Raising interest rates is counterproductive

As of last month (April), the country’s inflation rate has gone up to 4.5 percent from only 3.2 percent in the same month last year and 4.3 percent in the previous month (March). This is the highest rate since November 2011.

Inflation rate measures the average increase in prices in a basket of goods and services commonly purchased by households. In our basket, the items that surpassed the overall 4.5 increase in prices were alcoholic beverages and tobaccos (20.0%), followed by food and non-alcoholic beverages (5.9%), and transportation (4.9%).

The rest had lower price increases than the overall inflation rate. These are restaurant and miscellaneous goods and services (3.4%), housing, water, electricity, gas, and other fuels (3.0%), furnishing, home equipment, and routine maintenance (2.8%), health (2.8%), clothing and footwear (2.2%), education (1.8%), recreation and culture (1.5%), and communication (0.3%).

The latest inflation rate is the second month in a row to breach the 2 to 4 percent government inflation target. This forced the BSP Monetary Board to raise the interest rate on its overnight reverse repurchase (RRP) facility by 25 basis points, from 3.0 percent to 3.25 percent. The interest rates on the overnight lending and deposit facilities were also raised accordingly.

It is the first rate hike since September 2014.

Another hike might be expected soon as prices are still seen to rise further because of the recent uptick in the price of oil. Higher BSP interest rates implies much higher lending rates in the rest of the banking system.

The Monetary Board says that the balance of risks to the inflation outlook continues to lean toward the upside, with price pressures emanating from possible adjustments in transport fares, utility rates, and wages.

It thus believes that the increase in interest rate will help arrest potential second-round effects by tempering the buildup in inflation expectations.

Now the effect of the new consumption taxes imposed under the Train Act is to raise the unit cost of the affected firms.

This also raises their marginal costs, which is equivalent to the shifting of their supply curves upward to the left. With the demand curve being downward sloping for firms that has the market characteristic of an oligopoly, the final result of the Train Act is to raise the prices and lower the output of the affected firms.

Now what the BSP is doing when it raised the interest rates that cut down consumption and investment demand, is to shift the aggregate demand curve downward to the left.

The result is lower prices but it also comes with further cut in output not only in the products covered by the Train Act but also for many other products and services as well.

The point I want to make is that while fighting cost-push inflation by pulling down aggregate demand through higher interest rate may indeed slowdown the inflation rate, this also leads to further lowering of output.

In pushing for the contraction in demand by way of higher interest rate, therefore, we must be prepared also for slower economic growth and higher unemployment rate to come.

It is counterproductive, in short.