TARGETS AND TOOLS OF MONETARY POLICY

The targets of monetary policy could be (a) monetary aggregates, (b) interest rates, or (c) inflation rates.
When one is pursued, the monetary authority loses control over the other possible targets.
The tools of monetary policy may be classified as (a) those that are aimed directly at affecting monetary
aggregates, and (b) those that are primarily aimed at the money multiplier and/or interest rates. The actual
tools for the first are the purchase/sale of foreign exchange and open market operations. For the second,
the BSP uses the reserve requirement and rediscounting facility. In addition, the BSP may engage in
selective credit control and moral suasion.
1. Monetary Aggregates
• Monetary aggregates refer to the different measures of money.
• These are deemed more directly related to the inflation rate.
• According to the Quantity Theory of Money and a large number of empirical studies supporting
the idea that over the long-run, money supply increases do tend to raise the inflation rate.
However, the results do not show a one-to-one relationship. Thus, it is logical that the BSP has
the power over the expansion or contraction in monetary aggregates.
• They may target some levels of money supply (M1 to M4) that is compatible with an acceptable
inflation rate and GNP growth.

Monetary Aggregates measures not only money but other liquid assets under the name:

M1: Narrow Money

• M1 includes currency in circulation. It is the base measurement of the money supply and
includes cash in the hands of the public, both bills and coins, plus peso demand deposits, tourists’
checks from non-bank issuers, and other checkable deposits. Basically, these are funds readily
available for spending. Adjusted M1 is calculated by summing all the components mentioned
above.

M2: Broad Money

• This is termed broad money because M2 includes a broader set of financial assets held
principally by households. This contains all of M1 plus peso saving deposits (money market
deposit accounts), time deposits and balances in retail money market mutual funds.

M3: Broad Money Liabilities

• Broad Money Liabilities include M2 plus money substitutes such as promissory notes and
commercial papers.

M4: Liquidity Money

• These include M3 plus transferable deposits, treasury bills and deposits held in foreign currency
deposits. Almost all short-term, highly liquid assets will be included in this measure.
Ordinarily, BSP targets the maximum growth of M3 (or M2) that they believe is
compatible to their inflation targets and supportive of other objectives.
However, as we shall see a little later, BSP does not have a direct handle on M3. What
they do have a direct control of is Reserve Money (RM) or Base Money (BM), which reflects the
money infusions into and withdrawals from the banking system.
 By examining the sources of the movements of Reserve Money, one can observe quite
readily the instruments that the BSP is issuing in the conduct of monetary policy.

