136.8

137.1

138.1

138.8

139.3

139.1

139.3

139.5

139.6

140.0

139.8

139.7

140.0

140.4

141.3

142.4

142.6

142.8

143.1

144.0

145.1

146.8

147.3

148.6

151.6

153.8

157.4

0.74

0.73

0.73

0.73

0.72

0.72

0.72

0.72

0.72

0.72

0.72

0.71

0.72

0.72

0.71

0.71

0.71

0.70

0.70

0.70

0.70

0.69

0.69

0.73

0.68

0.68

0.67

0.66

0.65

0.64

2.4

2.7

2.7

3.2

3.9

4.9

5.4

6.4

8.3

9.5

11.4

Bangko Sentral ng Pilipinas

INFLATIONREPORT

20082008

ISSN 1655-5104

SECOND QuarterSECOND Quarter

REPORTINFLATION

INFLATION REPORT

Second Quarter 2008

Bangko Sentral ng Pilipinas

FOREWORD  

   he primary objective of monetary policy is to promote a low and stable rate of inflation conducive to a balanced and sustainable economic growth. The adoption

in January 2002 of the inflation targeting framework for monetary policy was aimed at helping fulfill this objective.

One of the key features of inflation targeting is greater transparency, which means greater disclosure and communication by the BSP of its policy actions and decisions. This Inflation Report is published by the BSP as part of its transparency mechanisms under inflation targeting. The objectives of this Inflation Report are: (i) to identify the risks to price stability and discuss their implications for monetary policy; and (ii) to document the rigorous economic analysis behind the conduct of monetary policy and convey to the public the overall thinking behind the BSP’s decisions on monetary policy. The broad aim is to make monetary policy easier for the public to follow and understand and enable them to better monitor the BSP’s commitment to the inflation target, thereby helping both in anchoring inflation expectations and encouraging informed debate on monetary policy issues.

The government’s targets for annual headline inflation under the inflation targeting

framework have been set at 4.0 percent and 3.5 percent for 2008 and 2009, respectively, both with a tolerance interval of ± 1.0 percentage point.

The report is published on a quarterly basis, presenting a survey of the various

factors affecting inflation. These include recent price and cost developments, prospects for aggregate demand and output, monetary and financial market conditions, labor market conditions, fiscal developments, and the international environment. A section is devoted to the BSP’s view of the inflation outlook during the policy horizon. This is followed by a discussion of the implications of the assessment of inflation and economic conditions on the monetary policy settings of the BSP. This issue also features two box articles on the dynamics and measures of inflation expectations in the Philippines.

The Monetary Board approved this Inflation Report at its meeting on 24 July 2008.

   

           AMANDO M. TETANGCO, JR.

Governor                                                                                      

July 2008

T

ii

List of Acronyms, Abbreviations and Symbols AMCs Asset Management Companies ARMM Autonomous Region of Muslim Mindanao BAS Bureau of Agricultural Statistics BES Business Expectations Survey BI Bureau of Immigration BIR Bureau of Internal Revenue BNM Bank Negara Malaysia BNBs Bank Negara Bills BOC Bureau of Customs BOE Bank of England BOJ Bank of Japan BOK Bank of Korea BOT Bank of Thailand BTr Bureau of the Treasury CalPERS California Public Employees’ Retirement System CAMPI Chamber of Automotive Manufacturers of the Philippines, Inc. CAR Capital Adequacy Ratio CBD Central Business District CCRs Credit Card Receivables CES Consumer Expectations Survey CDS Credit Default Swaps CPI Consumer Price Index DBCC Development Budget Coordinating Committee DCS Depository Corporations Survey ECB European Central Bank ERC Energy Regulatory Commission FBT Food, beverage and tobacco FIREBS Financial institutions, real estate and business services FLW Fuel, light and water FOMC Federal Open Market Committee GDP Gross Domestic Product GNP Gross National Product GRAM Generation Rate Adjustment Mechanism GS Government Securities HICP Harmonized Indices of Consumer Prices ICERA Incremental Currency Exchange Rate Adjustment IMF International Monetary Fund KBs Commercial banks KWH Kilowatt hour LFS Labor Force Survey LPG Liquefied Petroleum Gas LTO Land Transportation Office MAS Monetary Authority of Singapore MEM Multi-Equation Model Meralco Manila Electric Company MISSI Monthly Integrated Survey of Selected Industries MS Monetary Survey MSBs Monetary Stability Bonds MT Metric Tons MTP Major Trading Partner NCR National Capital Region NEER Nominal Effective Exchange Rate NFIA Net Factor Income From Abroad NG National Government NIA National Income Accounts NPC National Power Corporation

iii

NPLs Non-performing loans NSO National Statistics Office OECD OFs

Organization for Economic Cooperation and Development Overseas Filipinos

OMOs Open market operations OPEC Organization of Petroleum Exporting Countries PBC People’s Bank of China PMI Purchasing Managers’ Index PSEi Philippine Stock Exchange Composite Index PSS Postal Savings System PSIC Philippine Standard Industrial Classification PTIC Philippine Telecommunications Investment Corporation RDA Reserve Deposit Account REER Real Effective Exchange Rate RM Reserve Money ROP Republic of the Philippines RP Repurchase RRP Reverse Repurchase RVAT Reformed Value Added Tax SEM Single-Equation Model SDA Special Deposit Account TLP Total Loan Portfolio TMA Truck Manufacturers Association TransCo National Transmission Corporation U/KBs Universal/commercial banks VAPI Value of Production Index VOPI Volume of Production Index WESM Wholesale Electricity Spot Market

