Determinants of Inflation Expectations in the Philippines AUTHORS Vanessa T. Espafio ‘Vanessa Espa event serves as Bark ier atthe Department of Economie Research (DER) of the BSP. She is presently assigned atthe Monetary Poly Research Group ofthe DER, were she is involved in tho preparation of studies on hoy issues relating to ilaton targenng and raretary poly feimulation and analysis. She holds an MS In Economies, Sanking, and France (th distinction) tm the Unversiy of Glasgow, Unites Kingsom, and an MA Eeonomes and BS in Earomies (eum laude) fom the Unversity of the Pippin (Giiman), Ma, Ail Camille C. Santillan va, zi Camille C. Santitan is Bank Officer IV atthe Department of Eeonamc Research (DER) ofthe BSP. Spe s presently assignes atthe Monetary Poi Research Group (MPR) of the DER, Her work responabities In NPRG are prmany centered on research ang preparation of stusies and analses on key issues relating to monetary poley stateples fad operations. Prior to ining the BSP in 2015, she was a poly research assistant at Health Poly Development Program, a USAID funded project granted tothe UFECon ouncaton, In, wherein she worked itn various Professore at the UP Senoo| of Eoonemics {as well as experts inthe elds of medicine, heath poly, and public heath. She obtained her BS Applied Eonomies and RB Poitial Scence degrees fom St. Scholastics College ‘nd sho hel a Master of Arts egroe in Eeonamics from the Univers ofthe Philippines.angio Sena) Revow 2038 8 Introduction Prior to the adoption of inflation targeting as a framework, the Philippines. experienced high and volatile inflation for almost a decade as a result of several episodes of supply shocks. For instance, the power crisis in the early 1990s from the non-utilization of the Bataan Nuclear Power Plant and the abolition of the Department of Energy by the Aquino regime, led to a significant rise in electricity costs (Patalinghug, 2003). As a result, headline inflation hit double-digit rates from January to December 1994. Similarly, the rice crisis in 1995, which produced long queues of people hoping to buy rice at government-subsidized prices, was a result of the government's erroneous rice importation plans (Sabangan, 2008). As a consequence, headline inflation was reported at around 8 to 9 percent in 1995 and 1996. Meanwhile, the 1997- 1998 El Nifio phenomenon created a huge dent on agricultural output, particularly on rice and corn production (Rincdn & Virtucio, 2008). This led to headline inflation breaching the 10-percent mark in the second half of 1998. Likewise, volatile global oil prices and the depreciating Philippine peso against the US dollar in 2000 led to another episode of persistent commodity price hikes. During this period, the Philippines was implementing monetary aggregate targeting as an approach to monetary policy. The assumption behind this approach is that there is, a stable and predictable relationship between money, output, and inflation. And given, the assumption that velocity of money* remains stable over time, changes in money Supply are then directly related to inflation. However, introduction of new products and changes in the financial system appeared to have weakened the relationship between money supply and inflation. This compelled monetary authorities to review their approach to monetary policy. The inflation targeting framework gained much interest among industrialized economies? in the 1990s (Bernanke & Mishkin, 1997). This approach to the conduct of monetary policy entails the announcement of an inflation target at a specified level or range that the central bank authorities will strive to achieve within a given period of time. The adoption of inflation targeting as a framework is assumed to be consistent with the primary goal of achieving price stability and maintaining the credibility of central banks in ensuring that inflation is kept within the target over the policy horizon, |The rate at wnien money ie exchanged from one transaction to another, and how mh a uni of eurency Is sed ina gven period ot time the Unted Kingdom, New Zealand, Sweden, Atala Finland, Spin,With the aim of keeping inflation low and stable, the Philippines formally adopted the inflation targeting framework in 2002.