A Primer: Inflation targeting and the BSP

( Second of three parts )

What is inflation targeting?

On Jan. 24 2000, the BSP’s policy-making body, the Monetary Board, approved in principle the shift to inflation targeting as a framework for conducting monetary policy. Inflation targeting focuses mainly on achieving price stability as the ultimate objective of monetary policy. This approach entails the announcement of an explicit inflation target that the central bank promises to achieve over a given time period. The target inflation rate will be set and announced jointly by the BSP and the government through an inter-agency body, although the responsibility of achieving the target would rest primarily on the BSP. This would reflect an active government participation in achieving the goal of price stability and greater government ownership on the inflation target.

The BSP formally adopted inflation targeting as the framework for monetary policy at the beginning of 2002. The Philippines joined a long list of inflation targeters‚ such as Australia, Canada, Finland, Sweden, New Zealand, the United Kingdom, Israel, Brazil, Chile and Thailand, which have moved from high inflation to low inflation following the successful implementation of inflation targeting in their countries.

Why is the BSP shifting to inflation targeting?

Over the past two decades, changes in the structure of the financial system and the introduction of new financial products and services as a result of financial deregulation and liberalization appeared to have weakened the traditional relationship linking money supply to income and prices. This has prompted many central banks to review their approach to monetary policy.

The BSP is shifting to inflation targeting for the following reasons:

• It is a relatively simple framework and can, therefore, be easily understood by the public.

• It allows a greater focus on the goal of price stability, which is the primary mandate of the BSP.

• It is forward-looking and recognizes that monetary policy actions affect inflation with a lag.

• It reflects a comprehensive approach to policy by taking into consideration the widest set of available information about the economy.

• It promotes transparency in the conduct of monetary policy through the announcement of targets and the reporting of measures that the BSP will adopt to attain these targets, as well as the outcomes of its policy decisions.

• It increases the accountability of monetary authorities to the inflation objective since the announced inflation target serves as a yardstick for the performance of the BSP, and thus helps build its credibility.

• It depends not depend on the assumption of a stable relationship between money, output and prices, and can still be implemented even when there are shocks that could weaken the relationship.

What are the requirements for the successful adoption of inflation targeting?

The success of implementing inflation targeting as the framework for monetary policy depends on the following preconditions that complement and reinforce each other:

• Firm commitment to price stability. The primary objective of the central bank is to maintain price stability that is conducive to a balanced and sustainable economic growth. As such, the central bank should not be bound by multiple objectives such as financing the government’s deficit, keeping the exchange rate at a given level, or other policy agenda of the government.

• Central bank independence. The central bank must be able to conduct monetary policy without political interference. The central bank must also be able to use whatever instrument of monetary policy is needed to achieve price stability. The central bank should also have fiscal independence, i.e., it must not be constrained by the need to finance the fiscal deficit.

• Good forecasting ability. The central bank should have a good statistical model for forecasting inflation.

• Transparency. The central bank should promote transparency by clearly communicating to the public its policy actions and the reasons behind them.

• Accountability. Should actual inflation deviate from the target, there should be accountability on the part of the central bank.

• Sound financial system. The financial system should be fundamentally sound to make monetary policy more effective in influencing output and prices.

Can inflation targeting work for the Philippines?

As the following below suggests, most of the basic requirements for the successful adoption of inflation targeting are already in place in the Philippines.

• Central bank independence. Yes, the law provides fiscal and administrative independence to the BSP as the central monetary authority.

• Central bank commitment. Yes, the law mandates that the central bank should be primarily concerned with maintaining price stability.

• Good forecasting ability. Inflation forecasting models are continuously being improved; these will be supplemented by judgment and discretion given available economic and financial indicators.

• Transparency. In addition to existing reports and publications, the BSP will also publish Inflation Report and the minutes of relevant Monetary Board (MB) discussions on monetary policy (with a lag).

• Accountability. The BSP will stand firmly behind inflation target and will explain to the public and higher authorities should there be any deviations.

• Sound financial system. The financial system is constantly developing partly in view of the measures implemented by supervisory authorities to strengthen it. (To be continued)