Amando Tetangco and the Bangko Sentral Innovate on Inflation 235.0

Governor Amando M. Tetangco Jr. and the Bangko Sentral have adapted a great innovation for the Philippines – inflation targeting.

I say adapted because inflation targeting is typically applied in industrial nations and not an emerging market like the Philippines. The adaptation is in setting a medium-term target and range to 4% +or- 1% to allow for constraints unique to an emerging market, i.e. higher variability in the inflation base, and their own dual charter, i.e. both growth and price stability mandates.

The Bangko Sentral today. Governor Tetangco’s team has successfully navigated the BSP through a period of market-oriented and slow appreciation of the peso and the global financial crisis from the debacle of 2007. I think they have regained the retained earnings lost in creating transfer payments to exporting and export labor sectors as mandated by their political masters.

Now, I think they should press for a new Central Bank Act that transfers its own retained earnings – up to P40 billion as required by law – to its capital given the government’s inability to do so. It may be time to give priority to price stability viz growth as they have de facto done with this innovation. Criteria for appointment of Monetary Board members that allow more independence from the political influence may also be good for a new Act.

Monetary Policy and Bernanke, New Zealand. I have quoted key words from the Bangko Sentral memo that reads in English but have specific technical meanings as well. I took the technical definitions from the book above on inflation targeting by Ben Bernanke, et al. Please find the Amazon link for the book at the right sidebar.

In SYNTHESiST, I have also written about the independent Central Bank and inflation targeting with the pioneer, Reserve Bank of New Zealand.

Recent history. The financial crises from 2007 has made a Keynesian out of Ben Bernanke’s Federal Reserve – using expensive reserves to refill aggregate demand. In the long run, I believe that the sound assumptions behind inflation targeting are such that it can become mainstream practice after this crisis.

As it stands today, the Europeans whose ECB has a single charter of price stability are already pushing for austerity. At the same time, Bernanke delivered a speech about uncertainty in the near future for the American economy with a promise that the Federal Reserve still has a few tools to help move the American economy build more jobs.

I think he feels this way because deflation, and not inflation, seems to be the near terms outlook despite his fellow Republican’s ideological shout that the historic American deficit will automatically create high inflation.

Governor Tetangco and his team at the Bangko Sentral are setting the stage in monetary policy for an investment and innovation growth for the Philippines if the rest of the government pulls together.

The timing seem to be right; the external environment indicates a prolonged period of slow growth that can be disinflationary. The 3% – 4% range, while higher than the typical industrialized country inflation level but is well supported by recent history for the Philippines.

Inflation targeting framework. The use of Rules vs. Discretion in running monetary policy is the subject of much research in Central Banking. The Bangko Sentral’s use of the word Framework to describe its approach to inflation targeting indicates that they accept that running a central bank is largely art and to allow more flexibility in the day-to-day management of the monetary system. In Bernanke’s book, a framework is a policy space within which “constrained discretion” can be exercised. Furthermore:

“We see the inflation targeting framework as serving two important functions: (1) improving communication between policy-makers and the public, and, not unrelatedly, (2) providing discipline and accountability in the making of monetary policy.”

Setting up Rules for inflation targeting would have been too rigid and make the Bangko Sentral vulnerable to carry trade plays because it would make the Bangko Sentral predictable.

Innovation in inflation targeting. The Bangko Sentral‘s innovation is to ‘fixed inflation target for the medium term of 4 ± 1 percent for 2012-2014′.

Gaining a reputation for inflation fighting is a slow slog. Most investors need to be shown toughness over time.

The German Bundesbank and the Swiss central bank have historically been known to fight inflation even if it kills growth. Early adopters of inflation targeting like New Zealand, Canada, and the UK have also acquired such reputation.

Why fighting inflation is important. The theory on monetary finance has evolved over time. In the past, a relationship between unemployment and inflation was accepted as truth; Milton Friedman’s NAIRU or non-accelerating inflation rate of unemployment, for example.

That has changed as it is now accepted that inflation has negative effects in the long run and that it is better to attack unemployment by fiscal or firm-level means.

Inflation, defined as a general increase in prices, directly affects and is affected, at the same time, by economic growth, interest rates, and foreign exchange rates and mostly in the negative.

For me, as a student of innovation, the most important benefit of inflation targeting is that it creates a nominal anchor of expectations. With low inflation expectations, speculation is minimized and firms compete on product and process and on investment and innovation.

Long-term investment, because the discount rate hurdle is more solid, is less risky. Likewise, innovation with long-term gestation is easier to justify and fund.

The Bangko Sentral‘s take on inflation targeting. Medium-term inflation targeting, as framework, was approved by the Development Budget Coordination Committee (DBCC) on 9 July 2010 under DBCC Resolution No. 2010-3.

Its goals read like the list on Bernanke’s book:

• to promote a long-term view on inflation;
• to increase the predictability of monetary policy;
• to help better anchor inflation expectations; and,
• to support consumption and investment by fostering greater predictability in economic decisions.

On long-term view on inflation. A long-term view of inflation will eventually result in less speculation and support longer-term investments. It will result into price stability with the nominal value of currency closer to its intrinsic value.

On increasing predictability of monetary policy. The charter of the Bangko Sentral has dual objectives of supporting growth as well as price stability. Inflation targeting will create a bias for price stability that is as it should be. It will result into a more technical and less political or commercial approach to central banking.

Fiscal policy must take the brunt on supporting growth much like in developed worlds were politics has been mainly taken out of monetary policy.

In the present Philippine context, this is tough because it means taking control of the budget deficit either by raising taxes or better collection efficiency. By implication, it also means controlling corruption not just in the collection stage but more importantly in the spending phase.

On helping anchor inflation expectations. By having a medium-term measure of inflation, over time, people will start to expect lower inflation. The era of automatic +10% rental or budgeting increases will become a thing of the past; maybe, 5% will become more likely.
Still, it will take time before the Bangko Sentral will gain credibility as inflation fighter.

On supporting consumption and investment by fostering greater predictability in economic decisions. Lower interest rates, resulting from lower inflation expectations, will support consumption.

More importantly, for me, it supports investments and innovation because the basis of competition changes from price speculation to product and process emphasis.

Final words. To achieve inflation targeting, we must keep central banking professionals like Governor Armando Tetangco to head the Bangko Sentral. The present team has been the most professional, in this sense, in recent memory.

We must especially avoid placing commercial bankers or businessmen to head the Bank; they would not have the right instincts about the job.

The press release from the Bangko Sentral website:

Bangko Sentral Press Release on Medium-Term Inflation Targeting, July 25, 2010