Tools Aimed at Monetary Aggregates

a) Purchase/Sale of FX(Overbought/Oversold)
• Every time the BSP buys dollars in the foreign exchange market, it will have to correspondingly
pay pesos for them. And if it sells dollars, it will receive pesos in exchange. Thus, they can know
exactly how much pesos they would infuse or withdraw from the banking system. If it wants to use it to
buy dollars from the market and increase its foreign exchange reserves, say by $1 B, then they will
have to pay the existing exchange rate (say, P50/$1) for the dollars. Thus, P50 B will be issued to the
banking system as new money.
• However, this operation is constrained by the level of international reserves that the BSP wants to keep.
If it feels it needs more international reserves, then it will have to buy more dollars from the market, and
thereby infuse more pesos. On the other hand, if they are satisfied with the level of international reserves,
and there is speculation in the peso-dollar rates, they may opt to sell dollars to the market and withdraw
pesos (liquidity) from the market.
• Historically, we have always been short of international reserves when compared to our progressive
neighbors. So there has been a tendency in the decade of the 1990s to increase these reserves. So the
effect had been peso infusions. However, that process of building up reserves may be so fast that the BSP,
at the same time that it buys dollars, may also remove some or all of the pesos generated by its other
tools. This process is called sterilization. It was also used this a lot in the 1990s when there were much
foreign capital inflows into the country, and the economy was more upbeat.
b) Open Market Operation (Repo/RRP)
• Open Market Operation is a form of control over the money supply, which is favored even by foreign
central banks because it is like fine-tuning monetary aggregates. It is because it can be done at any time
and in judicious amounts so that policy can immediately be translated into quantitative terms.
• Having other powerful tools on hand, the BSP has the capability of effecting drastic changes in money
supply and loanable funds. However, such powerful tools are often times inappropriate in situations
where only minor changes are desired. The CB should not use the powerful tools of required reserves and
rediscounting to effect small changes.
• A fine tool for these small changes is the purchase and sale of government securities in active money
markets where the BSP/CB and commercial banks (KBs) along with many others participate. Since this
purchase or sale by the BSP/CB of government securities is made in the open money market, it is called
an "open market operation."
• This operation requires that the BSP/CB hold government securities to trade in the market. Prior to the
existence of the BSP, the old Central relied much on the Treasury bills (T-bills) during the regular
auctions of the National Government (NG) with different tenors. The tenors were 91 days 182 days and
364 days. After 1993, BSP was provided with a stock of T-bills by the NG and assumed also its debts, so
that the BSP could start afresh and use these for trading.
• Authorized dealers, mostly commercial banks, were the buyers and sellers in this segment of the money
market. Furthermore, this market must be active enough to assure that when buyers decide on a purchase,
they can do so, and likewise, when sellers decide on a sale, they can also do so at truly market prices.
How does this tool work?
To slightly loosen money supply, the BSP in effect buys government securities in the market with
the condition that it will be repurchased after a specific number of days, and a specific amount, reflecting
the interest rate for that period. We say "in effect" because the agreement is called a Repurchase
Agreement (also called Repo). This operation infuses money into the banking system to the extent
desired by the BSP.
To work out the opposite effect or tighten money supply and credit, the BSP in effect sells
government securities and gets paid for it, thus, withdrawing pesos from the money market.
The actual instrument used is a Reverse Repurchase Agreement (Reverse Repo or RRP). Just like
the above case, but in reverse, we have the BSP selling government securities, with the condition that it
would buy it back with interest after a specific time period has elapsed. This operation will withdraw
pesos from the banking system in the amount of Reverse Repo's actually issued. Reverse Repo's,
however, are more commonly used especially after the BSP took over from the old CB by 1994. These
have been much used to control monetary aggregates, especially, to sterilize large inflows of foreign
capital or loans into the country. It reached a peak in October 2000, when it hit P144 billion.
c) Outright Transactions
• The outright transactions refer to outright purchase and sales of securities in the market. Such
operations are not reversible and have a permanent effect in the money market. They are only
employed as transactions to adjust the market structure. An outright transaction implies a full transfer
of ownership from the seller to the buyer with no reverse transaction.
• Unlike the repurchase or reverse repurchase, there is no clear intent by the government to reverse the
action of their selling/buying of monetary securities. Thus, this transaction creates a more permanent
effect on our monetary supply. When the BSP buys securities, it pays for them by directly crediting its
counterparty's Demand Deposit Account with the BSP. The reverse is done upon the selling of securities.
d) Foreign Exchange Swaps
• A FX swap, or Forex swap, is a foreign exchange derivative traded between two parties, usually
financial institutions. Together, they lend and borrow an equal quantity of money in two different
currencies over a specified time period.
• The swap agreement has two legs. The first leg, the near leg, involves the two parties swapping one
currency for another at an agreed spot rate, with the second leg, or far leg, agreeing to return the borrowed
funds at a specified FX forward rate. A common motive behind employing a currency swap is cheaper
debt.
• According to the Bank for International Settlements, FX swaps have been employed to raise foreign
currencies, both for financial institutions and their customers, including exporters and importers, as
well as institutional investors who wish to hedge their positions. They are also frequently used for
speculative trading, typically by combining two offsetting positions with different original maturities.
e) Non-Global Tools
Monetary authorities can supplement these tools that regulate the overall credit or money situation with
other tools. These may be deemed necessary because the impact of monetary policy on the different
sectors of the economy is usually uneven. In order to balance it out or direct credit toward what it
considers would be better for the economy, the BSP resorts to such means as: selective credit
privileges, maximum interest rates, and moral suasion.
Selective controls.
• There are two primary reasons why the private sector borrows money from the banks. One is for
consumption, such as going on a world tour, buying a car or appliance. The other motive is for
production, meaning, to use the money for investment in business.
• In relation to purpose, the BSP possesses another tool: selective credit controls. For example, when
firms import goods, it usually must open a letter of credit with a bank, which has deposits/relations with a
bank abroad.
• Ordinarily, a certain percentage of the value of the import is required by the bank as "marginal
deposit" in opening letters of credit.
• Thus, BSP may require a higher percentage as marginal deposit for consumption imports, thereby
discouraging the importation of luxury consumption items.
• Also, the BSP may classify commercial bank loans into priorities where it states that loans for
