Inflation, the peso, and overall spending

Domestic prices have been on the front burner of Philippine concerns in recent times.

Inflationary times. Though Philippine inflation had been relatively modest prior to 2018, the inflation rate has steadily risen since the beginning of the year.

The year-on-year average rate of price increases from January to July (this year) was 4.5 percent. This exceeded the programmed expectations of the Philippine central bank, the BSP.

In fact, the annual inflation rate rose gradually but persistently from a low of 3.2 percent in January to 5.7 percent by July.

The August annual inflation rate had further risen to 6.4 percent. No wonder, the hot topic of the week has been rising prices.

The rising prices are felt generally across sectors of the economy. However, they accelerate the problems of the most vulnerable, the poor and those whose incomes are not catching up with inflation.

In the current context, the problem has been aggravated by food prices, especially of rice, the basic staple. Rice prices have ratcheted up unnecessarily because the long-term problem of rice production and supply procurement has been badly managed across the years.

The National Food Authority in its function of providing sufficient supply of rice at reasonable price has been a topic of major policy debate up till now. (This complex subject requires a separate discussion, but not today.)

Causes summarized. A short list of factors or events that appear to fuel the current inflationary experience in the country may be summarized.

(1) High aggregate demand. The level of overall aggregate demand in the economy has risen in view of the continued high consumption demand and relatively favorable private investments in the country.

The high consumption demand has been financed by the country’s continued sustenance through high OFW remittances to families at home, new incomes generated by a rise of BPO service exporters and greater revenues pesowise from the country’s export industries.

(2) Government spending and the Build Build Build program.  A significant element in the rise of overall demand has been the growth of public spending, especially the rise in public infrastructure spending by the Duterte administration through its Build Build Build program.

The rise in government spending has signaled further a tolerance for a higher level of fiscal deficit which is targeted to rise to three percent of gross domestic product.

The passage of the first package of tax reform of the government, known as TRAIN 1 (“Tax Reform for Acceleration and Inclusion”) introduced a major revision of taxes, included a notable rise of fuel taxes that would align Philippine fuel taxes with progressive economies in the East and Southeast Asian countries.

TRAIN relies more on indirect taxation compared to the previous tax regime that was revised. One reason for its revision was the fact that it was less efficient as a tax system.

To partly alleviate the rise of the tax burden on the poor, budgetary allocations designed to raise social programs on health and education and income transfers for the poor (the Pantawid program, or the conditional cash transfer program) were increased.

(3) Peso depreciation. Most national currencies have depreciated against the dollar. Strong US economic recovery arising from the Trump tax-cut policies and economic deregulation added fuel to a recovery that had begun during the Obama years.

The Philippine peso, along with most other currencies, depreciated given these developments. In July 2016, it took P47  to exchange for one US dollar. The dollar closed on Sept. 10, 2018 at P53.83 to the dollar.

But the peso depreciation has also come from economic factors associated with domestic policies. Rising domestic demand, including a strong demand for capital goods to jumpstart the public investment program has widened the trade deficit. The country’s international reserves are strong, but they are strained by these trade deficits.

The country could move toward stronger export performance if only it could rely on a broader opening of the economy through improved foreign direct investments.

However, this has been hampered by continuing uncertainties domestically because of major impending reforms that are not yet fully defined. The economic program still has to address the issue of amending restrictive economic provisions embedded in the political constitution.

(4) External uncertainties. There are major tensions in the world economy today that are the product of recent political developments.

The trade wars initiated by the United States under Donald Trump has unleashed uncertainties that hover over world trade in general. While it might seem that the tense situation between the US and Europe and the US and NAFTA are quieting down toward possible negotiated outcomes, the US-China trade war appears escalating.

The tensions arising from geopolitical issues rose with the US withdrawal from the Iran nuclear agreement. In East Asia, the fate of the US-North Korean summit appears to be far from clarifying fully toward denuclearization of the Korean peninsula.

The rise of crude oil prices has provided further complication to the country’s import bill. Crude oil prices have risen threateningly again because of the tensions that continue in the Middle East.

In  July 2017, Brent crude oil prices were only at around $50 per barrel. Latest prices (September 2018) puts a barrel of crude at $78. Moreover, there is sharp volatility as long as the Middle East situation remains tense.

The serious Turkish economic crisis which has resulted in widespread exchange rate volatility in that country has been in part fueled by political developments in that country as well as the complications of the Middle Eastern political landscape.

 “(5) Rising interest rates.”  Interest rates are definitely destined to rise further in the near future. The signal for this was made by the US central bank as economic recovery there strengthened in 2017.

Thus ended the period of several years when US interest rates – and hence the world’s – were close to zero, in order to stimulate recovery. As the US followed through on its interest rate policy, the rest of the world would follow so that they could rebalance their own monetary policy with the US move.

In terms of the Philippines, this means raising domestic interest rates at a premium level over US rates. Otherwise, within free-flowing financial movements, an inadequate adjustment could cause capital to flow out of the economy. This could unsettle domestic monetary stability as it momentarily does.

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