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Monetary Policy - Glossary and Abbreviations

Base Money (BM) – the sum of the reserve money (RM), reserve-eligible government securities,
liquidity reserves and reserve deficiency of banks. 1

Consumer Price Index (CPI) – represents the average price for a given period of a standard basket of
goods and services consumed by a typical Filipino family. This standard basket contains hundreds of
consumption items (such as food products, clothing, water and electricity) whose price movements are
monitored to determine the overall change in the CPI, or the level of inflation (See also Inflation Rate).

Demand-Pull Factors of Inflation – pressures on inflation caused by relatively 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. In addition, supply shocks in the economy
that, either increase the costs of raw materials or curtail supply or both could result in second-round
effects that, in turn, may lead to higher demand-side price pressures. Higher oil and agricultural
commodity prices, for instance, may eventually affect the price- and wage-setting behavior of economic
agents, which could then lead to second-round price pressures from the demand side.

Explanation Clauses - the predefined set of acceptable circumstances under which an inflation targeting
central bank may fail to achieve its inflation target. Such circumstances recognize the fact that there are
limits to the effectiveness of monetary policy and that deviations from the inflation target may
sometimes occur because of factors beyond the control of the central bank. Under the inflation
targeting framework of the BSP, these circumstances include price pressures arising from: (a) volatility in
the prices of agricultural products; (b) natural calamities or events that affect a major part of the
economy; (c) volatility in the prices of oil products; (d) significant government policy changes that
directly affect prices such as changes in the tax structure, incentives and subsidies.

Inflation Rate - the rate of change in the weighted average prices of goods and services typically
purchased by consumers. The weights of the goods and services are based on their corresponding share
to the Consumer Price Index (CPI) basket, i.e., the standard basket of goods and services purchased by a
typical household. In the Philippines, the composition of the CPI basket is determined from the Family
Income and Expenditure Survey (FIES) periodically conducted by the National Statistics Office (NSO).
Inflation is typically defined as the annual percentage change in the CPI. It indicates how fast or slow the
CPI increases or decreases.

 Headline Inflation – the rate of change in the weighted average prices of all goods and services
in the CPI basket.

 Core Inflation – An alternative measure of inflation that eliminates transitory effects on the CPI,
core inflation removes certain components of the CPI basket that are subject to volatile price
movements, such as food and energy, and other items affected by supply side factors, the price
changes from which are not within the control of monetary policy.

Official Definition - This refers to the rate of change in the CPI which excludes the following items/
commodity groups: rice, corn, fruits and vegetables, and fuel items (gas, liquefied petroleum gas (LPG),
kerosene, gasoline and diesel), which together represent 18.4 percent of the CPI basket. Core inflation
data for 2001-2002 are BSP estimates while the data starting January 2003 are the official National
Statistics Office (NSO) figures.

BSP’s Alternative Measures of Core Inflation:

o Net of Selected Volatile Items - This measure refers to the rate of change in the CPI
which excludes the following items/ commodity groups: educational services, fruits and
vegetables, personal services, rentals, recreational services, rice, and corn which
together represent 37.6 percent of the CPI basket.

o Trimmed Mean - represents the average inflation of the (weighted) middle 70 percent in
a lowest-to-highest ranking of year-on-year inflation rates for all CPI components.

o Weighted Median - represents the middle inflation (corresponding to a cumulative CPI


weight of 50 percent) in a lowest-to-highest ranking of year-on-year inflation
rates.

Inflation Expectations – the perceived rate of change, trends and movements of the prices of goods and
services in the economy. Measures of inflation expectations include survey-based consumer and
business expectations of inflation and inflation forecasts of private analysts, among others.

Inflation Target – level of inflation which the BSP aims to achieve over a given period under the inflation
targeting framework. The government’s inflation target is an annual target, currently expressed in terms
of a point target (with a tolerance interval of ± 1 percentage point) and is set jointly by the BSP and the
government through an inter-agency body, the Development Budget Coordination Committee (DBCC),
although the responsibility of, and accountability in, achieving the target rests primarily on the BSP.

Inflation Targeting (IT) – a framework for monetary policy that focuses mainly on achieving price
stability as the ultimate objective of monetary policy. The IT approach entails the announcement of an
explicit inflation target that the monetary authority promises to achieve over a policy horizon of two
years.

Interest Rates – the cost of borrowing money or the amount paid for lending money expressed as a
percentage of the principal.

Interest Rate Differential - the difference or margin between interest rates such as the difference
between domestic and foreign interest rates.

M1 or Narrow Money – consists of currency in circulation (or currency outside depository corporations)
and peso demand deposits.
M2 or Broad Money – consists of M1 plus peso savings and time deposits.

