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Deutsche Bank’s minority report on monetary policy

THE prevailing view of the current state of inflation in the Philippines, the view shared by policymakers, most analysts, and even the strident activist crowd demanding various forms of extraordinary relief from higher prices, is that the elevation of consumer prices is supply-driven. Almost everyone agrees that inflation can be traced to higher oil prices, which affect the price of everything; a weakened peso, which is mostly the result of the dollar being stronger; and to some extent, although not nearly as much as the opposition claims, higher taxes.

Banking giant Deutsche Bank, however, takes an altogether contrary view. In a report released toward the end of last week, Deutsche Bank said it “fundamentally” disagrees with the assertion that inflation is being pushed by the supply side, and, instead, sees it as “a demand-side, overheating phenomenon.”

It is a surprising assessment and one that may after all be entirely wrong, but seems to have some merit, enough, at any rate, that it is worth examining more closely.

The Deutsche Bank assessment offers two main points to support its conclusion. First, core inflation, which does not include volatile food and fuel prices and is seasonally adjusted, has been rising steadily, reaching 3.6 percent in May. The reasons for the underlying price increases in core inflation may vary, but it is always indicative of increased spending. Second, despite a recent hike in policy rates by the BSP, real interest rates, i.e., interest rates adjusted for inflation, are at their lowest level in three years; real interest rates and spending are always inversely proportional, though the degree to which they are can vary.

So Deutsche Bank is fundamentally correct to say that inflation is being demand-side driven, although that does not necessarily mean that it is not also being driven by supply-side factors. Anecdotally, the bank’s argument is supported by the fact that government spending has been increasing at a significant pace, and the logical conclusion that inflation in general (core and headline) obliges consumers to spend more to maintain the same standard of living.

The debatable issue is whether or not all that means the economy is actually “overheating,” or is at risk of doing so. One big factor that suggests it may not be is the inflation rate itself.

While it has been increasing relatively quickly for an extended period of time (since December of last year), it is still rather mild, and is slowing as it approaches the discomfort level of 5 percent. True, the inflation rate has stubbornly remained above the government’s ideal target range of 2 to 4 percent, but there may not necessarily be any certain negative implications in that. The target range is aspirational, being an informed judgment that economic growth will be supported best at that level, and in that sense somewhat arbitrary.

The level and pace of inflation are keys to determining whether or not the economy is overheating, because inflation is generally considered the definitive indicator. An economy can be said to be overheated when it experiences an extended period of strong economic growth and aggregate demand is increasing at a significantly faster pace than productive capacity. The result of this state of “too much money chasing too few goods” is higher inflation, initially, which if not checked in some way will lead to recession; inflation will reach a level where it cancels out the advantages of high liquidity, and spending will slow.

In Deutsche Bank’s view, the rise in inflation through May is one indication of overheating risk, and that risk is magnified by the BSP’s apparent reluctance to apply tighter monetary policy. Inflation has risen 1.7 percentage points since the end of last year, but the BSP’s recent hike in interest rates – the first in nearly two years – only amounted to 0.25 percent. There is not a uniform correlation between interest rates and inflation – in other words, Deutsche Bank is not necessarily suggesting the rate hike should have been equal to the 1.7-percent increase in inflation – but the bank is suggesting the rate hike was not enough.

Aggravating the situation was a reduction, the second this year, in banks’ reserve requirement ratio (RRR), the amount of money they are required to hold in their vaults or on deposit in various forms with the BSP to ensure they have enough cash. Lowering the RRR allows banks to use more of their money for lending and other purposes, which adds money to the financial system, which in turn increases inflation.

The BSP’s stated objective in reducing the RRR, which it intends to keep on reducing, is not to affect inflation, but rather to shift from what it considers an outmoded tool to more flexible ones, such as its term deposit facility (TDF). The BSP expected the first reduction of the RRR in February to be inflation-neutral, with the excess money released by the lower reserve requirement soaked up by the TDF. Some of it undoubtedly was; subsequent term deposit auctions have been more heavily subscribed than they were last year. On the other hand, inflation has continued to rise, and while a substantial increase in the money supply in March was followed by a modest reduction in April, the numbers do not yet add up to a conclusion that the BSP’s concept is working, or working enough.

The BSP has been so generally successful that there is a natural inclination to regard it is infallible, but Deutsche Bank’s minority viewpoint might yet remind us that it is not. One way or another, the economy is not likely to go into a sudden reversal, but the second half of this year might see some unexpected shifts in how policymakers handle it. If the BSP is right, then the next rounds of indicators – inflation, money supply, the peso-dollar exchange rate – will show clear and substantial improvements. If they do not, and the Deutsche Bank view is closer to reality, however, then aggressive action to lift interest rates and either raise or at least suspend further reductions in the RRR are probably in the offing.


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