* Under this framework, the BSP announces an Inflation target that it promises to achieve within a time period. Because the BSP covers, 2 two-year policy horizon, a forward-looking approach in assessing inflation was used to ensure that monetary policy decisions, i.e., adjusting the BSP’s key policy interest rate, are appropriate. ‘Anumber of authors have identified inflation expectations as an important indicator in inflation dynamics (Mankiw, Reis, and Wolfers, 2003; Kirchner, Giucci, Suchok, Kuziakiy, ‘and Movchan, 2008). This paper aims to provide a comprehensive assessment of the determinants of private sector inflation expectations in the Philippines since the Inflation targeting framework was introduced in 2002 by taking into consideration the roles of backwarc:-looking and forward-looking components, as well as monetary, fiscal and supply-side factors. The rest of the paper is structured as follows. In Section II, we discuss the literature Con the various determinants of the formation of private sector economists’ Inflation expectations in emerging market economies; in Section Ill, we describe the data and the econometric methodologies used; in Section IV, we present empirical results and analyses; Section V provides robustness checks; and Section VI concludes. Review of Related Literature Under the inflation targeting framework, the inflation expectations channel has taken on a crucial role in the effective transmission of monetary policy decisions. Thus, itis Inthe interest of the central bank to make sure that the long-term inflation expectations of those who participate in the wage- and price-setting process are aligned with its, Inflation objective (Bernanke et al., 2001). Studies investigating the formation of inflation expectations in emerging market, economies largely emphasize the roles of inflation persistence, credibility of monetary and fiscal policies, and supply-side factors. For instance, Patra & Ray (2010) use a new Keynesian Philips curve framework incorporating the roles of past inflation, output ap, growth in real government expenditure, exogenous supply shocks, marginal costs, and the stance of monetary and fiscal policies to assess the determinants of inflation expectations in india. Their estimation results reveal that the main drivers of inflation expectations are the following: lagged inflation (comprising around 50 percent of the Variation in inflation expectations), changes in the prices of fuel and food (accounting for 40 percent of expected inflation), and output gap (explaining around 14 percent of future inflation). These findings indicate a high degree of inflation inertia and the vital impact of supply factors and excess demand conditions in the formation of inflation expectations. In addition, they also find a negative and significant relationship between the real interest rate, which represents the monetary policy stance, and inflation expectations, which means that an increase in interest rates results in a reduction in inflation expectations. This indicates that a credible monetary policy helps anchor inflation expectations. Similarly, Cerisola & Gelos (2005) examine the macroeconomic determinants of expected Inflation In Brazil over the period 2000 to 2004, Employing a reduced-form inflation expectations model which accounts for past and future inflation as well as monetary and fiscal policies, real marginal costs of production, and supply-side factors, they present 3 Ih 2000, the BSP approved in rnp iiaton targeting as the new framework fr the conduct of ‘monetary policy. Tn framework was frmally adopted in 2002 withthe primary ebjectve of achieving price stably 02 nono ens osieg aangio Sena Review 2038 2 statistical evidence that the adoption of the inflation targeting framework (whose impact, ranges from 0.66 percentage point (ppt) to almost 1.0 ppt) as well as fiscal policy (1.0, ppt) mainly contributed to the anchoring of inflation expectations. Moreover, their findings also suggest that a negative (albeit insignificant) relationship exists between the real policy rate and inflation expectations. They also find the lags of real effective exchange rate and wage gaps to be significantly influential in determining inflation expectations. In Brazil, However, they show a comparatively low contribution of inflation inertia in shaping inflation expectations at around 0.18 to 0.29 ppt. Their findings confirm the earlier assessment by Minella etal. (2003) who provide evidence that a credible inflation target played a eritical role in contributing to macroeconomic stability via the