Inflation and high interest rates

Some weeks ago, President Duterte said the economy is in doldrums, and the high interest rates are causing high peso-dollar exchange rate. Government economists and Malacañang tried to explain what he really meant, and that the economy is not really in doldrums but kept silent on the error in the direct relationship between interest rates and foreign exchange rates. A private academic economist pointed this out, because high domestic interest rates are supposed to slow down or stop foreign exchange outflow to countries with higher interest rates, so the peso would strengthen. In theory, the relationship is inverse.

Duterte never claimed expertise in economics or fiscal and monetary policy so he should be exonerated for this error. On the other hand, he is not totally wrong as this claimed relationship are only two of the variables and does not really consider other factors like historical fiscal deficit, structural terms of trade, and political environment. Economics is a social science and causal relationships happen not in a controlled laboratory but in the real world where you make assumptions on people’s actions and reactions. This brings us to the issue of whether the Banko Sentral ng Pilipinas (BSP) moves to creep up the domestic interest rates will be good for the economy in terms of lowering inflation and the foreign exchange rates.

DEMAND PULL INFLATION: The basis for the belief that increasing interest rates will temper inflation is the theory that inflation is caused by too much money or liquidity chasing a limited supply of goods and services. So, by increasing interest rates and siphoning excess liquidity, money supply will be reduced, ergo aggregate demand will be lower and prices will not go up. If this works, the economist will take credit, but if it doesn’t he will say that on the other hand there were other factors involved that got into the equation. So, we should always look for a one-handed economist, who cannot say, “on the other hand.”

COST PUSH INFLATION: The other cause of inflation is the higher cost of producing a product or service. We have no control of the price of oil, so part of the higher prices are the fuel and transport costs related to the product or service. The increased costs brought about by bad weather are also uncontrollable costs that add to the prices. Maybe, the only controllable costs are the taxes and the labor costs; but these are needed to provide the government with the revenues to operate the government and make capital investments for infrastructures and services. Increasing the salaries of the military, police, public school teachers, and other government employees, plus the pension costs are “cost push factors” in inflation. And labor will then demand higher salaries and wages when prices go up to restore their purchasing power. This could lead to an upward spiraling of inflation which would be more problematic.

The Marcos years may be worth reviewing in coming up with an inflation strategy. I say strategy because inflation containment is not a short-term initiative. The BSP, which has shifted to “inflation targeting” as a pillar in its monetary policy in the past 16 years, has done a commendable job. But as far as I can recall, in the Marcos years, there were many times when interest rates were high but inflation was also very high, and foreign exchange rates were also high. It could be that the troubled political conditions at that time dominated all other factors. I believe this is something the current government should consider. Good luck and Godspeed to the government economic managers.