BSP : Guardian of price stability

The primary objective of the Bangko Sentral is to maintain price stability conducive to a balanced and sustainable growth of the economy.
-Sec. 3, RA 7653 (New Central Bank Act)

The BSP formulates and implements monetary policy consistent with its price stability objective.

OUTLINE
A. Introduction B. Inflation and Price Stability C. Monetary Policy and Inflation Targeting D. Inflation: Recent Trends and Outlook Inflation: E. Contemporary issues in Monetary Policy

What is price stability?

Price stability

An environment in which inflation is

sufficiently low that it is no longer a
consideration in the economic decisions of households and firms Alan Greenspan

Prices are stable when ordinary people stop

talking about inflation. - Alan Blinder

What is price stability?

Price stability

On average, prices
neither increase nor decrease markedly There is low and stable inflation

What is inflation?

Inflation

sustained increase in the

average prices of goods and
services typically purchased by consumers

measured as the annual

percentage change in the Consumer Price Index

How are prices measured?

CPI

represents the average price

of a standard basket of

goods and services consumed by a typical Filipino family for

a given period
Positive rate of change in CPI = Inflation Rate

What causes inflation? Prices increase when Supply < Demand Demand > Supply Prices decrease when Supply > Demand Demand < Supply
Changes in price level result from interaction of supply and demand.

What causes inflation?

Types of inflation
Cost-push Due to increase in cost of production and other supply factors (e.g.,

weather disturbances, increase in world oil prices) Outside the influence of BSP

What causes inflation?

Types of inflation
Demand-pull Due to excess demand
relative to supply of goods and services (e.g., increase money supply) BSP exerts influence over money supply and thus can control inflation

Why is price stability important? Impact of high inflation on the economy

Distorts economic decisions: consumption saving investment production Inefficient allocation of resources

High and volatile inflation

Lower confidence in financial instruments as a form of savings Loss of purchasing power Negative effects on income distribution

Slower economic growth

OUTLINE
A. Introduction B. Inflation and Price Stability C. Monetary Policy and Inflation Targeting D. Inflation: Recent Trends and Outlook Inflation: E. Contemporary issues in Monetary Policy

What is Monetary Policy?

Level of Money and Credit

Monetary Policy Actions by a central bank to manage the availability and cost of money and credit to attain stable prices

Price of Money and Credit

PRICE STABILITY

to attain

What is Monetary Policy?

Level of Money and Credit

Monetary Policy Actions by a central bank to manage the availability and cost of money and credit to attain stable prices

Refers to the level of money or credit supply which a central bank can directly control

What is Monetary Policy?

Level of Money and Credit Price of Money and Credit Refers to the price of savings/ investment which influences how much and where money goes

Monetary Policy Actions by a central bank to manage the availability and cost of money and credit to attain stable prices

What are the tools of Monetary Policy?

Level of Money and Credit Price of Money and Credit
to attain
Quantity instruments

Monetary Policy

Price instruments

PRICE STABILITY

What are the tools of Monetary Policy?

Monetary Policy instruments

control directly
Quantity instruments

the availability

or level of loanable funds (e.g., reserve requirements, rediscounting)

Price instruments

influence the rate of return on

financial instruments
(i.e., RRP and RP rates)

What are the tools of Monetary Policy?

Monetary Policy instruments

1. Open market operations (OMO) - involves the buying and selling of government securities from/to the public as well as repurchase and reverse repurchase agreements (the RP/RRP rate is the main policy instrument) Market/

To liquidity

Reduce RRP rates or Purchase of GS

BSP will release money into the system Market/ BSP will siphon off money from 20 the system

To liquidity

Raise RRP rates or Sale of GS

What are the tools of Monetary Policy?

2. Reserve Requirement amount of money/liquid assets that banks are required to keep in their vaults or deposit with the BSP
To liquidity Lower RR
Banks have more money for lending & investments

To liquidity

Raise RR

Banks have less money for lending & investments

What are the tools of Monetary Policy?

