Selected Issues


Selected Issues

The Rise and Fall in Inflation During 2018–191

Inflation rates declined in 2019 after they rose sharply in 2018. Understanding the sources of inflation dynamics is key to formulate the monetary policy response. A semi-structural dynamic model is used to decompose these dynamics in the Philippines during 2018–19. The results suggest that increases in global oil prices, shocks to domestic food prices, and the relatively loose monetary policy stance up to early 2018 explain much of the rise in inflation rates in 2018. The decline in inflation rates in 2019 is largely attributed to the unwinding food and energy inflation increases, and the tighter monetary policy.

A. Introduction

1. Inflation rates were volatile in 2018 and 2019. On a year-on-year basis, inflation rates rose from 2.9 percent at end-2017 to 6.7 percent in September 2018, then declined to 0.8 percent as of October 2019. Several factors, including changes in oil and rice prices, an increase in excise tax rates, monetary policy adjustments, and the changes in the cyclical positions of the economy, are widely cited as contributors to the volatile inflation dynamics.

2. A semi-structural model is used to decompose the inflation dynamics into the contributions of various exogenous shocks. These shocks can be broadly classified into several major categories: global oil and food prices, domestic pass-through of commodity prices, monetary policy, growth and inflation in the United States, shocks to aggregate demand, and other cost push shocks etc. The model is a version of the IMF’s “Forecasting and Policy Analysis System” (FPAS) based model. It has a standard core structure based on New Keynesian models, including: (1) Phillips curves to model prices; (2) a dynamic IS curve for the demand-side dynamics; (3) uncovered interest parity; and (4) a version of the Taylor rule. Expectations are forward-looking, consistent with the projections of the model itself. The technical details of the model are discussed in Guo and others (2019). Compared with econometric models, inflation expectations (which are a major component in the Phillips curve) are “rational” in our model: they are consistent with the future inflation path projected by the model itself (Box 1).

3. The purpose of the decomposition exercise is to better understand the underlying sources of the recent inflation dynamics and, thereby, contribute to the current debate about inflation prospects and the appropriate monetary policy stance.

B. Background—Broad Success in Reducing Inflation

4. Inflation has been better anchored since the Philippines adopted inflation targeting (IT) in 2002. Average inflation rates declined from 9.7 percent (y/y) in the 1990s to 4.6 percent during 2002–09, and 3.1 percent during 2010–18. The lower inflation rates after 2002 coincided with less volatile real GDP growth.


Average Inflation and Growth Volatility

(In percent)

Citation: IMF Staff Country Reports 2020, 037; 10.5089/9781513529158.002.A003

Source; Philippine Statistics Authority.

5. Monetary operations have improved, which has enhanced the transmission of monetary policy and the functioning of the IT regime. Historically, volatile cross border capital flows and the lack of effective sterilization tools in the toolkit of the Bangko Sentral ng Pilipnas (BSP) used to create misalignments between the BSP’s policy rate and short-term market interest rates, dampening the transmission of monetary policy. This was especially obvious in 2016, when T-bill rates and interbank rates were substantially below the policy rates as a result of capital inflows.2 Since late 2017, the BSP has improved its liquidity management by using its Term Deposit Facility (TDF) to absorb excess liquidity. As a result, market rates have generally been anchored by policy rates, and the rise in policy rates in 2018 was transmitted to the long-term government bond yields and bank lending rates. All these changes will further improve the functioning of the IT framework.

6. Despite these improvements, in a small open economy such as the Philippines, inflation is inevitably affected by external factors. Historically, inflation in the Philippines has been sensitive to international oil prices: the oil price increases in 2005, 2008, and 2018 all led to notable pickups in headline inflation. In addition, the low inflation in 2015 and 2016 (0.7 percent and 1.3 percent, y/y) was likely associated with the low inflation in trading partner countries at the time, especially China.3 These external factors contribute to the inflation volatility in the Philippines and create challenges for policymakers to gauge the source of inflation.