M3 or Broad Money Liabilities – consists of M2 plus peso deposit substitutes, such as promissory notes
and commercial papers (i.e., securities other than shares included in broad money).

M4 - consists of M3 plus transferable and other deposits in foreign currency.

Monetary Aggregate Targeting – an approach to monetary policy whereby the central bank adjusts its
monetary policy instruments to control the level of monetary aggregates. This approach is based on the
assumption that there is a stable and predictable relationship between money on the one hand, and
output and inflation on the other hand. This means that the reaction of inflation to changes in money
supply is stable over time and is, therefore, predictable. The approach assumes that the monetary
authority is able to determine the level of money supply that is needed given the desired level of
inflation that is consistent with the economy's growth objective. In effect, the monetary authority
influences inflation indirectly by targeting the money supply.

Monetary Policy – measures or actions taken by the central bank to influence the general price level
and the level of liquidity in the economy. Monetary policy actions of the BSP are aimed at influencing
the timing, cost and availability of money and credit, as well as other financial factors, for the main
objective of stabilizing the price level.

o Expansionary Monetary Policy – monetary policy setting that intends to increase the
level of liquidity/money supply in the economy and which could also result in a
relatively higher inflation path for the economy. Examples are the lowering of policy
interest rates and the reduction in reserve requirements. Expansionary monetary policy
tends to encourage economic activity as more funds are made available for lending by
banks. This, in turn, increases aggregate demand which could eventually fuel inflation
pressures in the domestic economy.

o Contractionary Monetary Policy - monetary policy setting that intends to decrease the
level of liquidity/money supply in the economy and which could also result in a
relatively lower inflation path for the economy. Examples of this are increases in policy
interest rates and reserve requirements. Contractionary monetary policy tends to limit
economic activity as less funds are made available for lending by banks. This, in turn,
lowers aggregate demand which could eventually temper inflation pressures in the
domestic economy.

Liquidity reserves - refers to the option given to banks in complying with the reserve requirement,
whereby bonds deposited in the reserve deposit account (RDA) facility are considered as compliance
with the reserve requirement. 2

Monetary Policy Instruments –the various instruments used by the BSP to achieve the desired level of
money supply. These include (a) raising/reducing the BSP's policy interest rates; (b)
increasing/decreasing the reserve requirement; (c) encouraging/discouraging deposits in the special
deposit account (SDA) facility by banks and trust entities of BSP-supervised financial institutions; (d)
increasing/decreasing its rediscount rate on loans extended to banking institutions on a short-term basis
against eligible collaterals of banks’ borrowers; and (e) outright sales/purchases of the BSP’s holdings of
government securities. The BSP’s primary monetary policy instruments are the overnight reverse
repurchase (borrowing) rate and the overnight repurchase (lending) rate.

Moral Suasion – the influence which the central bank exercises to induce or convince banks to conduct
operations in a manner that would contribute to the attainment of monetary goals but not necessarily
support the profit-maximizing objectives of the banks.

Open Market Operations (OMO) – the sale or purchase of government securities by the BSP to
withdraw liquidity from or inject liquidity into the system.

Quasi-money – the sum of savings and time deposits

Rediscounting – a special refinancing facility of central banks wherein a financial institution borrows
money from the BSP using promissory notes and other loan papers of its borrowers as collateral

Repurchase (RP) Rate - the policy interest rate at which the BSP lends to banks with government
securities as collateral

Reserve Deposit Account (RDA) – The reserve deposit account (RDA) is a deposit facility with the BSP
designed to facilitate the adoption of the change in the banks’ mode of compliance with the liquidity
reserve requirement, pursuant to Circular No. 539 which became effective on 25 August 2006. The
liquidity reserve requirement consisted of market-yielding government securities purchased directly
from the BSP. The RDA, which eventually replaced government securities as a form of compliance with
the liquidity reserves, allows banks to keep a portion of their reserves in the form of a three-month term
deposit in the RDA maintained with the BSP. The Treasury Department also has the option of offering
RDA with 6-and 12-month tenors, with interest rate at one-half percent (1/2%) below the prevailing
market rate for comparable government securities. Pre-termination of RDAs is allowed, subject to a
reduction in applicable interest rates, as prescribed by the Treasury Department.

Reserve Money (RM) – the sum of currency in circulation and reserves of banks which include cash in
banks’ vault and reserve balances or deposits with the BSP including banks’ balances under the reserve
deposit account (RDA).