 

iv

THE MONETARY POLICY OF THE BANGKO SENTRAL NG PILIPINAS

The BSP Mandate The BSP’s main responsibility is to formulate and implement policy in the areas of money, banking and credit, with the primary objective of maintaining stable prices conducive to a balanced and sustainable economic growth in the Philippines. The BSP also aims to promote and preserve monetary stability and the convertibility of the national currency. Monetary Policy Instruments The BSP uses various instruments to effect the desired monetary policy stance to achieve the inflation target. 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 its overnight reverse repurchase (borrowing) rate and overnight repurchase (lending) rate. Policy Target The BSP uses the Consumer Price Index (CPI) or headline inflation rate which is compiled and released to the public by the National Statistics Office (NSO) as its target for monetary policy. The policy target is set by the Development Budget Coordinating Committee (DBCC)1 in consultation with the BSP. For 2008, the Government’s target for annual headline inflation has been set at 4.0 percent with a tolerance interval of ± 1.0 percentage point. For 2009, the headline inflation target has been set at 3.5 percent ± 1.0 percentage point. BSP’s Explanation Clauses These refer to the predefined set of acceptable circumstances under which an inflation-targeting central bank may fail to achieve its inflation target. These clauses 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 exemptions include inflation 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; and (d) significant government policy changes that directly affect prices such as changes in the tax structure, incentives and subsidies.

1 The DBCC, created under Executive Order (E.O.) No. 232 dated 14 May 1970, is an inter-agency committee tasked

primarily to formulate the National Government's fiscal program. It is composed of the Department of Budget and Management (DBM), National Economic and Development Authority (NEDA), and the Department of Finance (DOF). The BSP sits as a resource agency.

v

The Monetary Board The powers and functions of the BSP, such as the conduct of monetary policy and the supervision over the banking system, are exercised by its Monetary Board, which has seven members appointed by the President of the Philippines. Beginning in July 2006, the Monetary Board meets every six weeks to review and decide on the stance of monetary policy. Prior to July 2006, monetary policy meetings by the Monetary Board were held every four weeks.

Chairman Amando M. Tetangco, Jr. Members Romulo L. Neri

Vicente B. Valdepeñas, Jr.2

Raul A. Boncan2

Juanita D. Amatong

Nelly F. Villafuerte

Alfredo C. Antonio

Ignacio R. Bunye3

The Advisory Committee The Advisory Committee was established as an integral part of the institutional setting for inflation targeting. It is tasked to deliberate, discuss and make recommendations on monetary policy to the Monetary Board. The Committee meets every six weeks (beginning July 2006) but may also meet in between the regular meetings, whenever it is deemed necessary. Prior to July 2006, the Committee met every four weeks.

Chairman Amando M. Tetangco, Jr.

Governor Members4 Diwa C. Guinigundo

Deputy Governor Monetary Stability Sector

Nestor A. Espenilla, Jr. Deputy Governor Supervision and Examination Sector

Ma. Cyd N. Tuaño-Amador

Managing Director Monetary Policy Sub-Sector

Ma. Ramona GDT Santiago Managing Director Treasury Department

2 Up to 3 July 2008 3 Assumed office on 3 July 2008 4 The Advisory Committee is supported by a Technical Secretariat composed of officers and staff from the Department of

Economic Research, Center for Monetary and Financial Policy, and the Treasury Department.

vi

Mtg. No. Advisory Committee 1/ Monetary Board 2/ Publication of Monetary Board Highlights 3/

1 28 January, Monday 31 January, Thursday 28 February, Thursday

2 10 March, Monday 13 March, Thursday 10 April, Thursday

3 21 April, Monday 24 April, Thursday 22 May, Thursday

3 2 June, Monday 5 June, Thursday 03 July, Thursday

5 14 July, Monday 17 July, Thursday 14 August, Thursday

6 26 August, Tuesday /a 28 August, Thursday 25 September, Thursday

7 6 October, Monday 9 October, Thursday 06 November, Thursday

8 17 November, Monday 20 November, Thursday 18 December, Thursday

9 b 15 December, Monday 18 December, Thursday 22 January 2009, Thursday

Notes:

SCHEDULE OF THE MEETINGS ON MONETARY POLICY AND PUBLICATION OF HIGHLIGHTS FOR 2008

2008

starting July 2006. Prior to this, the Advisory Committee and Monetary Board meetings were held every four weeks. 2/ Monetary Board meetings on monetary policy are held on the Thursday after the latest Advisory Committee meeting. 3/ Under MB Resolution No. 630, the lag in the publication of the highlights of the Monetary Board meetings on monetary policy issues

b/ The AC and the MB meetings will be held two weeks earlier in observance of the Christmas holidays.

1/ Under MB Resolution No. 630, the frequency of meetings of the Advisory Committee and the Monetary Board was set at every six weeks

was reduced to four weeks. Prior to this, the highlights were published six weeks after the reference meeting date.a/ The AC meeting will be held a day later since the scheduled AC meeting date on 25 August 2008 (Monday) coincides with National Heroes' Day.

vii

CONTENTS

  

Overview 1

I. Inflation and Real Sector Developments 3

Prices 3

Aggregate Demand and Supply 11

Labor Market Conditions 21

II. Monetary and Financial Conditions

22

Interest Rates 22

Financial Market Conditions 24

Banking System 26

Exchange Rate 30

Monetary Aggregates 32

Fiscal Developments 33

III. External Developments 34

IV. Monetary Policy Developments 38

V. Inflation Outlook 40

Private Sector Economists’ Inflation Forecasts Box Article: Measures of Inflation Expectations in the Philippines Box Article: Understanding the Dynamics of Inflation Expectations BSP Inflation Forecasts

40

41

46

53

Risks to the Inflation Outlook 56

IVI. Implications for the Monetary Policy Stance 60

Summary of Monetary Policy Decisions 62

1

OVERVIEW5

Inflation accelerated in Q2 2008. Against the background of a continuous surge in energy and food prices, average headline inflation rose to 9.7 percent from 5.6 percent in the previous quarter. The strong price dynamics of food and oil have also started to feed into other prices, as evident in the uptrend in core inflation. Core inflation, which measures the underlying trend in inflation by excluding specific food and energy items, accelerated to 6.2 percent during the review quarter from 4.1 percent in the previous quarter.