3. Rediscounting facility a BSP facility that provides refinancing for banks for credits extended to the private and public sectors To contract or expand liquidity in the financial system, the BSP can increase/decrease the rediscount rate (pegged to the policy rate) or

decrease/increase the rediscounting budget

What are the tools of monetary policy?

Rediscounting facility
Increase rediscounting budget/ reduce policy rate (accordingly, rediscounting rate is also reduced)

To

liquidity

Banks are encouraged to refinance loans with BSP

Banks tend to reduce excess reserves; cheaper to refinance loans

What are the tools of monetary policy?

Rediscounting facility
Reduce rediscounting budget/ increase policy rate (accordingly, rediscounting rate is also increased)

To

liquidity

Banks are discouraged to refinance loans with BSP

Banks tend to raise excess reserves; more costly to refinance loans

What are the tools of Monetary Policy?

4. Special Deposit Account (SDA) facility - a BSP deposit facility for banks and trust entities of BSPsupervised financial institutions To contract or expand liquidity in the financial system, the BSP can encourage/discourage deposits in the SDA by increasing/decreasing the RRP rate (since the SDA rate is pegged to the policy rate)

How does Monetary Policy affect prices?

Total Aggregate Demand
Consumption

Quantity instruments Affect Price instruments

Investment Government Spending Exports

Inflation

Imports

Monetary Policy manages inflation by influencing aggregate demand and hence, output growth in the economy.

How does Monetary Policy affect prices? Transmission channels how monetary policy affects price and real variables
Supply

Interest Rate Credit

Domestic demand Total demand

POLICY INSTRUMENTS

Domestic inflationary pressure

INFLATION

Expectations

Asset prices

Net external demand Import prices

Exchange rate

Stage 1

Stage 2 15-21 months

Stage 3

What is the BSPs Monetary Policy framework?

Inflation targeting

Involves the central bank

publicly announcing an inflation target which it
promises to achieve over a certain period

Formally adopted by the

BSP in January 2002 as its
monetary policy framework

Why did the BSP adopt IT?

Inflation targeting

Is forward-looking Reflects a comprehensive approach to policy by

taking into consideration the widest set of available information about the economy

Increases accountability of the BSP and helps

build credibility

Promotes transparency in monetary policy

How does inflation targeting work?

Inflation targeting: essential elements

Set a target inflation rate - explicit inflation

targets for some period ahead

Forecast the future path of inflation - using a

model that uses relevant variables and information indicators

Compare forecast with the target Difference determines the extent that monetary
policy has to be adjusted

How does inflation targeting work?

Inflation targeting: framework

Government sets inflation target 2 years in advance (in consultation with BSP) 2011: 4.0% + 1 ppt 2012: 4.0% + 1 ppt

YES

BSP Publishes highlights of MB meetings on monetary policy discussions Publishes Inflation Report Releases press statement

FORWARDLOOKING
BSP announces inflation target (yearly)

Is inflation forecast in line with target?

PROMOTES TRANSPARENCY INCREASES ACCOUNTABILITY

BSP Adjusts policy rates Issues Open letter to the President (yearly)

BSP Assesses economic conditions Forecasts inflation Conducts monetary policy

COMPREHENSIVE

NO

How does inflation targeting work?

Data disclosure and policy communication Quarterly inflation report - serves as a monetary
policy statement

Press releases at the time of monetary policy decision - done every six weeks Highlights of the meeting of the Monetary Board on monetary policy - lag of four weeks Speeches by the Governor and other senior BSP
officials - public presentations and information campaign. Open letter addressed to the President of the Philippines.

How does inflation targeting work?

BSPs explanation clauses

Circumstances when the BSP is not held accountable for deviations from inflation target

High prices of agricultural products High prices of oil products Significant government policy changes that directly affect prices (e.g., new taxes and subsidies) Natural disasters and calamities affecting major sectors of the economy

How does inflation targeting work?