Reserve Requirement – refers to the proportion of banks’ deposits and deposit substitute liabilities that
banks are required to hold as reserves

Regular (statutory) reserves - pertain to the proportion of deposits and deposit substitute liabilities,
which must be held as deposits with the BSP in part, with the remaining balance allowed to be kept in
banks' vaults as cash or as reserve-eligible government securities

Regular Reserves – the proportion of deposits and deposit substitute liabilities, a certain fixed portion of
which must be held as deposits with the BSP, with the balance kept in banks’ vaults as cash or eligible
reserves.
Reverse Repurchase (RRP) Rate – the policy interest rate at which the BSP borrows from banks with
government securities as collateral.

Special Deposit Accounts – Fixed-term deposits by banks and trust entities of BSP-supervised financial
institutions with the BSP. These deposits were introduced in November 1998 to expand the BSP's toolkit
for liquidity management. In April 2007, the BSP expanded the access to the SDA facility to allow trust
entities of financial institutions under BSP supervision to deposit in the facility.

Supply Shocks to Inflation – pressures on inflation resulting from shortages in supply and increases in
the cost of production without a corresponding expansion in output. Examples of these are bad
weather, natural calamities and disasters; wage increases not matched by higher productivity of labor;
hikes in international oil prices; increases in prices of imported raw materials; and hikes in rental rates.
These tend to limit or decrease supply, and, assuming no decline in demand for goods and services, push
prices up. (Conversely, an oversupply of commodities tends to induce the opposite effect on prices.)

Transmission Mechanism of Monetary Policy – process by which monetary policy actions affect
economic and financial variables. This mechanism describes the various channels, as well as the length
of time, through which monetary policy actions affect the real economy, particularly inflation and
output.

Treasury Bill Rate – the yield on short-term debt instruments issued by the National Government (NG)
(the primary market) for the purpose of generating funds. Treasury bills come in maturities of 91, 182
and 364 day

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1
Liquidity reserves now take the form of deposits with RDA, which in turn is already counted as part of
Reserve Money.
2
Originally, these consisted of market-yielding GS purchased directly from the BSP under Circular No. 10
dated 29 December 1993.

 Open market operations – The conduct of open market operations refers to the purchase or
sale of government securities by the Bank to the banking and non-banking public for liquidity
management purposes. When the Bank sells securities, it reduces domestic banks’ reserves
(monetary base), and when it buys securities, it increases banks’ reserves.
Open Market Operations
Policy Rate Setting

The Bangko Sentral ng Pilipinas (BSP) formally adopted inflation targeting as the framework
for monetary policy in January 2002. This policy move is aimed at providing the BSP with a
more focused and forward-looking approach in the pursuit of its primary mandate, which is to
ensure price stability. Two intrinsic features of the approach—transparency and accountability
in monetary policy—is expected to enhance the credibility of the BSP in helping create a
stable macroeconomic environment in which vital economic reforms to raise the growth
potentials of the economy can continue.

This approach involves the announcement of an explicit inflation target that the BSP promises
to achieve over a given time period. The target inflation rate is set and announced jointly by
the BSP and the government through an inter-agency body. Although the responsibility of
achieving the target rests primarily with the BSP, this joint announcement reflects active
government participation in achieving the goal of price stability and government ownership of
the inflation target.

In the Philippines, the interest rates applied on the overnight RP/RRP signals the stance of
BSP’s monetary policy. The BSP created an Advisory Committee which deliberates, discusses
and recommends to the Monetary Board the appropriate monetary policy stance that will
enable the BSP to achieve the desired inflation target. The Advisory Committee meets every
six weeks and in between regular meetings, whenever it is deemed necessary.

Policy Instruments

The BSP implements monetary policy using various instruments to influence the level of
liquidity in the market and thereby steer inflation towards thetarget level. These instruments
can be classified into two types:

 Direct instruments enable the BSP to control directly certain items in banks’ balance
sheets which may be in the form of financial prices or quantities. Direct instruments
have a strong coercive element as in the case of reserve requirements and directed
lending requirements.

 Indirect instruments work through the market to influence the behavior of financial
institutions, usually through the pricing of central bank facilities. Indirect instruments
include adjustments in short-term policy interest rates and the conduct of open market
operations (OMO).

Mechanics of OMO

OMO is a monetary tool which involves the BSP publicly buying or selling government
securities from banks and financial institutions in order to expand or contract the supply of
money. By controlling the money supply, the BSP is able to exert some influence on the prices
of goods and services and achieve its inflation objectives.

