What a low inflation rate indicates

The inflation rate for August announced by the government last weekend undoubtedly elicited mixed reactions from this country’s monetary policymakers and economic analysts. The announced figure, 0.6 percent, was lower than July’s 0.8 percent and was within the 0.2 to 1.0 percent range projected by the national monetary authority.

On the one hand, monetary policymakers and economic analysts will have welcomed the continued decline in the inflation rate--in June 2014 the rate was just over 4 percent--because of its impact on this country’s overall financial stability and on the purchasing power of the citizenry. What the Bangko Sentral ng Pilipinas considers a stable monetary environment is indicated by the 2 to 4 percent range that it has set for the 2015 inflation rate. Clearly BSP’s economists have reason to be pleased with the August outturn if the inflation rate is viewed from the monetary stability standpoint.

But inflation does not exist in a vacuum, and the inflation rate tends to be intimately related to--and may be said to be the mirror image of--the rate of growth of GDP (gross domestic product). Recent trends in the inflation rate and the GDP growth rate have reinforced this close relationship.

Thus, while the inflation rate has been declining during the last two years, the growth of the Philippine economy has likewise been slowing. From the 2014 growth of 7.0 percent (apparently revised downward from 7.2 percent), Philippine GDP growth was recorded at only 5.0 percent in the first quarter of 2015. In the second quarter, the growth rate was a disappointing 5.6 percent. The parallelism should be obvious even to a non-economist.

To a person with economics training, a rise in inflation usually takes place when, because of vigorous economic conditions, demand for the factors of production--labor, land, credit and raw materials and other production supplies--are exerting downward pressure on their availabilities, so that bidding up of prices results. Strong demand for GDP components drags factor costs, and therefore the inflation rate upwards.

There has been no such situation in the past two years. On the contrary, there has been a lot of slack in the economy: no upward price pressure in the markets for labor and the other factors of production. Certainly not for labor, given that the Philippines, a Third World country, is by definition a labor-surplus economy.

However desirable, price stability is only one of the desiderata in the management of an economy. Other, more important desiderata are strong production growth, a high level of employment and steadily rising incomes. The ideal situation is one in which GDP was rising strongly but prices--especially consumer prices--were stable. BSP is projecting a 2016 GDP growth rate of between 6 and 8 percent and believes that such a projection is within the realm of attainability.

That GDP growth must be stronger in the coming days was indicated by the BSP governor in the statement he issued regarding the August inflation rate.

The beneficial effects on the inflation rate of the sharp drop in world oil prices--reductions in the power and transportation components of the cost of producing goods and services--was adverted to by Governor Amando Tetangco Jr. But the nation’s chief monetary policymaker warned about the likely effects of the El Niño weather phenomenon on the inflation rate. Food prices, the largest component of the CPI (consumer price index) could be driven up, Governor Tetangco said.

Any resulting rise in the inflation rate will hopefully be accompanied by a rise in the GDP growth number.


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