The BSP’s latest assessment is that inflation could settle above the 2008 and 2009 targets. Price pressures have increased even as they are projected to ease starting late 2008. This developed as concurrent and interrelated shocks to the economy—such as the persistent surge in oil prices and spikes in commodity prices—have contributed to elevated inflation readings. The pass-through from global prices is continuing and the global non-oil commodity price hikes appear prolonged and are expected to take longer to unwind. Importantly, second-round effects have set in, as evident in the surge in core inflation, and a rise in inflation expectations has been perceptible from surveys and term spreads.

Gross Domestic Product (GDP) grew at a slower pace of 5.2 percent in Q1 2008

compared to the expansion posted in the previous quarter and the comparable period last year. On the expenditure side, household spending and capital formation slowed down while government consumption declined. On the production side, all major sectors expanded at a slower pace relative to both year-ago and quarter-ago levels. Meanwhile, rising fuel costs moderated the demand for energy-related and -intensive goods, with electricity consumption by residential consumers declining and vehicle sales slowing down. Moreover, the US economic slowdown has resulted in reduced Philippine exports. Employment conditions have also weakened while business and consumer confidence have turned more cautious. Appliance sales, on the other hand, grew strongly during the quarter.

Financial markets were affected by heightened risk aversion brought about by worries over the global economy, as well as rising inflation. The peso weakened, activity in the stock market turned bearish, and secondary market yields for government securities rose across all tenors in Q2 2008 on news of an imminent recession in the US and the resulting slowdown in the broader global economy, and the continuing surge in international oil and food prices.

Higher oil and non-oil commodity prices have resulted in an “income crunch” across

the world. The recent run-up in commodity prices comes in the face of the weakness in US economic activity and global financial market volatility, which are already causing a slowdown in global expansion. Emerging market economies, however, have so far been less affected by the financial market turbulence and have continued to grow at a strong pace—particularly China and India—although economic activity is beginning to moderate in other Asian economies.

Domestic liquidity growth increased in March. Domestic liquidity or M3 increased in March. The growth of credit extended to the public and private sectors continued to be strong, although slightly lower than in the preceding month.

The BSP hiked policy rates during the quarter. After keeping monetary policy settings

steady in April, the Monetary Board hiked by 25 basis points in June the BSP’s key policy interest rates to 5.25 percent for the overnight borrowing or reverse repurchase (RRP) rate and 7.25 percent for the overnight lending or repurchase (RP) rate. The BSP believed that there were already indications of supply-driven pressures beginning to feed into generalized

5 The analyses in this report are based on information as of 30 June 2008.

2

pricing behavior. Given the early evidence of second-round effects, as indicated in the uptrend in core inflation, rising prices of services, upward shift in inflation expectations, and the earlier-than-expected wage adjustments, the Monetary Board recognized the need to act promptly to rein in inflationary expectations. Since monetary policy affects economic variables with a time lag, the policy measure undertaken is expected to help address risks to inflation in 2009.

[Subsequently, in July, the Monetary Board raised the BSP’s key policy rates by 50 basis points to 5.75 percent for the overnight borrowing or RRP facility and 7.75 percent for the overnight lending or RP facility. The Monetary Board believed that a more decisive monetary action was necessary as price pressures have increased and second-round effects have already set in.]

3

I. INFLATION AND REAL SECTOR DEVELOPMENTS Prices

0

2

4

6

8

10

12

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Headline Inflation Quarterly average in percent (2000=100)

Q2 2008:9.7

Against the background of a continuous surge in energy and food prices, average headline inflation rose further to 9.7 percent from 5.6 percent in the previous quarter. The strong price dynamics of food and oil have also started to feed into other prices, as evident in the uptrend in core inflation. Core inflation, which measures the underlying trend in inflation by excluding specific food and energy items, accelerated to 6.2 percent during the review quarter from 4.1 percent in the previous quarter.

0

2

4

6

8

10

12

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Headline Inflation Core Inflation

Headline and Core InflationQuarterly average in percent (2000=100)

Contribution to Quarterly Inflation

in percent

Item Weight in Headline CPI

Percentage Contribution to Year-on-Year Headline

InflationQ2

2008Q1

2008Q2

2007Core Inflation 81.6 5.12 3.56 2.02Non-core Items 18.4 4.62 2.01 0.33

Rice 9.4 3.09 0.81 0.15Corn 0.9 0.24 0.05 0.04Fruits and Vegetables 5.3 0.54 0.56 0.15Gas, LPG 1.3 0.28 0.28 0.05Kerosene 0.3 0.07 0.04 0.00Oil, Gasoline and Diesel 1.3 0.41 0.26 -0.05

Headline Inflation100.00 9.75 5.57 2.35

Source of Basic Data: NSO, BSP

Headline and Core Inflation Average headline inflation rose to 9.7 percent in Q2 2008 from 5.6 percent in the previous quarter and 2.4 percent in the same quarter a year ago. Of the 9.7 percent average headline inflation rate for Q2 2008, 6.8 percentage points were attributed to food alone. Services contributed 1.3 percentage points while housing and repairs contributed 0.7 percentage point. In terms of contribution to headline inflation, core inflation accounted for 5.1 percentage points of the headline inflation rate in Q2 2008, higher than 3.6 percentage points in Q1 2008 and 2.0 percentage points in the same quarter a year ago. Similarly, the contribution of non-core CPI items increased to 4.6 percentage points from 2.0 percentage points in the previous quarter; it was also higher than the 0.3 percentage point recorded in the same quarter a year ago.