anchoring of inflation expectations and reduction of the degree of inflation persistence in Brazil. Consistent with the results found in emerging market economies, Gurkaynak et al (2008) also report that a credible monetary policy, i.e, announced inflation target and published central bank inflation forecasts, anchors private sector economists’ inflation expectations. Hattori et al. (2016) and Hubert (201) likewise show that the publication of inflation forecasts of central banks significantly influences the formation of inflation expectations by private sector economists. Hubert (2015) argues that this may be due to three hypotheses: “central bank forecasts [1] are more accurate than private ones; [2] are based on different information sets; and/or[3] convey signals about future policy decisions and policymakers’ preferences and objectives." Data and Methodology This study's methodology is largely based on the inflation expectations model by Cerisola & Gelos (2005), which incorporates both backward-looking and forward-looking factors, as well as measures of monetary, fiscal, and supply-side factors. For robustness of estimation results, we employ two econometric methods, namely, Ordinary Least Squares (OLS) and General Method of Moments (GMM) to address potential endogeneity of regressors in the OLS regressions. In our inflation expectations models, the lagged value of actual inflation represents the backward-looking component while the inflation target and the BSP’s one-year ahead Inflation forecasts comprise the forward-looking variables. The inflation target is publicly announced by the National Government (NG) and is fixed over the policy horizon (ie., current and one-year ahead). Meanwhile, the BSP's inflation forecasts change more frequently, coinciding with the monetary policy cycle (Le. occurs every sixto elght weeks) To measure monetary policy credibility, we use the real policy rate which is defined as the weighted monetary operations rate (WMOR} adjusted for inflation. As a proxy for real marginal costs, we use the deviation of the real effective exchange rate from its trend value, which is estimated using the Hodrick Prescott filter. The roles of fiscal policy stance as well as supply-side developments are likewise accounted for by introducing fiscal balance as a percentage of GDP and the rate of change in international prices of crude oll, respectively, We also include a lagged term for private sector inflation expectations to control for persistence, The inflation expectations models (equations 4 to 4) are presented below. Equations 1 and 3 are estimated using the OLS approach while equations 2 and 4 are estimated sing GMM. The main difference between equations 1-2 and equations 3-4 is in terms of the measure used in capturing the forward-looking aspect of monetary policy. The first two equations make use of the National Government's publicly-announced inflation target which is fixed over the policy horizon (e.g., one to two years), while the last twoequations employ the BSP's official one-year ahead inflation forecasts, which change ‘more frequently and coincide with the monetary policy cycle (Le., occurs every six to eight weeks) =c+B, Os) *Pi Ec) Blt BP ONY, reer, ol, fscalrdunmyu,e4 (OLS Eg CB, Oy PP) Bl gd) BPO, rr cit, focal dammyy, 4 QYGMM 7B, gs) PB) "Bsa “BeP OMB peer*B, O1-B, fiscal donmu, 64 SJOLS Hag" gi) Pica “B ad Ba BOC gg B,C, eB, fcal-aunmy ty, 644)GMM. ~ tyep!8 096 YF ahead ination expectations from the Consensus Eeonomies (CE) survey, The CE survey iy survey of private sector economists inflation forecasts covering a two year horzon (current quarter mean ifationfoocast (eg, March June, September, Year and one-year ahead). We use th = Mera 148 GURrery,yearonsyear headin ination Ingaed by 4 auarers. = Trarga 5 ation target. — BSP, gq'% OSP's oficial one year hon ination forecast ‘BSP ggg 8 BSP’ official one year ahead ination Forecast rate, computes as WMOR minus inflaton. The WMOR refers to the weighted Interest 7188 or ne BSP's quit facies e.g, RRP, venight Deposit Facil, and Term Depost Fact) rears the deviation ofthe rea) effective exchange rate from its trend, lagged by one quarter. & postive ap corresponds to an appreciation wile anogative gap corresponds o a deprecation, ~ oils global ol lation rate, lagged by one quarter, proxies by Dubai al prices. = fiseal's 328 balance a8 a percentage of GOP, lagged by one