When interest rates are high, the cost of doing business will be high. This will force business to charge more for their products.
When there is inflation, the BSP responds by raising interest rates to lower it.
However, high interest rates may also have its own unintended negative effect when inflation is cost-push and not demand-pull.
I maintained that the current high inflation is cost-push in origin because the effect of the new and higher excise tax in the increase collection of the government is more than that what the government forego from the increase in income tax exemption and reduction in marginal income tax rates under the new train law.
The government reported that in October the inflation rate was recorded at 6.7 percent.
This is way beyond the 2 to 4 percent original inflation target for the year.
When inflation is high, the BSP usually responds by raising the interest rate for overnight funds borrowed from or deposited by commercial banks at the BSP.
Banks borrow overnight from the BSP when they are short of reserves, the fraction of their total deposits that they must keep in reserve daily as required by the BSP.
When the overnight rate goes up, banks also increase the interest rates they charge to their borrowers, mostly, businesses.
Businesses borrow money from banks to augment their provisions for operating capital and investment requirements.
The interest rate charged becomes part of the cost of doing business.
When interest rates are high, the cost of doing business will be high.
This will force business to charge more in prices for what their products.
However, the main effect of high interest rates is to curtail investments that form part of aggregate demand for goods and services in the economy.
The others being household final consumption, government expenditures, and net exports.
When new investments are down because of high interest rates, the aggregate demand of the economy will also go down.
Hence, lower inflation rate, depending on the condition of the aggregate supply or the supply of goods and services.
That is, whether aggregate supply is also rising or falling, and at what rate compared with the rising or falling aggregate demand.
Republic Act 7653 mandates the BSP to promote price stability conducive to a balanced and sustainable growth of the economy.
It does this by setting an inflation rate target that it believes is just right given the condition of the economy.
To achieve the inflation target, the BSP uses a number of monetary policy instruments.
Right now, the reverse repurchase (RRP) or overnight borrowing and lending rate is the primary monetary policy instrument of the BSP.
This rate, also called the BSP policy rate, was 3.0 percent at the start of the year.
Since then, the BSP has increased the policy rate four times until it reached 4.5 percent in September in response to the observed rising inflation rate this year.
Yesterday it increased the rate again by 25 basis points to 4.75 percent.
With the inflation remaining the same at 6.7 percent in October as in September and the GDP growth rate slowing to 6.1 percent in the third quarter, from 6.6 percent in the first quarter and 6.2 percent in the second quarter, is this a good move?
Not if the additional increase in interest rate will only make business more costly to do, which decreases aggregate supply, and discourage investments, which also decreases aggregate demand.
A decrease in aggregate supply increases prices and a decrease in aggregate demand lower prices.
Thus, they cancel each other of equal force.
Both, however, tend to decrease the total production of the economy or GDP.
What a way to solve inflation!