consumption purposes are not eligible for rediscounting while loans for investment are. In other words,
the BSP has the power to make credit difficult to purchase some items and easy to purchase others.
Moral suasion.
• If all these measures do not prove effective or before introducing drastic measures, the BSP can still
make use of other means lumped together and termed as "moral suasion.'
• Through the persuasive ability of the Monetary Board and the BSP Governor, the BSP can hold sessions
with commercial banks in an effort to gear them toward national goals in carrying out after banking
activities.
• It must be noted that the use of "moral suasion" is more powerful than can be imagined.
• With its power to limit rediscounting, opening of branches, and impose other administrative
requirements, the BSP can "talk" the banks to toe the line of monetary policy.
• After all, disregarding BSP "suggestions" could prove detrimental to a bank in the long term.
2. Interest Rates
Developed countries tend to target interest rates more frequently than the monetary aggregates. This
is because while they are concerned about price stability, in their case, investments tend to be
very sensitive to interest rates and therefore the income (and employment) level would also in turn
be affected.
In the Philippines, being on an inflationary targeting mode does not target interest rates directly.
Rather, it uses the policy interest rates (for Repurchase Agreements [Repos] and Reverse
Repurchase Agreements (Reverse Repos or RRPs]) to signal to the market their intention to tighten
or loosen monetary policy or simply maintain the status quo.
 The United States, for example, make use of the "Fed Funds" for their policy interest rates. BSP
decisions on their policy interest rates are made monthly by the Monetary Board, and published in the
papers, and on their website.
The BSP also has other tools that are intended to affect money and credit. These are those that could
be said to be aimed at influencing the money multiplier or the interest rate. These are (1) Reserve
requirements; and (2) Rediscounting.
Tools Aimed at the Multiplier or Interest Rate
a. Reserve Requirements
• Reserve requirements refer to the percentage of bank deposits and deposit substitute liabilities that
banks must set aside in deposits with the BSP which they cannot lend out, or where available through
reserve-eligible government securities. Changes in reserve requirements have had a significant effect on
money supply in the banking system, making them a powerful means of liquidity management by the
BSP.
• Reserve requirements are imposed on the peso liabilities of universal/commercial banks (UBs/KBs),
thrift banks (TBs), rural banks (RBs) and cooperative banks (Coop Banks), and non-bank financial
institutions with quasi-banking functions (NBQBs). Reservable liabilities include demand, savings,
time deposit and deposit substitutes (including long-term non-negotiable tax-exempt certificates of time
deposit or LTNCTDs)
• The existing reserve requirement ratios vary across bank types and liabilities.
• If the required reserves are low, banks can lend more of their deposit and the multiplier is high. If it is
increased, banks can lend less, and the multiplier goes down.
• The BSP, in general, exercises a wide discretion over required reserves. It does mainly three things:
• It defines what deposits are, for example, deposit by other local banks is not included.
• It sets the percentage of the reserves required against deposits; and
• It defines what reserves are.
• Under the discretion of the BSP, for the moment, it has allowed that only half of all required reserves
have to be deposited with the BSP. The remaining half of the requirement can be satisfied either by the
cash that banks keep in their vaults or by government securities that are declared as eligible. With this
BSP definition, banks are thus able to satisfy required reserves while earning some interest on bonds or
bills.
• As 1993 ended, a new type of reserve requirements was introduced. This was called “liquidity
reserves", through which the banks bought government securities from the BSP at market rates (i.e.,
0.5% less than the average 91-day T-bill rate of the most recent auction). With this new concept
(only in the Philippines!), the BSP started distinguishing between the "statutory reserves" (or ordinary
reserves as previously described) and "liquidity reserves". Nonetheless, they have the same impact on
the multiplier, and the only difference is that banks get market interest rates for that portion of cash
parked with the BSP.
• Thus, one way of studying the liquidity of the entire banking system is to compare the required reserves
(as a whole) with the eligible reserves of the banking system. If the required exceeds eligible, then
the banking system is deficitary.
b. Rediscounting
• Rediscounting is a privilege of qualified Bangko Sentral ng Pilipinas (BSP)-supervised banks that have
approved and active rediscounting line with the BSP to obtain loans or advances from BSP using the
eligible papers of its end-user borrowers (EUB) as collaterals.
• It is a standing credit facility to help banks meet temporary liquidity needs by refinancing the loans they
extend to their clients.
• The BSP can set the limit to the funds that commercial banks can borrow from it and also designate the
rate of interest at which it lends.
• The BSP lends to banks on the basis of (a certain percentage of) loan papers that the banks have from its
customers. The BSP "rediscounts" these loan papers and the rate of interest it charges is called the
rediscount rate.
• Rediscounting then is another powerful tool of the BSP. If the BSP wants to constrict deposits and
money supply, it simply reduces the amount of funds it makes available and/ or raises the rediscount rate.
For example:
• Instead of giving up to 80% of the face value of the loans rediscounted, it may give only up to 60%.
• Instead of rediscounting at 8% per year, it may use the rediscount rate of 10% per year.
• The rediscount rate also provides a signal to the bankers about the direction that interest rates are to take
in general. It is, therefore, helpful when the BSP seeks to target interest rates rather than monetary
aggregates.
3. Inflation Rates
The Development Budget and Coordination Committee (DBCC), an inter-agency economic planning
body together with the BSP sets the annual inflation targets. The government's inflation target is defined
in terms of the average year-on-year change in the consumer price index (CPI) over the calendar year.
The BSP makes the announcement of the inflation target two years in advance.
Inflation targeting is an approach to monetary policy that involves the use of a publicly announced
inflation target set by the Government, which the BSP commits to achieve over a two-year horizon.
Promoting price stability is the BSP's main priority, and the target serves as a guide for the public's
expectations about future inflation, allowing them to plan ahead with greater certainty.
Tools Aimed at Inflation Rates
a. Inflation Targeting
• Inflation Targeting requires a public announcement of an inflation rate that a country will target for
the coming years, or in a given period of time. It focuses on maintaining a low level of inflation, which is
considered to be optimal, or at least would allow the country to have ample economic growth.
• Its main desire is to achieve price stability as the ultimate end goal of monetary policy. The Philippines
formally adopted Inflation Targeting as the framework for Monetary Policy in January 2002.
• The Philippines’ inflation target is measured through the Consumer Price Index (CPI).
• The Development Budget and Coordination Committee (DBCC), an inter-agency economic planning
body together with the BSP sets the annual inflation targets.
• The government's inflation target is defined in terms of the average year-on-year change in the
consumer price index (CPI) over the calendar year.