PRIMER ON INFLATION

1. What is inflation?

Strictly, inflation refers to the economic condition characterized by a large and sudden increase in the general level of prices of goods and services. More loosely, inflation is the rate of increase in the price level. Since people are usually more concerned with what is happening to the prices of goods and services that they actually consume more often, it has become common practice to measure inflation as the annual percentage change in the Consumer Price Index (CPI).

2. What is the CPI?

The CPI is really just a measure of the average price of a standard "basket" of goods and services consumed by the typical Filipino family. The composition of such a standard basket, to make it as representative as possible, is determined from a Family Income and Expenditure Survey (FIES) periodically conducted by the National Statistics Office (NSO) on a nationwide basis. The standard basket contains hundreds of different consumption items. It is the actual movement in prices of each of these items that is monitored to determine the overall change in CPI, or in short, inflation.

3. What comprises the CPI basket?

The bulk of the Philippine CPI basket is accounted for by food items (58.5 percent), including beverages and tobacco. Rice, the country's main staple, accounts for about 13 percent of the basket. Non-food items comprising the rest of the basket include the following: housing and repairs, 13.3 percent; services, 10.9 percent; fuel, light and water, 5.4 percent; clothing, 4.3 percent; and miscellaneous items, 7.6 percent.

Thus, price movements in the food, beverages and tobacco sector have large effects on the overall price changes. Since 1994, food items have contributed more than 50 percent to overall inflation.

4. What causes inflation?

Several types of inflation have been identified depending on their underlying causes: Cost-push. A type of inflation characterized by the rise in prices resulting from increases in the cost of production without corresponding increases in output. Examples of this would be wage increases not matched by increased productivity of labor, hikes in international oil prices, higher cost of capital, higher interest rate, increases in prices of imported raw materials, and hikes in rental rates.

Shortage in supply due to natural calamities and disasters leading to higher prices provides the other source of cost-push inflation. Take, for example, rice. Because of drought that hit the country during the planting season, less palay was harvested than what was needed to feed the entire nation. And since there is more demand than supply, there is a natural tendency for the price of rice to increase. Compounding this problem, some producers and traders may have seen an opportunity to hoard, thus contributing to further uptrend in rice prices. To counter hoarding, the government imposed price controls and stepped up police action. More important, to normalize the supply situation, the government imported rice from abroad.

Just as a shortage of goods tends to push prices up, an oversupply of commodities tends to induce the opposite effect on prices. Those who live in the provinces are familiar with the kamatis (tomato) phenomenon during summer; tomatoes are dirt-cheap during harvest time, and nobody seems to buy them even at rock-bottom prices!

Demand-pull. This is the kind of inflation caused by higher demand compared to the available supply of goods and services. Usually, when people, business or the government receive more income, realize capital gains or obtain easier access to credits, the overall demand for goods and services may increase. This would lead to increased prices, assuming the supply of goods and services is not able to adjust quickly enough to meet the higher demand.

Structural. A type of persistent inflation caused by deficiencies in certain conditions in the economy such as a backward agricultural sector that is unable to respond to people's increased demand for food, inefficient distribution and storage facilities leading to artificial shortages of goods, and production of some goods controlled by some people.

5. What is the "cost" of inflation?

The immediate impact of any increase in prices is a decline in the purchasing power or in the amount of goods and services any given amount of money can buy. Thus, inflation means that households with a fixed income can only buy a smaller amount of goods and services. More often than not, these tend to be low- income households while higher-income households have more flexibility to neutralize inflation by investing in assets that hold their value against inflation.

The savings pattern may also be affected. With the declining value of money, people would be more inclined to spend than save anticipating that their money can buy even less in the future. Therefore, with its adverse effect on savings, inflation can also discourage investment.

Inflation can also erode the external competitiveness of domestic products if it leads to higher production costs such as wage increases, higher interest rate and currency depreciation.

6. What is the responsibility of the BSP in relation to inflation?

Section 3 of R.A. 7653 or the New Central Bank Act states that the primary objective of the BSP is to maintain price stability conducive to a balanced and sustainable growth of the economy. As such, the BSP monitors the movements in prices, analyzes their causes and undertakes necessary measures to ensure that money supply is managed in a manner that does not contribute to inflation.

7. How does the BSP maintain price stability?

The BSP is principally concerned with regulating money supply in a manner consistent with the economy's legitimate monetary requirements to be able to execute transactions smoothly and deal with unforeseen contingencies. Too much money in circulation is often one of the basic causes of inflation but, and this is very important, not all inflation should be addressed by monetary policy. An obvious example is inflation triggered by weather-related food supply shortages.

The BSP has a well-planned monetary program precisely geared to regulating money supply consistent with the anticipated level of economic activity that is believed to be sustainable.

8. How has the level of prices been behaving recently?

Since 1992, the average annual inflation rate has been kept at a single digit. A rate of 8.9 percent was posted in 1992, a marked deceleration from the 18.7 percent in the previous year. In 1993, inflation decelerated further to 7.6 percent.

Inflation was higher at 9.0 percent in1994, but still within the 9.5 percent target inflation in the economic and financial program supported by the IMF. Several cost-push factors tended to raise inflationary pressures. These included temporary agricultural shortages spawned by the series of typhoons in December 1993, phased increases in minimum wages in December 1993 and April 1994, some speculations about the temporary fuel price increases early in the year and the impending implementation of the expanded value-added tax (EVAT). A depreciating peso, the uptrend in interest rates and in money supply growth also partly pushed prices upward during the period. Prices during the first half of 1995 were generally stable despite some unanticipated external shocks and the rising domestic liquidity in the early part of the year. However, this trend was reversed in the last four months of the year as the rice shortage pushed inflation to double-digit levels. Supply-side factors such as the dry spell which significantly affected rice and corn production, the resulting rice shortage which was aggravated by hoarding and delayed rice importation, and the foot-and-mouth disease in hogs contributed to the increase in prices. For 1995, inflation averaged 8.1 percent compared with the year-ago level of 9.0 percent and the whole year target of 6.5-7.5 percent.

For the first quarter of 1996, inflation remained double-digit at an average of 11.6 percent. The lingering effect of the rice shortage, the implementation of the EVAT, the increase in the prices of oil products, and their combined influence on higher price expectations contributed significantly to this relatively high price regime. It is expected, however, that by the second half of 1996, when both the production-related and monetary measures of the government take full effect, inflation will be back to single-digit levels to settle at between 5.5-6.0 percent by December 1996.

In comparison to other Asian countries, price movements in the Philippines used to accelerate faster. In 1992, the inflation rates of Malaysia, Taiwan, Thailand and Singapore were recorded at 4.7 percent, 4.5 percent, 4.2 percent and 2.3 percent, respectively, as compared to the Philippines'
8.9 percent. Nevertheless, the inflation differential has narrowed down as the country's inflation has moved more closely to those of said Asian countries.

9. What is "core" or "underlying" inflation?

The dependence of policy actions on just the "headline" or "published" concept of inflation may sometimes lead to an inaccurate assessment of the impact of specific events on the long-term trend of the price level. The concept of "core" or "underlying" inflation becomes important since it aims to capture only the movement in prices related to long-run economic fundamentals, e.g., productivity, efficiency and competitiveness in the domestic economy.

Core or underlying inflation measures the long-run trend in the general price level. As such, certain items are usually excluded from the computation of core inflation. These items include: (1) prices subject to government policy such as taxes and changes in the price of oil, and in some instances, interest rates; and (2) components which are volatile or subject to short-term fluctuations and/or seasonal in nature.