Inflation accelerates in Q2 2008.

4

-2

0

2

4

6

8

10

12

14

16

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Headline Inflation Food Inflation Non-food Inflation

Headline, Food and Non-food Inflation Quarterly average in percent (2000=100)

Both food and non-food inflation were higher compared to the previous quarter and the same quarter a year ago. Inflation for food, beverages and tobacco (FBT) reached double-digit levels at 13.8 percent in Q2 2008 from 7.0 percent in the previous quarter and 2.7 percent in the same quarter a year ago. Likewise, non-food inflation was higher at 6.1 percent relative to 4.2 percent in the last quarter and 2.0 percent in Q2 2007.

Alternative Core Inflation MeasuresQuarterly averages of year-on-year change

Quarter TrimmedMean 1/

WeightedMedian 2/

Net of Volatile Items 3/ *

2006 5.4 5.0 6.9Q1 5.9 5.4 8.1Q2 5.8 5.0 7.6Q3 5.2 5.2 6.7Q4 4.5 4.2 5.0

2007Q1 2.9 2.5 3.0Q2 2.2 2.2 2.5Q3 2.3 2.1 2.5Q4 2.9 2.5 3.0

2008Q1 5.1 4.5 5.2Q2 7.7 7.4 8.0

1/ The trimmed mean represents the average inflat ion rate of the (weighted) middle 70 percent in a lowest-to-highest ranking of year-on-year inf lation rates for all CPI components.

2/ The weighted median represents the middle inflat ion rate (corresponding to a cumulative CPI weight of 50 percent) in a lowest-to-highest ranking of year-on-year inf lat ion rates.

3/ The net of volatile items method excludes the following items: educational services, fruits and vegetables, personal services, rentals, recreational services, rice, and corn.

* The series has been recomputed using a new methodology that is aligned with NSO’s method of computing the off icial core inf lat ion, which re-weights remaining items to comprise 100 percent of the core basket after excluding non-core items. The previous methodology retained the weights of volatile items in the CPI basket while keeping their indices constant at 100.0 from month to month.

Source: NSO, BSP estimates

Core inflation, an indicator of the long-term trend of inflation, continued to rise during the review quarter. The official NSO core inflation measure rose to 6.2 percent in Q2 2008 from 4.1 percent in the previous quarter and 2.6 percent in the same quarter a year ago. The alternative measures of core inflation estimated by the BSP all increased markedly in Q2 2008. The trimmed mean went up to 7.7 percent from 5.1 percent in Q1 2008 and 2.2 percent in Q2 2007; the weighted median rose to 7.4 percent from 4.5 percent in the previous quarter and 2.2 percent in the same quarter a year ago; and the net of volatile items measure went up to 8.0 percent from 5.2 percent in the previous quarter and 2.5 percent in the comparable quarter in 2007.

Core inflation rises further in Q2 2008.

Both food and non-food items register stronger price pressures.

5

The number of items with above-target inflation rates increases.

0

10

20

30

40

50

60

70

80

90

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2

2004 2005 2006 2007 2008

Cumulative Weight (in percent) Number of Items Exceeding Threshold Inflation

CPI Items with Inflation Above Threshold

Looking at the distribution of price changes in the CPI basket, it would also be useful to determine the proportion of CPI basket components (at the 4-digit Philippine Standard Industry Classification (PSIC) level) showing inflation rates above a given threshold and find out whether that proportion has been increasing or decreasing. This would provide an indication as to whether pressures on consumer prices are becoming generalized over time. As may be expected with higher inflation, the number of items with inflation rates greater than 5.0 percent, the upper end of the inflation target for 2008, increased to 80 in Q2 2008 from 54 in the previous quarter. Likewise, these items accounted for a bigger proportion of the CPI basket at 52.2 percent compared to 40.0 percent in the last quarter.

Dividing the CPI basket into food and non-food components generates the same trend. There were 51 food items with inflation rates above threshold compared to 41 in the previous quarter. Meanwhile, 29 non-food commodities posted inflation rates higher than the threshold in the current quarter compared to 13 a quarter earlier.

6

Inflation Rates for Selected Food ItemsQuarterly averages in percent (2000=100)

Commodity2008 2007

Q2 Q1 Q4 Q3 Q2

Food, Beverage and Tobacco 13.8 7.0 4.1 2.9 2.7Food 14.6 7.2 4.1 2.9 2.6Cereal & Cereal Products 28.0 8.6 6.0 3.5 2.2o/w Rice 33.0 8.7 7.0 3.4 1.6

Corn 27.0 5.9 2.7 4.3 4.1Dairy Products 13.5 11.4 7.6 5.5 4.1Eggs 7.9 8.1 7.6 7.6 6.3Fish 9.7 7.8 3.8 2.6 3.3Fruits & Vegetables 10.2 10.6 3.4 1.7 2.8Meat 10.5 4.9 2.6 3.1 2.4Misc. Food 7.4 4.2 2.5 1.9 2.3Beverages 5.1 3.7 2.7 2.9 3.5Tobacco 3.5 3.1 2.5 2.4 2.1