When the BSP buys securities, it pays for them by directly crediting its counterparty’s Demand
Deposit Account that is being maintained with the BSP. Effectively, the transaction increases
the buyer’s level of reserves and on an aggregate level, expands the system’s money supply.
Conversely, when the BSP sells the securities, the buyer’s payment (via direct debit against
the buyer’s Demand Deposit Account with the BSP) reduces his reserve account causing
money supply to contract.

In conducting OMO, the BSP uses two instruments: (1) repurchase (repo)/reverse repurchase
(reverse repo) agreements and (2) outright purchases and sales of securities.

 Repurchase (repo) / reverse repurchase (reverse repo) agreements. The BSP


purchases government securities from a bank with a commitment to sell it back at a
specified future date at a predetermined rate. In effect, a repo transaction expands the
level of money supply as it increases the bank’s level of reserves. Under a reverse
repo, the BSP acts as the seller of government securities, thus, the bank’s payment
reduces its reserve account resulting in a contraction in the system’s money supply.
For both repos, the BSP can only affect the level of money supply temporarily, given
that the parties involved commit to reverse the transaction at an agreed future date. At
present, the BSP enters into repo agreements for a minimum of one (1) day (overnight)
for both repos and a maximum of 91 days and 364 days for repo and reverse repo
agreements, respectively.

 Outright purchases and sales of securities. An outright contract involves direct


purchase/sale of government security by the BSP from/to the market for the purpose of
increasing/decreasing money supply on a more permanent basis. In such a
transaction, the parties do not commit to reverse the transaction in the future, creating
a more permanent effect on the banking system’s level of money supply.

The BSP may also use other monetary policy tools such as reserve requirements and
rediscounting to expand or contract money supply. The BSP may also grant loans and
advances to banking institutions to influence the volume of credit consistent with the objective
of price stability. In addition, the BSP can employ moral suasion as a last resort when existing
market mechanisms cannot adequately and promptly ensure the attainment of specific
monetary objectives.

Advantages of Open Market Operations

However, among the tools available to the BSP, OMO offers advantages and continues to be
the most practical tool for the following reasons:

 First, it works within the BSP’s initiative and control. Having the authority to steer
market interest rates, the BSP can influence money supply by changing the monetary
policy rates. Consequently, OMO gives the BSP greater flexibility in terms of the
amount and timing of intervention.
 Secondly, it is fast to implement and gives quick results. Any change in the policy rates
is readily implemented, i.e., on the same day that the Monetary Board makes the
resolution. Thus, any effect on the market is evident right after the overnight trading for
the day.

Call Loans and the Interbank Call Loan Market

Call money are amounts traded in the interbank call loan market that correspond to the excess
or deficiency of each bank in terms of reserves. These can be overnight placements.

IBCL transactions among banks are done primarily to correct reserve requirements. The
reserve position of each bank or quasi-bank is calculated daily on the basis of the amount of
the institution’s reserves at the close of business for the day and the amount of its liability
accounts against which reserves are required to be maintained. The reserve positions of
banks are normally known after the check clearing results have been transmitted. As the
check clearing results are known only by late afternoon, interbank call loans are currently done
from 4:45 PM to 5:30 PM.

The interbank market can either be securitized (collateralized) or unsecuritized (clean)


lendings/borrowings, as well as repurchase agreements. Repurchase Agreements (RPs) are
generally short-term sale of government securities with an agreement to repurchase on the
agreed maturity date. Repurchase agreements are extensively used as a means of short-term
financing by government securities dealers and by banks.

Banks establish credit lines with its counterparties for these transactions.

Managing Risks in OMO Transactions

A valuation scheme for securities used in repos is adopted by the BSP to help manage the
credit risk inherent in OMO transactions. Eligible securities are valued based on their current
market yields as well as the applicable cut based on remaining life of securities involved.

To avoid exposing the BSP to undue risks arising from purchases of securities, Section 91,
Article V of RA 7653 (The New Central Bank Act) sets the type of securities that can be bought
or sold by the BSP for its own domestic portfolio, as follows:

 Evidences of indebtedness issued directly by the Government of the Philippines or by


its political subdivisions; and

 Evidences of indebtedness issued by government instrumentalities and fully


guaranteed by the Government.

Section 92 of the same article also provides the BSP with effective instruments for OMO, that
is, it may, subject to such rules and regulations as the Monetary Board may prescribe and in
accordance with the principles stated in Section 90, issue, place, buy and sell freely negotiable
evidences of indebtedness of the BSP, provided that such issuance shall be made only in
cases of extraordinary movement in price levels. Said evidences of indebtedness may be
issued directly against the international reserves of the BSP or against securities, which it has
acquired under the provisions of Section 91 or may be issued without relation to specific types
of assets of the BSP.