quarter. A positive ratio denotes 9 surplus wile-a negative rato signifies a dete. dummy varale whieh kes on the value 01 cunng perods when actual infatin s above target, and = y's the enor orm, Empirical Results and Analysis Overall, the infiation expectations models generate consistent and robust results (Table 1). In all four equations, the most important determinants of inflation are the measures, of forward-looking anchor of monetary policy (.e., the NG's announced inflation target, ‘and BSP’s one year ahead inflation forecasts) and lagged inflation. In particular, in GMM estimation results in equations 2 and 4, every 1-ppt increase in the inflation target (BSP. ‘one-year ahead inflation forecast) leads to a corresponding rise in inflation expectations, of around 0.30 ppt (0.26 pat). Likewise, the backward looking or inertial component of the models, which refers to the persistence of inflation, also has a positive and significant effect on the formation of Inflation expectations. In particular, every 1-ppt increase in the lagged value of inflation leads to a corresponding uptick of 0.11 to 0.12 ppt (GMM results, equations 2 and 4) in private sector inflation expectations. This result is significantly lower compared to the 0.50-ppt impact of past inflation on inflation expectations in other emerging market economies (Patra & Ray, 2010). Estimation results using GMM also suggest that the current monetary policy stance, Which Is represented by the real policy rate, i.e., WMOR adjusted for inflation, is a significant factor in the formation of private sector inflation expectations, as an upward adjustment in current real policy interest rate tends to lower one-year ahead inflation expectations. That is, every J-ppt increase in the real policy rate results in a decline of about 0.04 ppt to 0.09 ppt (GMM results, equations 2 and 4) in inflation expectations. The coefficient obtained is relatively low which could be an indication of the length of time it takes for monetary policy actions to work their way through the expectations channel. To provide further support for this finding, we test for the validity of the Imposition of a restriction on the coefficients of nominal policy rate and inflation, as represented by 02 nono ens osieg aSareio Sentra) Revew 2018 8 equations 1, 2, 3, and 4, From the equations using unrestricted coefficients, namely: By nyo) Bs Basse) *Bs og) PsP OC gg “B, reer Boi, fiscal +a, eq Ql) OLS. B, ag) "Bs Base) *Bs ag) Bs POH ng “B, reer Bol, focal +4, 4 Ql) GMM = €5B, in) *Bo Cause) Bs pad “By POS Breer oils, fiscal ~u, eq QA) OLS Bi co) Bo ana) “Bs peal “Bs POU ag “Ptr B 01°B, fiscal “4, 64 (4.1) GMM. we impose a restriction on the coefficients Of aceyat AU Polleyggm Such that By = Bp, To determine whether the unrestricted models have signficanty greater predictive power over the restricted ones, we conduct the Wald Test for coefficient restrictions which gives the Fstatistc The resuts are presented in Table 2. Since the pvalues of the Fstatstc for equations 41.1 and 2.1 far exceed the 1 5, and 10 percent levels of significance, we fll to reject the null hypothesis that By = Ba. This implies that the predictive powers of the unrestricted ‘models are not statistically greater than those ofthe restricted ones, thus, the restriction we imposed holds. Similarly, for equation 3.4 we fal to reject the null rypothesis that Bg = Bp at the 5 and 10 percent levels of significance. This provides further evidence that the real policy rate, as used in the restricted equations, is significant in driving inflation expectations. However, for equation 4.2, we reject the null hypothesis that By = Bz at the 5 and 10 percent levels of significance. This indicates that the predictive powers ofthe unrestricted models are significantly higher compared to those of the restricted ones. Thus, the restriction we imposed does not hold. This implies that in the formation of private sector inflation expectations, current nominal policy rate does not matter and that inflation expectations are largely backward:-looking in nature. This finding can be explained by the possibility of a reverse causation wherein high inflation causes a higher policy rate. Hence, the mixed results for the use of the policy rate (real versus nominal) indicate that, in this study, we cannot make a definitive conclusion regarding Its significance in the formation of inflation