Source of Basic Data: NSO, BSP

Food Prices Food remained the major driver of overall headline inflation in Q2 2008. Food prices followed a continuous uptrend since mid-2007 due to a surge in the prices of some agricultural commodities in international markets, caused by a combination of factors affecting both supply and demand. Recent typhoons affected agricultural crops, particularly fruits and vegetables, and the supply of fish. In addition, more expensive input costs continued to support higher rice and meat prices. Food items which contributed significantly to inflation were rice, meat, fish, fruits and vegetables, and miscellaneous food items. Rice, which constitutes 9.4 percent of the CPI basket, surged by 33.0 percent in Q2 2008 from 8.7 percent in the previous quarter. Domestic retail prices of rice increased sharply during this quarter, with higher farmgate prices due to more expensive fertilizer and irrigation inputs. World rice prices registered sharp increases in April and May 2008, after several major rice-producing countries imposed more stringent export-restrictions. In addition, reports of rice hoarding by some traders also contributed to the uptrend in rice prices. In June, international rice prices started to soften, but the sharp rise in April and May dominated during the quarter. In response to the unabated rise in food prices, the Department of Agriculture (DA) teamed up with the International Rice Research Institute (IRRI) in carrying out plans to raise the country’s palay harvests so as to attain 98 percent self-sufficiency in the staple food by 2010.

Meanwhile, the price spikes in fruits and vegetables were traced mainly to supply disruptions as a result of a series of typhoons which swept the country during the quarter. The price of meat products also increased due mainly to the rising cost of feeds and the tight domestic supply of beef and pork.

Food prices continue to drive headline inflation.

7

Inflation Rates for Selected Non-Food

ItemsQuarterly averages in percent (2000=100)

Commodity2008 2007

Q2 Q1 Q4 Q3 Q2Non-Food Items 6.1 4.2 2.6 2.2 2.0Clothing 4.1 3.1 1.8 2.1 2.5Housing & Repairs 4.1 2.7 1.2 1.3 1.5Fuel, Light & Water 8.0 5.4 2.8 4.2 3.3

Fuel 19.0 16.8 10.1 0.8 3.5Light 1.7 -1.8 -2.6 6.7 2.8Water 2.2 2.5 4.4 4.5 5.0

Services 8.2 5.9 4.3 2.1 2.1Transpo & Comm. 9.4 5.6 3.2 -1.1 -0.5Miscellaneous 2.8 2.0 1.3 1.4 1.6

Source of Basic Data: NSO, BSP

5152535455565758595

105115

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Dubai Crude OilQuarterly average spot price in US dollars per barrel

Q1 2008 US$116.91

Non-Food Prices Non-food inflation rose further to 6.1 percent from 4.2 percent in the previous quarter, as inflation dynamics appear to have been higher in fuel and the transportation and communication sectors. In particular, the high global prices of oil were reflected in the twelve rounds of increases in the domestic pump prices of petroleum products during the quarter. The inflation rate of services, which accounts for 15.9 percent of CPI, was higher at 8.2 percent in Q2 2008 as against 5.9 percent in the previous quarter, and was considerably higher than the 2.1 percent registered in the same period last year. Meanwhile, all other non-food sub-components registered increases in their inflation rates during the quarter compared to a year ago and the previous quarter. Energy Prices International oil prices rose sharply in Q2 2008 with the continued tightness in supply, due to higher demand supported by the weak US dollar, the decision of the Organization of Petroleum Exporting Countries (OPEC) to keep its output unchanged, and dwindling US crude inventories. At the same time, the falling value of the US dollar drove investors to the oil commodity market.6 The US Energy Information Administration (EIA) noted that the global oil market remained fundamentally tight in the second quarter due to rising world oil consumption despite a slowdown in U.S. consumption and growing risks to global economic growth, low surplus production capacity, and the flow of investment money into commodities. Although higher oil prices and slower economic growth have dampened consumption in the United States, the EIA noted that global oil consumption is still increasing because of continued economic expansion in China, India, Russia, and the oil-exporting countries in the Middle East.

6 Crude prices offer a hedge against a falling dollar, and oil futures bought and sold in dollars are also more attractive to foreign investors when the dollar is falling.

Likewise, fuel and transportation costs continue to push up non-food inflation.

International oil prices rise sharply.

8

Local pump prices of oil products rise during the quarter.

6

16

26

36

46

56

66

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Premium Gasoline Diesel Oil

Local Retail Prices of Selected Oil ProductsPrice in pesos per liter

JuneP52.44

JuneP60.07

10

30

50

70

90

110

130

150

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Spot and Estimated Future Prices of Dubai Crude Oil* Price in US dollars per barrel

*Futures price derived using Brent crude futures data.

31 Mar 08

28 Dec 07

30 Jun 08

In addition, with the start of the summer driving season in the US, demand for diesel and jet fuel continued to rise although gasoline demand had weakened due to higher prices. This was due to the inherently less flexible demand for diesel and jet fuel for freight transportation compared to consumers’ travel behavior.7 Meanwhile, supply remained tight following disruptions in Nigeria due to attacks in major Shell oil facilities, and OPEC’s reluctance to raise its output. In its 5 March meeting, OPEC decided to keep its output quota unchanged at 32 million barrels per day. Dubai crude oil reached an average of US$116.91 per barrel in Q2 2008, higher by 27.9 percent compared to the previous quarter’s average of US$91.38 per barrel. In the domestic market, both the pump prices of gasoline products and diesel increased by P13.00 per liter while that of LPG increased by P3.45 per liter in Q2 2008 relative to the end of Q1 2008. The prices of gasoline products and diesel oil increased twelve times while the price of LPG increased six times during the review quarter. From two percent in March, the import tariff on specific crude and refined petroleum products was reduced to one percent in April and May 2008 and further to zero in June 2008.8 The estimated future price of Dubai crude oil, based on movements in Brent crude oil futures, suggest higher prices for the whole of 2008. Market fundamentals are projected to remain tight despite forecasts of slower global economic growth which could weaken demand for oil. Power Electricity rates of Meralco9 were generally

Outlook for world prices remains tight.