Headline Inflation and Oil Price Changes

(In percent)

Citation: IMF Staff Country Reports 2020, 037; 10.5089/9781513529158.002.A003

Sources: Philippine Statistics Authority: and FRED Economic Data.

C. Inflation Dynamics in 2018 and 2019

7. Inflation rates rose sharply in the first three quarters of 2018. The CPI increased by 5.7 percent from end-2017 to September 2018. Much of the increase was observed in 2018:Q1 (after the hike in excise taxes in January 2018) and 2018:Q3. By components, food and energy price increases contributed the most to the rise in the headline CPI. In particular, the price of rice, representing 9.6 percent of the CPI basket, increased by 10.2 percent in the first three quarters of 2018. However, the contributions from core CPI items were also nonnegligible.


Inflation and Inflation Target

(In percent, year-ori-year)

Citation: IMF Staff Country Reports 2020, 037; 10.5089/9781513529158.002.A003

Sources: Bangkc Sentral ng Pilipinas; and IMF staff estimates.

8. Inflation decreased in late 2018 and 2019. CPI inflation started to decelerate in late 2018 and eventually moved back into the target band (2–4 percent) in February 2019. Much of the deceleration was due to lower food and energy inflation. Core inflation, on the other hand, held up.

9. Policy responses during 2018–19. The Monetary Board meets eight times a year in the Philippines. After the February and March 2018 meetings, the Monetary Board decided to keep the policy rate unchanged despite the increasing inflation rates, noting the temporary factors that pushed up inflation rates and the relatively benign inflation forecasts at that time. After the May 2018 meeting, when inflation pressure became more broad-based, the Monetary Board started to increase the policy rate. Policy rates were increased by 175 basis points from May 2018 to November 2018. The higher policy rate was transmitted to financial markets. The average bank lending rates increased from 6.03 percent in May 2018 to 7.02 percent in December 2018 and 7.42 percent in March 2019. Credit growth to the private sector decelerated from 17.4 percent (y/y) in May 2018 to 9.9 percent (y/y) in March 2019, and 7.6 percent (y/y) in June 2019. Meanwhile, a few nonmonetary measures were also deployed or planned to help curb inflation, including increasing transfers to low-income families4 and relaxing the quota on rice imports. In 2019, when inflation rates were back in the target band and global economic conditions changed,5 discussions about cutting interest rates began. In May 2019, the BSP reduced the policy rate by 25 basis points to 4.5 percent. Subsequently, the policy rate was cut further to 4.25 percent and 4 percent, respectively, in August and September 2019.


Policy Rate and Headline Inflation

(In percent)

Citation: IMF Staff Country Reports 2020, 037; 10.5089/9781513529158.002.A003

Sources: Philippine Statistics Authority; and Bangko Sentral ng Pilipinas.

D. Model Decomposition of the Inflation Dynamics During 2018–19

10. The rise in inflation during 2018 was mainly driven by the following factors:

  • Global oil prices. Brent oil prices increased from an average of US$54 per barrel in 2017 to US$75 per barrel in 2018:Q3. This increase affected headline inflation directly, through the rise prices of energy items (electricity, fuel and transportation), and indirectly through higher energy costs in production. This can be seen in the contribution to headline inflation of global oil prices, which turned positive in 2018 (yellow bars in Figure 1).

  • Domestic shocks to food prices. The impact of food-related (domestic and global) shocks is shown by the light green bars in Figure 1. The contribution from food prices was the highest in 2018:Q3, but still smaller than that of oil prices. Overall, food prices in the Philippines increased by 9.3 percent (annualized) in the first three quarters of 2018 (Table 1). The contribution of food prices to headline inflation mainly reflected domestic sources, such as disruptions to domestic rice production and inventories,6 as well as the excise tax hike on beverages and tobacco implemented in January 2018.7

  • The accommodative monetary policy during 2017–2018:H1. Interest rates contribute to inflation through their impact on output gaps and exchange rates in the model. The contributions of monetary policy to inflation is measured by the blue bars in Figure 1. Monetary policy was relatively accommodative before the interest rate hikes in 2018. The real interest rates, defined as the interbank rates subtracting the expected inflation, were close to or below zero percent during 2017 and 2018:H1, and hence clearly lower than the neutral real rate, which is estimated at 1–2 percent (see IMF Country Report No. 18/287). Apart from the policy rate, the generally low interest rates were also partly the result of the large unsterilized capital inflows experienced before late-2017.

