The Bangko Sentral ng Pilipinas (BSP) decided to maintain its policy rate at 2.00% in its recent policy meeting. Likewise, the overnight deposit and lending facility rates were maintained at 1.50% and 2.50% respectively.
The policy rate has been at 2% for 17 months since November 2020. Meanwhile, the real policy rate has been negative for 18 months.
The following table shows the new inflation forecast of the central bank:
Inflation Forecast
February Meeting
March Meeting
2022
3.7%
4.3%
2023
3.3%
3.6%
ANALYSIS
Upside risks to inflation continue to build up with commodity prices as the main driver. Electricity cost is expected to increase further as energy companies will likely pass on the cost to consumers, especially given the 324% jump in coal prices. Meanwhile, the recent increase in oil prices will likely have an impact not only on transport but also on food. So far the contribution of food to inflation is small due to favorable base effects, but it may eventually expand in the coming months due to rising logistics costs. If oil stays at $100 on average for most of the year, there is a significant chance that inflation will breach the target of the BSP this year.
Peso depreciation is another upside risk to inflation. The Peso has weakened further due to a combination of factors, namely the increase in imports, tighter Dollar liquidity due to Fed hikes, and the jump in oil prices. All of these were the same drivers back in 2018 when the Peso depreciated significantly and inflation reached 6%. The pass-through effect of the Peso on inflation might be bigger now because of the country’s increasing reliance on imports, especially food like pork and rice.
The BSP’s inflation target is also at risk because of global supply chain issues. The recent COVID surge in China has further disrupted the global supply chain given Chinese government’s zero COVID policy and the lockdowns it has implemented.
The price of other commodities like fertilizer, coal, wheat, and corn has also increased due to the conflict in Europe. Russia and Ukraine are major exporters of these commodities, accounting for 10 to 20% of global production. The conflict could restrict the supply of these commodities and add up to the country’s inflation risks, especially for food.
FOMC officials expect 6 more rate hikes in 2022 and 3 hikes in 2023 based on the latest dot plot released by the central bank. In this scenario, the Fed Funds rate will end the year at 1.9% and 2.8% next year. Without any rate hikes from the BSP, the interest rate differential between the Philippines and the US will be close to zero and will turn negative in 2023. A situation like this will likely result to a substantial depreciation of the Peso and may de-anchor inflation expectations further.
Considering all of these, we continue to expect a 75 bps adjustment in the policy rate this year from 2% to 2.75%. Even with this magnitude of increase, the policy rate will still be below historical levels and it may not have a substantial impact on growth and employment. Furthermore, the impact of rate hikes is usually gradual and the economy has the capacity to absorb slightly higher interest rates especially now that demand is almost back to pre-pandemic level. A more significant risk to the country’s economic prospects is the depreciation of the Peso, which will increase the cost of oil that the country imports from abroad on top of the increase brought by the conflict in Ukraine. A surge in consumer prices due to oil might eventually hurt consumer spending and lead to slower growth. Hiking the policy rate will serve as a stabilizing tool that could temper the depreciation of the Peso. Also, this will likely prevent a substantial decline in Dollar reserves that could lead to more volatility in the local markets.
The chances of an intermeeting/unscheduled BSP rate hike are increasing because of oil and currency volatility. Kicking the can further may eventually lead to a situation that could force the BSP to hike by more than 25 bps in one meeting, similar to what happened in 2018.
MARKET IMPLICATIONS
Upward pressure on local yields might persist given the existing and emerging inflationary pressures. Supply disruptions have kept food prices elevated and could be vulnerable to a surge in transport costs, trade restrictions, the threat of ASF for pork producers, and weather disturbances. Also, substantial Peso depreciation due to import expansion and hawkish Fed policy might force the central bank to make sizeable adjustments in their policy settings in mid-2022 as the likelihood of a rate hike in 1H2022 is low amid the campaign season.
We continue to expect Peso depreciation in the medium term as imports will likely recover once the country has vaccinated a huge percentage of the population. Dollar demand may pick up and keep the exchange rate above the 51 level. Meanwhile, the possibility of tighter Dollar supply may contribute further to Peso depreciation. The Federal Reserve is expected to hike 6 more times this year.