9

Power rates are higher in Q2.

PSALM bids out 12 power plants, accounting for 42.8 percent of the capacity target set to be completed in 2009.

higher in the second quarter due to higher prices in the Wholesale Electricity Spot Market (WESM) in April. The spike in WESM prices was attributed to the low utilization of coal plants and rate hikes by independent power producers (IPPs) due to the slight depreciation of the peso against the dollar. Meralco likewise passed on an increase in transmission charge of P0.08/kwh starting April 2008 to reflect the 2008 rate of the National Transmission Corporation (Transco) which was 8.3 percent higher relative to year- and month-ago levels. System-loss charges also went up by P0.07/kwh, or 10.0 percent higher than the year- and month-ago levels. However, relative to the previous month, electricity rates softened in May due to a month-on-month reduction in generation and system-loss charges. Meralco attributed the reduction in generation rates to the low prices obtained from the WESM in May. Nonetheless, generation rates for April and May were still higher compared to the first quarter levels and in the same period a year ago. In the near term, sources of upside risks to inflation emanating from electricity tariffs include the depreciating peso, rising fuel prices, and constraints on the supply of coal. On the status of the privatization program, the Power Sector Assets and Liabilities Management Corporation (PSALM) had successfully bid out 12 plants (Tolomo, Agusan, Barit, Cawayan, Loboc, Pantabangan-Masiway, Magat, Masinloc, Calaca, and Ambuklao-Binga). This translates to 1,855.5 MW operating capacity, or 42.8 percent of the 4,336 MW aggregate capacity target set for bidding up to 2009. There are 31 National Power Corporation (NPC) plants identified for privatization. On other industry developments, PSALM prepaid Y27.2 billion, or around US$263 million, of NPC’s debt on 2 June. This was on top of the prepayment made last 19 March

10

A higher discount under the foreign currency differential adjustment tempers water rates in the second quarter.

amounting to Y17.4 billion worth of loans, or about US$174.1 million. The prepayment reduced NPC's debt obligation from US$7.0 billion as of end-2007 to US$6.6 billion and improved its debt to total GOCC debt ratio from 58.4 percent in 2007 to 57.1 percent. The prepayment reduced NPC’s foreign exchange debt by four percent and increased the peso component of the debt currency mix to 13.0 percent from 11.0 percent. Moreover, the prepayment of NPC’s loan obligations will reduce electricity cost as the unpaid portion of NPC’s debt is part of the electric bill through the universal charge. The loan prepayment was made possible by the privatization of NPC’s generation plants. Pursuant to the Electric Power Industry Reform Act (EPIRA), proceeds from the privatization of the government's power generation assets should be used to liquidate the financial obligations of NPC. Water The Metropolitan Waterworks and Sewerage System (MWSS) approved a discount under the foreign currency differential adjustment (FCDA) in Q2 2008. This effectively reduced water rates for both Manila Water and Maynilad by 1.7 and 0.8 percent, respectively, in the second quarter relative to the previous quarter. However, on a year-on-year basis, Manila Water rates were higher by 18.2 percent while Maynilad water rates were lower by 4.2 percent. The higher FCDA discount was due to the appreciation of the peso from November 2007 to February 2008.

7 EIA’s Short-Term Energy and Summer Fuels Outlook, 8 April 2008 and 10 June 2008 releases 8 Under the implementing guidelines, the tariff on imported oil products will be reduced from 3 percent to between 0-2 percent when oil prices reach the (revenue neutral) trigger price levels indicated by the DOF. The trigger period shall be based on the first 15 days of the month when the average price of oil shall be computed for purposes of determining the trigger prices. If the trigger price levels are reached, the DOE shall issue a certification to DOF for the latter to implement the corresponding reduction in oil import tariff. 9 Meralco’s franchise area covers a quarter of the country’s total population.

11

Aggregate Demand and Supply The economy grows at a slower pace.

-3

-1

1

3

5

7

9

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

GDP GNP

GDP and GNP Growth RatesAnnual Growth in Real Terms

Gross Domestic Product (GDP) grew at a slower rate of 5.2 percent in Q1 2008 compared to the growth posted in the previous quarter and the comparable period last year. On the expenditure side, household spending and capital formation slowed down while government consumption declined. Total exports also slipped in the first quarter by 11.1 percent, dragged by the contraction in merchandise exports. Nonetheless, household spending remained as the main growth contributor followed by capital formation, particularly investments in durable equipment. All major production sectors expanded at a slower pace relative to both year- and quarter-ago levels. Gross National Product (GNP), however, expanded by 7.3 percent, an acceleration relative to the previous quarter and sustaining the growth in the same period in 2007. The strong GNP growth was supported by the 30.3 percent growth in the Net Factor Income from Abroad (NFIA) brought about by the 22.8 percent growth in property income10 and the increase in compensation inflow by 7.2 percent. Seasonally-adjusted GDP growth slowed down to 0.8 percent in Q1 2008 compared to 1.3 percent in the previous quarter on account of the contraction in agriculture, fisheries and forestry (AFF) and the slowdown in services and personal consumption expenditure (PCE) .