Recent developments in BSPs IT framework

Establishment of point target

Prior to 2008, inflation targets were given by a range (ex: Inflation target 2007: 4-5%)

Establishment of medium-term inflation target

Beginning 2010, BSP announces a medium-term inflation target to help anchor inflation expectations

Inflation target for 2011: 4.0 + 1.0% Inflation target for 2012-2014: 4.0 + 1.0%

OUTLINE
A. Introduction B. Inflation and Price Stability C. Monetary Policy and Inflation Targeting D. Inflation: Recent Trends and Outlook Inflation: E. Contemporary issues in Monetary Policy

How has inflation behaved over the years?

Headline inflation
Year-onYear-on-year change in percent (2000=100)
25

20

Oil price hike, peso depreciation, natural calamities (e.g. earthquakes)

2010 ave. = 3.8% 2011 YTD ave. = 4.3% Inflation Targeting Oil price hike and rise in prices of agri commodities Oil price hike RVAT June 2011 4.6%

15

Power crisis Rice crisis

Asian financial crisis, El Nio Peso depreciation, oil price hike

10

0 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 11-Jan

How has inflation performed vis--vis targets? visYear

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Notes: * For 2002-2004, actual inflation figures are 1994-based while data for 2005-2008 are 2000based 1 Annual target

Actual Inflation (in percent)

2.9 3.0 5.5 7.6 6.2 2.8 9.3 3.2 3.8 4.3 YTD as of June

Inflation Target (in percent)1

4.5 5.5 4.5 5.5 4.0 5.0 5.0 6.0 4.0 5.0 4.0 5.0 4.0 1.0 3.5 1.0 4.5 1.0 4.0 1.0

What is the outlook for inflation? inflation? Latest inflation forecasts indicate a manageable inflation environment over the policy horizon.

* Source: BSP Inflation Report Q1 2011

What is the outlook for inflation? Although inflation pressures have moderated slightly, the inflation target remains at risk.
Upside risks Downside risks

Higher global food and oil prices Potential adjustments in domestic rice prices and electricity charges Potential impact of weather disturbances on agricultural production

Sustained appreciation of the peso Weaker global recovery

OUTLINE
A. Introduction B. Inflation and Price Stability C. Monetary Policy and Inflation Targeting D. Inflation: Recent Trends and Outlook Inflation: E. Contemporary issues in Monetary Policy

Multispeed global recovery

Two-speed global recovery : Emerging and developing market economies to expand by 6.5 percent in 2011 Advanced economies to grow by 2.5 percent

Source: IMF World Economic Outlook Update, April 2011

Multispeed global recovery

Uncertainty of external demand poses risks to the economic outlook Slow recovery scenario for global growth in the US and other advanced economies given: Uncertainties in global financial markets Possible withdrawal of stimulus Impact of high commodity prices Possibility of default of some member in the Euro region
42

Large capital inflows

Drivers in the acceleration of cross-border capital flows:
Brighter growth prospects in emerging market (EM) economies Accommodative monetary policies in advanced economies (AE) Yield differentials favoring EMs Improved risk appetite for EM assets IMF REO for Asia (Oct, 2010): growth and strong macrofundamentals are the driving force behind the inflows; interest rates and yield differentials provide an ancillary role

Large capital inflows

Credit take-up has been moderate, with loan growth at pace with the expansion in economic activity
If current conditions of strong external liquidity continue, these could add to market volatility Managing these flows will test the effectiveness of central bank policies There is also a risk that flow of capital would reverse quickly, leading to costly sudden stops
Liquidity and Bank Lending Jan 2002 April 2011; in Php billion

5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

3,000

Domestic Liquidity - lhs

2,500

Bank Lending (Net of RRPs) - rhs

2,000

1,500

1,000

500

Large capital inflows

Policy toolkit
1. Improved monitoring of capital inflows 2. Greater exchange rate flexibility 3. Reserve accumulation and associated liquidity management operations 4. Financial sector reforms to deepen financial markets 5. Macroprudential measures to strengthen banking system health 6. Reform of the FX regulatory framework to encourage outflows 7. Prepayment of external debt 8. Careful communication to markets about central bank views/responses 9. Calibrations in monetary policy, when necessary