  • Stronger growth and inflation in the United States. Their contributions to the inflation in the Philippines are measured by the purple bars in Figure 1. Much of the inflation impact can be attributed to the pickup in U.S. inflation in the first half of 2018.

Table 1.

Inflation by Items

(In percent)

article image
Sources: Philippine Statistics Authority; and IMF staff estimates.

Energy related items include electricity, gas, fuel and transportation.

Figure 1.
Figure 1.

Inflation Decomposition

Citation: IMF Staff Country Reports 2020, 037; 10.5089/9781513529158.002.A003

Source: IMF’s FPAS Model.

Rice Price Index in the Philippines

(2012 = 100)

Citation: IMF Staff Country Reports 2020, 037; 10.5089/9781513529158.002.A003

Sources: Philippine Statistics Authority.

Real Interest Rate

(In percent per year)

Citation: IMF Staff Country Reports 2020, 037; 10.5089/9781513529158.002.A003

Note: Real interest rate is calculated as the difference between nominal overnight interbank rates and the model-projected (qoq) forward-looking inflation rates.Source: IMF staff estimates and projections.

11. The declining inflation pressure during 2018:Q4–2019Q3 was mainly driven by the following factors:8

  • Unwinding of domestic food price shocks. As shown in Figure 1 (light green bar), the contributions of food-related shocks turned negative in 2019. This was mainly explained by the decline in domestic rice prices after the relaxation of rice import quotas and, to a lesser extent, the waning of the temporary inflation impact of the excise tax hike.

  • Oil price pass-through. The effects are measured by the red bars in Figure 1. In the Philippines, even though there is no oil subsidy and hence retail fuel prices are very responsive to global prices, the prices of other energy-intensive items (such as transportation and electricity) often exhibit some stickiness and do not move one to one with global oil prices. That is, there is a domestic pass-through effect which decides the difference between the movements of domestic energy prices and global oil prices. Usually, when oil prices rise, the pass-through effect tends to suppress the increase in transportation and electricity prices. On a quarter-to-quarter basis (not shown in Figure 1), this pass-through effect was the strongest in 2018:Q3 and 2018:Q4 when the trend of oil price hike started to stall and then reversed.9 The delayed passthrough of the increase in oil prices propagated to a larger drag on inflation pressure in 2019 on a year-to-year basis.

  • Tighter monetary policy. This can be seen from the shrinking blue bars in Figure 1 in 2019. It should be noted that the positive contribution of monetary policy as of 2019:Q3 does not imply that monetary policy was still accommodative by then10—it mostly reflects the lagged effects of accommodative policies before the interest rate hikes.

12. The depreciation of peso contributed to rise in inflation moderately during 2018. In a counterfactual scenario with unchanged peso/U.S. dollar rate from end-2017 to 2019:Q2, year-on-year inflation rates could be about 0.6 percent lower at the peak (Figure 1).


Philippine Peso/U.S. Dollar Billateral Exchange Rate

Citation: IMF Staff Country Reports 2020, 037; 10.5089/9781513529158.002.A003

Sources: CEIC Data Co. Ltd.; and IMF staff estimates.

Headline Inflation

(Year-on-year, in percent)

Citation: IMF Staff Country Reports 2020, 037; 10.5089/9781513529158.002.A003

Sources: CFJC Data Co. Ltd.; and IMF staff estimates.