10 Interest income coming from bond placements abroad of private corporations and income receipts on deposits abroad.

12

-25-20-15-10-505

1015202530

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Govt. Spending Private Consumption Fixed Investment

Domestic DemandAnnual Growth in Real Terms

Aggregate Demand Expenditures (by major economic sectors) PCE remained firm and grew by 5.1 percent in Q1 2008. This, however, was a slowdown as food expenditure, which comprised over half of total PCE, grew slower than 6.0 percent for the first time since Q1 2006. Following the strong growth in real estate, expenditure on household furnishings surged by 9.7 percent. Expenditure on transportation and communication likewise accelerated to 12.2 percent reflecting the increase in domestic travel and value-added services in telecommunications. Government consumption (GC) declined by 1.0 percent in Q1 2008 from the 9.5 percent growth in the previous year. The decline can be attributed mainly to a high base following last year’s spending on the election and the hosting of the ASEAN summit. Meanwhile, after a strong performance in the previous year, growth in capital investments decelerated to 7.3 percent as construction grew only by 6.1 percent after posting double-digit growth rates in the previous year. The slowdown in construction was largely due to the contraction in public construction in the first quarter which offset the growth of private construction.11 Nonetheless, investments in durable equipment surged by 8.2 percent. Merchandise exports fell by 11.1 percent led by the general slowdown in the electronics industry and the decline in garment exports. At the same time, due to the decline in the importation of raw materials for electronic manufactures, merchandise imports dropped by 7.4 percent causing total imports to fall by 6.6 percent.

11 Private construction grew by 15.1 percent in Q1 2008, a significant increase from 9.2 percent in the previous quarter but a slowdown relative to the 21.3 percent growth in Q1 2007. Public construction, however, declined by 9.5 percent, a significant drop from the year- and quarter-ago levels.

Household spending and capital investment slow down.

13

Imports Based on Balance of Payments (BOP) data, imports of goods rose by 14.7 percent year-on-year in Q1 2008, an acceleration from both the year-ago and quarter-ago levels.12 With the exception of raw materials and intermediate goods, all major commodity groups posted year-on-year increments during the review quarter. In particular, imports of mineral fuels and lubricants rose significantly by 83.3 percent due to higher prices of petroleum crude and other mineral fuels and lubricants. Imports of consumer goods also posted a marked increase of 53.3 percent, led by the rising cost of rice and dairy products, and the strong demand for passenger cars and motorized vehicles. In terms of contribution to growth,13 mineral fuels, lubricants, and related materials accounted for 10.7 percentage points, the bulk of the total import growth for Q1 2008.

14

*Base year chosen was the earliest year for which data was available

Other Demand Indicators Other demand indicators seem to suggest a slight moderation in demand conditions: 1) sales of vehicles, power and appliances continued to grow although at a slower pace; and 2) business and consumer confidence declined. Meanwhile, property prices increased and vacancy rates declined. Property Prices • Based on estimates from Colliers

International Research, land values in Q4 2007 rose by 30.3 percent year-on-year for the Makati Central Business District (CBD) and 20.9 percent year-on-year for Ortigas Center. Quarter-on-quarter, the estimated land values in the Makati CBD and the Ortigas area were 5.5 percent and 4.0 percent higher, respectively. Colliers expects land values to rise further by 10.0 percent year-on-year in Q4 2008. Colliers further noted that the land value appreciation is expected to be tempered in 2008 and 2009 because of the massive potential supply of business process outsourcing (BPO) office space in 2009 across Metro Manila and the over-supply of residential condominium units in locations such as Fort Bonifacio where rents may be lower.14 Land values were about 60-70 percent of their 1997 levels in nominal terms, but only about one-third of their 1997 levels in real terms.

Vacancy Rates, Makati CBD (%)

2007 2006Forecast

2008Q4 Q3 Q4 Q4 Q1

Office 2.3 3.7 3.9 2.6 2.9Residential (3-bedroom

condominiums) 6.6 7.1 10.0 6.5 6.7

Source: Colliers International Research

Vacancy Rates • Office and residential vacancy rates in the

Makati CBD at 2.3 percent and 6.6 percent were lower in Q4 2007, respectively, compared to the previous quarter and year-ago levels. For Q1 2008, Colliers projects the office vacancy rate at 2.9 percent as office spaces being completed have already been pre-leased. For residential space, Colliers projects the Q1 2008 vacancy rate at 6.7 percent.

*Average Land Values, Makati CBD and Ortigas Real prices, based on CPI (1991=100) (in pesos per square meter)

0 50,000

100,000

150,000

200,000

250,000

300,000

1998 2001 2002 2003 2004 2005 2006 2007

Makati Ortigas

15

• For Q4 2008, Colliers expects the average

office vacancy rate to settle at 2.6 percent, which is lower than the Q3 2008 forecast, while the residential vacancy rate is projected to remain at 6.5 percent with expectations that new office spaces would be quickly occupied during the year.

Rental Values

• Office rents in the Makati CBD increased by 25.6 percent year-on-year in Q4 2007 to an average of P795/sq.m. and are forecasted to rise further by 10.0 percent in Q4 2008. Rents for 3-bedroom condominium units rose by 14.0 percent year-on-year to P539/sq.m. in Q4 2007 and are expected to increase by 10.0 percent in Q4 2008.

• Office rental values continued to rise in

Q4 2007 and have breached the 1997 levels for premium grade offices. In real terms, however, office rents are only 60 percent of the levels in 1997.

• Makati CBD data from Jones Lang La

Salle in Q1 2008 showed year-on-year increases in office and residential rents of around 18.2 percent and 10.9 percent (in peso terms), respectively. Jones Lang La Salle noted that the recession experienced in the US did not hinder the continued expansion of the BPO industry in the Philippines, which mainly contributed to the growth in rentals in Makati CBD.