Asset price bubbles

The asset price debate: should monetary policy try to burst the bubble? The BSP does not actively respond to asset price bubbles But continues to be highly attentive and alert to credit growth, asset price movements and imbalances BSP uses variety of macroprudential instruments to temper asset price escalations

Asset price bubbles

Limited evidence of stretched asset market valuations
Average Land Values, Makati CBD and Ortigas Real Prices, based on rebased CPI
(in pesos per square meter)
120,000

Office and Residential Rental Values Real Prices, based on rebased CPI
(in pesos per square meter per month)
700

Makati
100,000

Ortigas

Residential Rental Values

600

Office Rental Values

500 80,000

Q1 2011: P83,921/sq.m

400

Q1 2011: P351/sq.m

60,000 300 40,000

20,000

Q1 2011: P38,782/sq.m

200

100

Q1 2011: P239/sq.m

1Q '01 2Q 3Q 4Q 1Q '02 2Q 3Q 4Q 1Q '03 2Q 3Q 4Q 1Q '04 2Q 3Q 4Q 1Q '05 2Q 3Q 4Q 1Q '06 2Q 3Q 4Q 1Q '07 2Q 3Q 4Q 1Q '08 2Q 3Q 4Q 1 Q '09 2Q 3Q 4Q 1 Q '10 2Q 3Q 4Q 1 Q '11

PRICE-EARNINGS (P/E) RATIO

31 29 27 25 23 21 19 17 15 13 11 9 7

EFFECTIVE EXCHANGE RATE INDICES OF THE PESO

230 210 190 170
Narrow = 171.99 (May 201 1)

May 2011 = 15.32

150 130 110 90 70 50

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

2000

1Q '01 2Q 3Q 4Q 1Q '02 2Q 3Q 4Q 1Q '03 2Q 3Q 4Q 1Q '04 2Q 3Q 4Q 1Q '05 2Q 3Q 4Q 1Q '06 2Q 3Q 4Q 1Q '07 2Q 3Q 4Q 1Q '08 2Q 3Q 4Q 1 Q '09 2Q 3Q 4Q 1 Q '10 2Q 3Q 4Q 1 Q '11
Broad = 136.23 (May 2011 )
Major Trading Partners = 85.58 (May 2011)

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

47

2011

Commodity price increase

In Asia, recent bout of inflation being stoked by higher costs of food and oil Escalating prices are complicating trade-off between keeping a lid on prices and sustaining growth Why should we be concerned? -Erodes purchasing power -Could force policy tightening
Global Food Price Index and Dubai Crude Oil Prices 2007 -May 2011
Dubai Crude Prices (US$/barrel) 140 FPI Jun 2008 224.13 FPI Apr 2011 235 FPI May 2011 232 200 FAO Food Price Index (FPI) 250

120

100 150

80

60

100

40 50 20

0
Jan 2007 Feb Mar Apr May Jun Jul Aug Sept Oct Nov Dec Jan 2008 Feb Mar Apr May Jun Jul Aug Sept Oct Nov Dec Jan 2009 Feb Mar Apr May Jun Jul Aug Sept Oct Nov Dec Jan 2010 Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan 2011 Feb Mar Apr May

48

 Share of food to the consumption basket is higher than those in some neighboring countries
Country Energy Weight (in percent)
21.0 15.0 15.0 15.0 15.0 15.0 14.0 10.0 7.0

Commodity price increase

Country
Myanmar Nepal Philippines Sri Lanka Cambodia Mongolia Papua New Guinea Indonesia Fiji Thailand Malaysia China Taiwan Singapore Brunei Darussalam India* Korea, Rep *WPI Source: CEIC, official statistic website, and Bloomberg