expectations. Thus, further research on this issue is needed. Estimation results for one-year ahead inflation expectations 0.4505) | oasis) | (0.257% (03756) | osrsa) | (0.2008) | 1.7368) ie.a5aa) | (02400) | 1.1258) | (ox09 | 100 [ oroen | (070 | (00796) aosaees | oapeaes | Oana [Oawarrs [oazaares[oazaeee] Oaaiar | OADGIT woara; | woais | woz | wozen | woaen | woe | worn | ois (0254) wos | 0.0935), ros90; | yosan | owes) | (0.0508)ey, 0.0528 2.0346 0.006 (0.0389), (0.0390), (0.0390) o.0353), a Boose [00070 ‘cota | eae | onisa | oncee | o0oa7 (o.0:08) | (o.0136) jo.0083) | o0140) | o.0139) | jo.008s) | 0088) e020 | vocoae | woo1m | (o.c0ra | wos | oor | oor | oot ical ‘ora oo | oor | cont | anise | oone [ooze | omiss wore [roots | eoren | worse | oorso [ooren | oosn | (00107 voor | 102228 | (0.2349) [oasiny | 10.1759) + significant at 90% conidence interval ‘+ Significant at 95% conisence interval += Signfieant at 99% confgonce interval Ia. Vales in parentneses represent standard errors based on Newey. West HAC stancard eros. Inthe CGM approach, thelnstruments used ae as follows: lag 1 of fiscal balance, lags +4 actual nao, ea, nominal pole rate oil, rer, ad ition expectations. Eavations 1 ana? (which useinfation age are estimated eer tne period 2002°01-2018:02; equalons 3 and 4 (wich uso BSP inflation forecast are {estimated from 2005:022028:02. The dummy varabe represents periods when inflaton Is above target. Tabie2 Wald Test for Coefficient Restrictions Fatatste | Pvawe_] za6s1 | 02472] 0.0301 | 0.8630 | 4.0046 | _00514_| esrsa | oo1a7_| Meanwhile, with respect to the proxy for the fiscal policy stance, as expected, an Increase in fiscal balance as a share of GDP (denoting a surplus) results in a reduction In inflation expectations. If the government's commitment to fiscal sustainability over the near- to medium-term is credible, then this should lead to 2 lowering of inflation expectations. In the GMM estimation in which the fiscal balance coefficient is significant (equation 4}, every 1-ppt increase in the fiscal balance leads to a 0.02 ppt (equation 4) decline in inflation expectations. This result is particularly important as this implies the credibility of the NG's fiscal policy stance, which is given more importance during episodes of high public indebtedness, so that inflation expectations remain anchored around the inflation target. The Issue of fiscal sustainability is particularly relevant under the current government's “Build, Build, Build” Program which aims to accelerate Infrastructure spending and industry development to yield a sustainable broad-based growth across the country. A prudent management of the country’s fiscal resources. should help anchor inflation expectations going forward. Similarly, supply-side factors, which are proxied by the year-on-year growth in Dubal crude oil prices, are also significant inputs in the formation of private sector economists’ one-year ahead inflation expectations. A 1:ppt rise in Dubai crude oil inflation leads to a corresponding 0.004- to 0.006-ppt increase in private sector inflation expectationsangio Sena Review 2038 a (equations 2 and 4). This particular finding is rather intuitive as the Philippines is a ret oil importer, implying that sustained increases in the global prices of oll eventually translate into higher domestic petroleum prices. Thus, supply-driven factors, such as shocks to international prices of oll, play a crucial role in Philippine inflation dynamics. as these could give rise to potential “second-round effects” in the form of increased petitions for jeepney fare hikes, and ultimately lead to higher inflation expectations. In terms of the measure of marginal cost of production, the coefficient of the deviation of the REER from its trend is expected to be negative. In the Philippines, almost all manufactured products which are either for domestic and export purposes contain a certain amount of imported component. Therefore, a positive REER gap, representing an appreciation of the foreign exchange rate, could reduce a firm's marginal cost and, Via the pass-through effect from exchange rate to inflation, should lead to a lowering of inflation expectations. However, although the sign is negative as expected in equations. 