Urgency of monetary response

We recall our experience constructing some econometric models with our team in the early 1980s in the Department of Economic Research of the then Central Bank of the Philippines. Our then Special Assistant to the Governor, the late Edgardo P. Zialcita, never ceased reminding us to be very careful in our oil assumption because that could upset the results of the whole exercise. The blunder of Philippine econometricians in the early 1970s was oil-driven, and it was still resonating in his mind. Care should be taken well because calibrating the key assumptions when we ran the model was not exactly as easy as typing a few instructions on a desktop as we do today. We relied on our single terminal for the one single IBM mainframe for the whole Central Bank. One run took hours to complete, and we needed to send someone to get the hard copies of the results from the Electronic Processing Data Center, one building away from the Executive Building along Mabini Street.

Once again, oil prices have taken center stage, this time because of Ukraine. OPEC continues to be ubiquitous in the oil drama because it helps regulate global supply. Ukraine will not easily fade into oblivion because its invasion has had an enormous impact on world oil prices. During the weekend, the broadsheets reported another huge price hike — possibly as much as P5.40-P5.50 per liter for diesel and P3.40-P3.50 for gasoline — as “global oil prices threaten to reach or even punch into the critical $120 per barrel level amid Russia’s intensifying attacks on Ukraine.” Until that weekend, oil prices had sustained their uptrend for 10 days.

If these estimates hold, year-to-date cumulative increases of petroleum prices could indeed upset growth and inflation forecasting exercises of the National Government (NG) and the Bangko Sentral ng Pilipinas (BSP). Per liter, diesel would be priced at P68.70 and gasoline at P78.33. As if these are not high enough, the Department of Energy the other day talked of the possibility of gas prices surging to P100 per liter.

True, the Philippine Statistics Authority reported that the February inflation rate at 3% remained at the midpoint of the 2-4% official target. However, galloping global oil prices have been observed to be busting into the local consumer basket with emphasis on further upticks due to the possible escalation of the Russia-Ukraine conflict. Already, transport inflation in February accounted for more than a quarter of the overall inflation. Ukraine-related inflation pressure is also expected to come in a big way from wheat and nickel.

If oil, wheat, and nickel imports alone will prove problematic, the weakening of the peso is inevitable. BDO chief market strategist Jonathan Ravelas estimated over the weekend that the peso’s new trading range may further weaken, signaling the assault of the P52 level. Actually, it was more than a signal for the assault had broken into the P52 level as early as last Monday.

What kind of oil assumptions motivated the BSP inflation forecasts, one of the major factors in setting monetary policy?

Based on its published February 2022 Monetary Policy Report, the BSP expected inflation to average higher at 3.7% for 2022 and 3.3% for 2023. Table 3 of the Report shows average Dubai crude oil price assumptions at only $83.3 and $75.7 for 2022 and 2023, respectively. From all indications, should the conflict in Europe continue, these oil price assumptions are just too low. BSP’s Report is very useful in that it also shows in Table 4 that if the oil price average remains at $100 in 2022 and $95 in 2023, the inflation targets may be exceeded. The bad news is that oil prices are now hovering above $125 per barrel.

On the possible path of the exchange rate, the Report shows the BSP is well covered given its peso assumption of between P48-P53 for the next two years. But this could easily be compromised if the Ukrainian invasion stretches out and sustains oil prices at $125; the US Fed tightens beyond expectation; and market sentiment reverses against oil-dependent emerging markets like the Philippines.

Whether the BSP will try to preempt this surging inflationary pressure will depend on first, effectiveness of non-monetary measures and, two, risks to growth and inflation itself.

Due to the nature of this oil shock, it was correct for the Philippines to first cushion the impact of high oil prices on the consumers and industry. As announced the other day by Finance Secretary Sonny Dominguez, this package of mitigants consists of increasing the importation of key products like coal, rice, pork, and fish. Tariff duties shall also be reduced to help cushion the effects of high import commodity prices. Higher buffer stocks for oil and LPG are up for legislation. Public subsidy on fuel will also be doubled from P2.5 billion to P5 billion starting this March.

This move came hard on the heels of the Trade Department’s earlier approval of the increase in the suggested retail prices for sardines, bread, processed meat, and bottled water. The House’s proposal to suspend the excise tax on fuel should be studied thoroughly because it would be denying the people of one important source of revenues for funding social services and infrastructure while unwittingly supporting those who can very well afford the high fuel prices. Instead, the House’s leadership could consider expanding the subsidy to include other transport sectors like tricycles. NEDA has estimated that fuel prices could push inflation higher by some 0.3 – 0.9 percentage point. Second round effects are bound to be triggered.

The war’s long duration could be a potential game changer here. The government could support only up to a certain point because its fiscal space has been literally eaten up by the pandemic.

BSP Governor Ben Diokno is also justified to be concerned that the fuel factor is the main risk to us at this time. “The main channel through which the Russia-Ukraine war could affect the Philippines is higher oil prices.” In fact, the BSP estimates inflation to hit 4.4-4.7% in case petroleum prices remain stubborn at $120-140 per barrel!

While the target output growth rates have been maintained at 7-9% for 2022 and 6-7% for 2023, these numbers should be considered soft. If the BSP thinks this year would be a sweet spot for strong growth and stable inflation, perhaps there is room to think twice. The BSP Report was quite explicit that “the output gap is projected to close and turn positive in H2 2022.” This indicates that the economy’s actual output is strong enough to exceed its potential output, and as a result, inflationary pressures in the near term are beginning to build up. Easy monetary policy could abet this situation. But inflation expectations may be de-anchored.

Given the BSP’s primary mandate, some preemptive move might be necessary because the forecasts have one narrative to tell. There is a good likelihood that we might overshoot the inflation target this year or the next. This should be one single reason why monetary policy should act, and act fast.

Diwa C. Guinigundo is the former deputy governor for the Monetary and Economics Sector, the Bangko Sentral ng Pilipinas (BSP). He served the BSP for 41 years. In 2001-2003, he was alternate executive director at the International Monetary Fund in Washington, DC. He is the senior pastor of the Fullness of Christ International Ministries in Mandaluyong.