Toolbox

Most analysts are expecting the BSP to raise interest rates one more time later this week by a hefty 50 basis points. The goal is to bring down the inflation rate.

There are many instruments in the toolbox of our monetary authorities. Raising interest rates is always the handiest. It is easy to pull out and the effect is nearly immediate.

Raising interest rates is akin to applying the brakes on a speeding car. By making borrowing a bit more expensive, the monetary authorities hope to still inflationary pressures.

There is a downside to using this tool, of course.

By raising interest rates, the BSP will curtail bank earnings even as it might serve to encourage more deposits. Banks prefer lower interest rates. Deposits are, from the point of view of banks, liabilities. Higher interest rates increases bank payments for deposits as well as discourage borrowing.

In a higher interest rate regime, the weaker banks may not be able to cut it. This, in turn, increases pressure for mergers and acquisitions. From the point of view of regulators, it is preferable to have bigger but stronger banks. The risk of bank failures is lower.

Higher interests, being disincentives to borrowing, eventually reflects on our growth rate. Economic expansion is premised in increased business activity, driven by new investments using borrowed money.

When the global economy was threatened with recession after the 2008 financial meltdown, governments moved to lower interest rates and pump money into the economy by purchasing notes and bonds from the private financial institutions. For a decade, economies expanded in a cheap money environment. The emerging economies, including our own, benefitted from this.

During the last decade, we saw very low interest rates that spurred borrowing and investments. In some economies, interest rates ran way below the inflation rates. Inflation was low because money was cheap. In some instances, we were treated to the spectacle of negative interest rates.

This episode is ending rather quickly.

The US Fed, for instance, has not only increased interest rates sharply but are also unwinding trillions of dollars worth of notes and bonds it had accumulated when the first priority was to avert recession. By selling back its accumulated notes and bonds back to the market, the US Fed is also soaking up market liquidity.

This is the reason why US President Donald Trump openly disagreed with the US Fed. He wants the economy to continue to grow rapidly on the basis of cheap money and abundant liquidity. Such a condition will benefit Trump politically in the short term even as it will be bad for the economy in the long term.

If the US Fed holds on to its large pile of notes and bonds, it will be paying a huge amount for them. This will only add to the immense US debt.

The Fed, of course, can choose to sell its pile of notes and bonds to international buyers to avoid the toll on domestic liquidity. But the only capital surplus economy that could buy them is China. Given the tensions of the trade war, China is not likely to ride to the Fed’s rescue – especially since everyone is expecting a massive correction to happen in the global financial market.

Besides, holding on to more US debt paper will have the effect of unduly strengthening the Chinese currency. In the context of a deepening trade war, that is the last thing Chinese exporters want.

For our part, the financial tightening will likely slow down our growth from a gallop to a trot. The goal of achieving 7% GDP growth will likely have to be shelved for the moment.

Limited

The BSP’s move to raise domestic policy rates will arrest the erosion of the peso’s exchange value by making it more attractive to hold on to the local currency rather than flee to a dollar safe haven.

The effect of that move in bringing down the inflation rate may be limited, however.

Much of the inflationary pressure is due to two things: the rise in global crude oil prices over which we have no control and the imbalances in our food supply that can only be cured over the medium term.

Therefore, we will have no choice but to endure an elevated inflation rate for a longer period. At any rate, the elevated inflation rate is eminently manageable. Any drastic attempt to cure it might cause the economy more harm.

Those are the economic facts – although when Budget Secretary Ben Diokno said the same thing, populist rabble-rousers labeled him callous. That is unfair.

 Never before has a slightly elevated inflation rate been as politicized as it is now by opposition groups anxious to undermine the broad popularity of the Duterte administration. After two years of railing against Duterte’s war on drugs, including the staging of an international kangaroo court to try him, the latest SWS survey shows the anti-drug effort enjoys the support of four out of five Filipinos.

Now the same characters are trying to use the elevated inflation rate as a means to bludgeon the administration. They are demanding the scrapping of the tax reforms to force the administration to concede points.

Nothing could be more ignorant than that crowd-leasing demand to scrap tax reforms. It will weaken our fiscal position and cause the peso to fall through the floor. It will damage our credit ratings and increase the cost of our public financing.

There is nothing more inflationary than that.