E. Going Forward11

13. In the baseline forecast of the model, inflation rates will temporarily fall below the target band before converging back to the 3 percent mid-point of the target band. This forecast reflects the baseline assumptions that global oil prices (Brent) will remain around US$65 per barrel in the next two years, food inflation will remain moderate at around 4 percent in 2020–2022,12 and that the policy rate will broadly follow the path implied by the model’s Taylor rule. The model projects that inflation rates (y/y) will decline below the target band in 2019:H2 because of the negative base effect from the sharp increases earlier in 2018: inflation had risen sharply in 2018:Q3 (7.5 percent q/q, annualized), especially food inflation (11.3 percent, q/q, annualized). However, starting in 2020, inflation is project to move back to the target band, as the base effect wanes.


Headline Inflation Projected by IMF’s FPAS Model

(In percent)

Citation: IMF Staff Country Reports 2020, 037; 10.5089/9781513529158.002.A003

Sources: CE1C Data Co. Ltd.; and IMF staff estimates.

Nominal Policy Rate Projected by IMF’s FPAS Model

(In percent annual)

Citation: IMF Staff Country Reports 2020, 037; 10.5089/9781513529158.002.A003

Sources: CEIC Data Co. Ltd.; and IMF staff estimates.

14. Implications on monetary policy. Our model suggests that a broadly neutral monetary policy stance, with the possibility of some moderate loosening would be appropriate to achieve the inflation target within the usual one- to two-year horizon. In the baseline projections, interest rates would be around 3.5–4 percent in 2020.13 However, monetary policy stance should be data-dependent, as illustrated by the plausible alternative scenarios presented below.

15. Alternative scenarios.14

  • Higher domestic food inflation. The left chart below shows that the prices of food items relative to the CPI basket were below the trend as of 2019:Q2. Assuming a “catch-up” of food prices relative to the CPI would imply a higher food inflation (around 5 percent annually) than our baseline assumption (4–4.5 percent). This would obviously raise the projected headline inflation for the medium term (dashed line in the right chart below).

  • Higher oil prices. If oil prices increase to US$70 per barrel in 2019:Q4 (from the baseline assumption around $65 per barrel) and stay constant till 2023. The projected inflation path would be generally higher than baseline.

  • Lower growth in the United States. In the baseline, the model uses the IMF’s October 2019 WEO projection for U.S. growth. Under the alternative assumption that the growth in the U.S. would be slower than expected—with U.S. output levels in 2020–21 0.5 percentage points below baseline—the projected inflation path would be generally lower.


Relative Price of Food


Citation: IMF Staff Country Reports 2020, 037; 10.5089/9781513529158.002.A003

Source: IMF staff estimates and projections.

Inflation—Scenario with Higher Relative Food Price

(In percent)

Citation: IMF Staff Country Reports 2020, 037; 10.5089/9781513529158.002.A003

Source: IMF staff estimates and projections.

Inflation—Scenario with Oil Prices at US$70

(In percent)

Citation: IMF Staff Country Reports 2020, 037; 10.5089/9781513529158.002.A003

Source: IMF staff estimates and projections.

Inflation—Scenario with Slower growth in the U.S.

(In percent)

Citation: IMF Staff Country Reports 2020, 037; 10.5089/9781513529158.002.A003

Source: IMF staff estimates and projections.

Inflation Expectation in the Model versus Survey

Inflation expectation enters the model through the forward-looking Phillips curve. Because the FPAS model is essentially a rational expectation model, inflation expectation used in the model is “rational” in the sense that it is consistent with the model’s own forecasts.1/ Obviously, the model-consistent inflation expectation is not necessarily comparable with the survey-based inflation expectation, because the latter is usually highly adaptive. We report the model-consistent inflation expectation (annualized q/q and y/y) and the comparison with survey-based expectation in the two charts below.

  • Model-consistent inflation expectation (for next quarter and next year) rose sharply during 2017:Q4–2018:Q1 and started to decline in 2018:Q4. The dynamics are likely driven by the movements of oil prices and monetary policy.

