Central bank walks tightrope

As inflation, growth risks collide

MANILA, Philippines — The Bangko Sentral ng Pilipinas (BSP) entered 2026 with a hard-earned policy cushion: inflation had fallen below target, banks remained strong and monetary authorities had spent the previous year easing borrowing costs to help support demand.

That cushion is now being tested.

After cutting its key policy rate by a cumulative 125 basis points in 2025, the BSP was forced to reverse course this year as the Middle East conflict pushed up global oil prices, weakened the peso and reignited inflationary pressures at a time when domestic growth was already showing signs of strain.

In its 2025 annual report, BSP Governor Eli Remolona Jr. acknowledged the shift in conditions facing the economy.

“The economy is now navigating new headwinds. The Middle East conflict early in 2026 pushed inflation higher, prompting the BSP to raise rates,” Remolona said.

“Fortunately, we remain on solid footing. Inflation is rising from a low base. Our banks also remain strong, ready to absorb shocks and sustain lending,” Remolona said.

The statement captures the central bank’s present dilemma: raise rates enough to stop inflation from becoming entrenched, but not so aggressively that it deepens the economic slowdown or strains the financial system.

The BSP has so far opted for a calibrated response. The Monetary Board raised the benchmark rate by 25 basis points in April and again in June, bringing the policy rate to 4.75 percent.

The hikes came after inflation accelerated sharply from last year’s benign levels. Inflation peaked at 7.2 percent in April before easing to 6.4 percent in June, but remained well above the BSP’s two to four percent target range.

More worrying for policymakers, core inflation quickened to 4.4 percent in June, suggesting that price pressures are spreading beyond volatile food and fuel items.

For the first half, headline inflation averaged 4.8 percent, already above the three-percent target. This left the BSP with little room to look past the supply shock, especially as second-round effects from higher transport, food, utility and wage costs became more visible.

Bank of the Philippine Islands lead economist Emilio Neri Jr. said the BSP may need to raise rates further in the coming months as upside risks to inflation remain significant.

“While headline inflation has slowed, core inflation continues to trend higher, indicating that price increases are becoming more widespread beyond food and energy,” Neri said.

“Additional rate hikes could temper economic activity, but the adverse effects of elevated inflation may be more detrimental to growth,” Neri said.

This is the policy tradeoff now confronting the central bank. Higher interest rates could cool demand and raise borrowing costs for households and companies, but allowing inflation to remain elevated could erode purchasing power, weaken confidence and eventually inflict deeper damage on growth.

The challenge is more complicated because the economy is not overheating. Gross domestic product growth slowed to 2.8 percent in the first quarter, the weakest in five years, as high fuel prices and slower public infrastructure spending weighed on activity.

Citi economists Wei Zheng Kit and Helmi Arman said that a recovery in the second half appears to be the consensus among policymakers, though this optimism is not fully shared by the private sector.

The government’s growth forecast for 2026 has been lowered to 3.5 to 4.5 percent, while Citi expects a weaker 3.2-percent expansion.

Citi said the BSP expects growth to land toward the higher end of the official range, supported by a possible recovery in public spending and strength in electronics exports.

However, the economists said political uncertainty, including concerns surrounding the flood control controversy, could extend the period of policy indecision and delay the recovery in public capital expenditures.

These growth risks help explain why the BSP has avoided more forceful rate moves despite inflation running above target. According to Citi, the Monetary Board’s measured 25-basis-point hike in June reflected the need to balance still-elevated inflation risks against subdued and below-trend growth.

A larger rate increase could have risked a deeper slowdown without materially speeding up inflation’s return to the target range, Citi said.

Inflation risks linger

Neri said upside risks remain significant even after the latest easing in headline inflation. A potential El Niño could reduce agricultural output and push up food prices, while high fertilizer costs could feed into harvest prices in the second half. Recent minimum wage adjustments could also add to second-round inflation effects if businesses pass on higher labor costs to consumers.

The peso is another pressure point. Neri said depreciation pressures have persisted despite lower oil prices, partly due to expectations of further US Federal Reserve tightening. A weaker peso raises the cost of imports and could worsen inflation, while also putting pressure on the country’s international reserves.

Citi also warned that persistent peso weakness could amplify balance of payments pressures. The current account deficit is expected to widen from 2025 levels, while capital flows could become more sensitive to currency movements.

For the BSP, the peso is not a policy target, but it is a key channel through which external shocks affect inflation and confidence.

The central bank has repeatedly said it allows the exchange rate to be market-determined, while stepping in only to smooth excessive volatility and ensure orderly market conditions.

“The good news is that the banking system remained in robust health. Banks were well-capitalized and were flush with liquidity. The banking system continued to support lending and economic activity,” Remolona said.

“That resilience was no accident. Years of prudent supervision and regulation ensured that our banks were in a good position to absorb shocks,” the BSP chief said.

The central bank has also strengthened its systemic risk oversight. In its report, the BSP said it continued to monitor valuation pressures, leverage in the non-financial sector, financial sector exposures and liquidity and funding risks. It also worked on a Systemic Crisis Management Playbook to guide surveillance, escalation, communication, coordinated interventions and post-event learning during potential systemic events.

These efforts point to a broader view of central banking, where the BSP is not only setting interest rates but also supervising banks, protecting the payments system, managing currency stability and preserving trust in financial institutions.

That trust is now being tested by a difficult policy environment. For analysts, the question is no longer whether inflation has peaked, but whether it can return to target without forcing the economy into a deeper slowdown.

For the BSP, the answer will depend on timing, credibility and transparency.

If it tightens too little, inflation may stay high for longer and hurt the very growth it wants to protect. If it tightens too much, it could worsen an already fragile recovery. In between lies the narrow path the central bank must navigate, one where price stability, economic growth and financial stability all have to be protected at the same time.

As Remolona put it, the BSP and its partners are facing conditions that require continued collaboration.

“Our combined efforts put us in a good position to weather the current challenges,” Remolona said. “I am confident that continued collaboration will enable us to navigate these conditions and further strengthen the Philippine economy and the financial system for the benefit of all Filipinos.”