Food Weight
68.3 53.2 46.6 45.5 42.7 41.1 40.9 36.0 35.4 33.0 30.0 26.9 26.0 22.1 17.1 14.3 14.0

Singapore Indonesia Thailand Malaysia China Korea, Rep India Philippines Taiwan
Source: Nomura

49

Commodity price increase

Compared with neighboring countries, recent Philippine food inflation is one of the lowest
35.0 30.0
Indonesia

35.0
Year on year inflation of selected countries
January 2008 May 2011

Year on year food inflation of selected countries

January 2008 May 2011

30.0
Malaysia Thailand Philippines Vietnam

Indonesia Malaysia Thailand

25.0 20.0 15.0

25.0 20.0 15.0

Vietnam Philippines

10.0 5.0 0.0

Jan-08 Jul-08 Oct-08 Jan-09 Jul-09 Oct-09 Jan-10 Jul-10 Oct-10 Apr-08 Apr-09 Apr-10 Jan-11

10.0 5.0
Apr-11

-5.0 -10.0

0.0
Jan-08 Apr-08 Jan-09 Apr-09 Jan-10 Apr-10 Jan-11 Apr-11 Jul-08 Oct-08 Jul-09 Oct-09 Jul-10 Oct-10

50

Commodity price increase

Some reasons why food inflation is lower in the Philippines Favorable domestic supply conditions
Timely importation of rice and sugar Recovery of agriculture in Q4 2010 sustained into 2011

while neighboring countries have faced supply constraints

Malaysia: food inflation affected by subsidy rationalization program South Korea: foot and mouth disease affected meat prices Extreme weather conditions in parts of Asia: Country India Indonesia South Korea China Impact on Food Inflation Unseasonal rains in some parts of the country disrupted vegetable output Extreme weather disrupted harvests and food distribution Heavy snow and unusually cold weather affected vegetable supply Cold spring delayed planting and damaged vegetable crops; rising labor costs also pushed up the price of agricultural products

Source: FAO Crop Prospects and Food Situation December 2010

Commodity price increase

Well-behaved rice prices
Timely importation of rice augmented by domestic production brought inventory to record levels in recent months Domestic rice production in Q4 2010 recovered, growing by 21.1 percent compared to -24.8 percent in Q3 Corn production also recovered by 13.8 percent
Country
Philippines India Indonesia Thailand
a/Includes paddy, tubers and their b/Refers to weight

Weight of Rice in CPI Basket

9.36 1.79 5.80a/ 2.88b/

products of rice, flour, and cereal products

Commodity price increase

Stronger private demand & liquidity growth in some Asian countries compared to relatively moderate growth in PHL
PCE Growth (YoY, %)
9.0 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0

Q1 2010

Q2 2010

Q3 2010

Indonesia
Source: Bloomberg

Thailand

Malaysia

South Korea

India

Philippines

Growth in Liquidity (YoY, %)

Q1 2010
25

Q2 2010

Q3 2010

Q4 2010

20

15

10

0
I ndonesia Thailand Malaysia South Korea India Philippines China
S ource : Bloomberg Data for Indonesia, Thailand and China refer to M2 g rowth rates

Commodity Price Increase: Persistent?

Upside pressures on commodity prices expected to persist in 2011 and 2012 due to : strong global demand supply disruptions and sluggish supply response Inflation pressures more pronounced in emerging and developing countries
IMF Projections for Consumer Prices Advanced Economies Emerging and Developing Economies 5.2 6.2 6.9 5.3

2009 2010 2011 2012

0.1 1.6 2.2 1.7

Source: IMF WEO Update, April 2011

54

Financial stability
Financial stability dimension of price stability Price stability: necessary but not sufficient to achieve financial stability Emergence of imbalances even when monetary policy settings appear appropriate Best approach is to involve a portfolio of instruments with macroprudential regulation

The BSPs Conduct of Monetary Policy

Director Economic and Financial Learning Center University of the Philippines Manila 13 July 2011

ZENO RONALD R. ABENOJA