  • Model-consistent inflation expectation is more comparable with business survey-based inflation expectation in the Philippines. There is a larger discrepancy between the expectation from the model and the consumer survey—which is likely driven by the adaptive nature of consumer survey.2/


Inflation Expectation of Next Quarter

(In percent)

Citation: IMF Staff Country Reports 2020, 037; 10.5089/9781513529158.002.A003

Sources: Haver Analytics; and IMF staff estimates.1/ The “Model Eased Expectation” refers to the model-projected annualized q/q inflation rates for the next quarter; the “Business Survey Index” refers to fraction of survey respondents enpecting higher inflation rates in the next quarter minus the traction expecting lower inflation rates.

Inflation Expectation; Next 12 Months 1/

(In percent per year)

Citation: IMF Staff Country Reports 2020, 037; 10.5089/9781513529158.002.A003

Sources: Haver Analytics; and IMF staff estimates.1/ The “Model Based Expectation” refers to the mode I-projected yoy inflation rates for the next 12 months.
1/ This is in comparison with some models with “adaptive” inflation expectations. In those models, the expected inflation rates used in the models’ Phillips curves are usually different from the inflation rates forecasted within the model.2/ There are three published survey-based inflation expectation series in the Philippines. The business survey conducted by the BSP asks the “inflation expectation of the next quarter.” It reports the difference between the fraction of respondents who think the inflation in the next quarter would rise vs. those who think inflation would decline. The consumer survey conducted by the BSP asks the “inflation expectation of the next 12 months.” The “Consensus Forecast” asks investment banks about their inflation forecasts. Because the inflation expectation in the consensus forecast is reported by calendar year (e.g., the respondent interviewed in September 2018 would be asked to report their inflation forecast for calendar year 2018 and 2019, instead of the inflation between September 2018 and September 2019), we only compare our model-consistent inflation expectation with the business survey and consumer survey.

Prepared by Si Guo (APD).


In the Philippines, nonresidents can invest in the T-bill market but are not allowed to have access to the BSP’s standing facilities. Thus, when there are capital inflows, the yields for the T-bills are usually lower than interbank rates that are largely influenced by the BSP’s standing facilities.


China is the biggest trading partner of the Philippines. The PPI inflation in China had been negative from early 2012 to late 2016.


The rationale for using transfers to contain inflation was that higher transfers to low-income families would reduce the need to increase minimum wage, which is determined in annual bargaining. A smaller increase in the minimum wage will result in less pressure on labor cost and inflation. The effectiveness of this measure remains to be evaluated, as higher transfers can also put upward pressure on inflation through increasing workers’ purchasing power.


The main changes to global conditions include the trade tension and the prospective of monetary loosening in other countries, especially the United States.


Rice price inflation reached its peak at 10.7 percent (y/y) in October 2018. The weight of rice is 9.6 percent in the CPI basket.


Higher excise taxes were implemented in January 2018 on tobacco and beverages (as well as oil products). Its (positive) contributions to inflation are largely captured in the contributions of food prices (light green bars). However, the separation between the impact of excise taxes and other food-related factors is not available because it would require the specification of separate Phillips curves for tobacco and beverage items.


It should be noted that the decomposition excise is model based, hence to some extent the results would depend on the specifications of the model.


This probably reflects that transportation and electricity suppers could adopt the “wait-and-see” approach to delay the pass through of previous (up to 2018:Q3) oil price increase.


As shown in the “Real Interest Rate” figure, the real interest rate as of 2019:Q2 was higher than neutral level.


The projections in this section were produced based on the information as of November 2019.


The average food inflation rates during 2002–2019:Q2 and 2010–2019:Q2 were 4.8 percent and 4.3 percent, respectively.


The model assumes a 4 percent nominal interest rate in the steady state (1 percent neutral real interest rate plus 3 percent inflation).


All scenarios assume that domestic interest rates will adjust following an assumed Taylor rule.

Philippines: Selected Issues
Author: International Monetary Fund. Asia and Pacific Dept