4 and 2, the coefficient is not significant. Finally, we include a dummy variable which takes on the value of 1 in periods when actual inflation is above the inflation target and O otherwise, and the coefficients turn out to be significant: Robustness Checks We test the sensitivity of our benchmark regression results against the use of an alternative measure of real policy rate (RRP minus inflation). Estimation results show generally robust results (Table 2). All the significant variables in the previous section retain their significance, The main difference is that while the coefficient of the real RRP rate retains its significance in equations using the inflation target as a forward-looking ‘monetary policy anchor, it tums insignificant in equations using the BSP inflation forecast. Tobie? Estimation results using real RRP le ‘ioeiors [aavos™ |aseeaen [Lvisuee [2am 7 sears sean] ls (oata _|osa77* | ozgaaes loazniees | o25a6™ [oz362e> [o.zen6s oz01a| 1656) [02481 |e.09e8) —[oto2s) faze _|es26n [oor —[o0s7s joazs4) (02886) [oo9Ts) [oanra [policy,., [aurea Soar 00266 4 Woalco tests the signieance of including a dummy valle to represent periods when actual ition Is bolow the inlauon target ut the cootilenss were not signieart[wstios ls aks a Jeers) 00012 | 0.0050 ‘20089 [oats |acora joaos? _acoss joois) |oo.zn [ooors [wcrc [eos [o.009s) |o.c092) loin (0.0086 |ooosarse (9.0057+* [o0088e=> [ooc75»¥= jxoasr#=[ocosses| {wxorn |eooan jweooxn [overs feos |eoczz foot (000s ical) [oie 00138 [eoie 0007 oatsa [eaira[aazss [ootar= (0086) [oor jor oos2s) fooisny ioosas) fo.0088) 0.0086) [dummy (068365 oggsie» | ogsz5e== [raaaseee [1959 [oas08 | osza7~ [oaieze (ws99 |o22as) 0366) [2034 foxrsny io6s6) —fo.625) (0665) le? joao loassi oasis loser oss? josie” josiak _josonr [iajusted R085 Jomo josooo _|ovrea_Josois jogo1s [ooo [0.9975 + Signcant at 90% confidence interval ‘+ Significant at 95% conigence interval see Significant at 99% confidence terval IB. Values in parentheses represent standard errors based on Newey: West HAC standard eros. Inthe GMM aporoaeh, the instruments used are a8 fallow lag tof fsea balance, lage 14 of actual nation, real/nomina poi) feo iflaon. rer, ad irlaion expectations. The sample perod when using ition target is ror 2002:01-2018.02, when using BSP inflation forecast, 2005.Q2-2018:Q2. The dummy varia represents periods when iain Is dove trae Conclusions In this study, we provide a comprehensive assessment of the determinants of private sector inflation expectations in the Philippines from 2002:1 to 2018:92 using an Inflation expectations model which accounts for the roles of backward looking and forward-looking components, as well as monetary, fiscal, and supply-side factors. The coverage of the study coincides with the transition of the Bangko Sentral ng Pilipinas to an inflation targeting framework in 2002. Estimation results using both the OLS and GMM approaches reveal generally robust findings. The most important determinants of inflation are the BSP's announced inflation ‘target, the BSP’s one-year ahead inflation forecasts, and lagged inflation. The results signify the effective conduct of monetary policy as the credibility of the governments inflation target is effective in anchoring the inflation expectations of private sector economists. With respect to the current monetary policy stance, we cannot establish conclusive evidence regarding its significance in the formation of inflation expectations as empirical results of using policy rate (real versus nominal) In the models are mixed. Thus, we believe that further research on this issue is needed. Meanwhile, we also find international oil inflation to be a significant driver of inflation expectations and, while its effectis minimal given a coefficient of around 0.001 to 0.002, itbears noting that a protracted rise in global ol prices can translate into a corresponding rise in domestic petroleum prices, which has the potential to generate second-round effects in the form of increased petitions for jeepney fare hikes, and ultimately lead to higher inflation expectations. We also provided evidence that a credible fiscal policy has a significant role in aligning private sector economists’ inflation expectations to the inflation target. 8102 monoy esos oeueg gBS 00 Serva Revow 018, References Sangho Sentral ng Pipinas. (2018). Ination Targeting: The 85's Approach to Monstary Paley. Retrieved rom M/s. Bono ‘Bernanke, 8. and Mishkin, F (1997). Inflation Targeting: A New Framework for Monetary Posy? 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