• In addition, Colliers reported that

residential rents in Rockwell and Fort Bonifacio as of Q4 2007 rose year-on-year by 4.6 percent to P636/sq.m. and 4.5 percent to P578/sq.m. Colliers expects residential rents in Rockwell and Fort Bonifacio to escalate by 10 percent and 5 percent, respectively, in 2008.

Office and Residential Rental Values Real prices, based on CPI (1995=100)(in pesos per square meter per month)

0 100 200 300 400 500 600 700 800 900

1,000

1998 2001 2002 2003 2004 2005 2006 2007

Office rental value Residential rental value

16

-100

-50

0

50

100

150

200

2003 2004 2005 2006 2007 2008Passenger Cars Commercial Vehicles

Sales of Passenger Cars and Commercial VehiclesYear-on-year change in percent

-80-60

-40

-20

020

40

60

80100

120

140

2003 2004 2005 2006 2007 2008

Sales of Trucks and BusesYear-on-year change in percent

Vehicle Sales • Passenger car sales in April-May 2008

rose by 10.8 percent year-on-year, up from the 10.1 percent expansion in the comparable period last year. However, this was lower than the 18.4 percent year-on-year growth registered in the first two months of the previous quarter due to the shift in consumer preference to commercial vehicles. Year-to-date sales15 also grew at a slower pace of 8.8 percent from 10.0 percent in the same period last year. According to the Chamber of Automotive Manufacturers of the Philippines, Inc. (CAMPI), the overall automotive industry growth can be attributed to steady vehicle prices despite increases in global raw materials, oil, and logistics. In addition, the wider product offerings contributed to the rise in sales. Meanwhile, total sales of passenger cars increased by 7.2 percent year-on-year in Q1 2008.

• Likewise, sales of commercial vehicles

continued to grow although at a slower pace of 24.8 percent year-on-year in the first two months of Q2 2008 from 33.7 percent a year ago. This was nearly double the 13.0 percent growth rate registered in the first two months of the previous quarter. Total commercial vehicle sales for the first quarter of 2008 registered a growth of 12.5 percent year-on-year. Year-to-date commercial vehicle sales decelerated to 17.5 percent from 21.7 percent in the comparable period a year ago.

• Similarly, sales of trucks and buses for the

first two months of Q2 2008 registered a growth of 35.7 percent year-on-year from 36.6 percent in the same period last year. This was a turnaround from the 14.1 percent decline registered in January-February 2008. In Q1 2008, sales of trucks and buses posted a 3.1 percent decline year-on-year. However, year-to-date sales decelerated to 12.5 percent from a 44.0 percent growth rate recorded in January-May 2007.

17

-10

-5

0

5

10

15

2000 2001 2002 2003 2004 2005 2006 2007 2008

Meralco Power SalesYear-on-year change in percent

-60

-50

-40

-30

-20

-10

0

10

20

30

40

J F M A M J J A S O N D J F M A M J J A S O N D J F M A M

Appliance SalesYear-on-year change in percent

2006 2007 2008

Power Sales • Energy sales by Meralco increased by 3.0

percent year-on-year for the first two months of Q2 2008. Growth in April-May was lower compared to the 4.2 percent expansion in the comparable period last year and 5.2 percent growth in the first two months of the previous quarter. The rise in energy sales can be attributed mainly to the decline in sales to the residential sector. Energy sales growth for Q1 2008 reached 3.0 percent year-on-year, while year-to-date sales declined to 2.5 percent from the 3.9 percent growth registered in January-May of the previous year.

Appliance Sales • Appliance sales surged by 21.3 percent

year-on-year in April-May 2008, more than double the 8.6 percent growth recorded in the same period a year ago. This was also significantly higher than the 12.3 percent year-on-year expansion in the first two months of the previous quarter. Total appliance sales in Q1 2008 registered a growth of 11.8 percent year-on-year. Year-to-date, appliance sales grew strongly by 16.0 percent from 11.3 percent in the same period a year ago.

78.0

78.5

79.0

79.5

80.0

80.5

81.0

81.5

82.0

2007 2008

Average Capacity Utilization for ManufacturingIn percent

• Based on the NSO’s Monthly Integrated Survey of Selected Industries (MISSI), average capacity utilization in manufacturing showed a gradual uptrend starting January this year. In April 2008, there was a modest increase in average capacity utilization at 80.7 percent from 80.4 percent (revised) in March.

18

-15

-10

-5

0

5

10

15

2007 2008

Volume of Production Value of Production

Volume and Value Indices of Manufacturing Productionyear-on-year change in percent

• On a quarterly basis, the average growth rate of the value of production index (VAPI) in Q1 2008 remained negative at -0.3 percent but was a slight improvement from the year- and quarter-ago average growth rates of -5.2 percent and -1.7 percent, respectively. Likewise, the VAPI grew at a rate of 7.3 percent year-on-year in April 2008, an improvement compared to the 5.3 percent and 6.1 percent decline posted a year and a month ago, respectively.

• Meanwhile, the quarterly average growth

rate of the volume of production index (VOPI) turned negative in the first quarter at -0.9 percent after posting a 0.1 percent average growth rate in the previous quarter. This, however, was an improvement relative to the -6.4 percent average growth rate in Q1 2007. The latest monthly data also showed a positive outturn of the VOPI in April as it grew 5.2 percent year-on-year from -6.1 percent in the previous month and -4.2 percent a year ago.

Business sentiment remains positive but has turned more cautious.

Business Expectations SurveyIndex 2008 2007

Q2 Q1 Q4 Q3 Q2

Business Outlook Index

Current Quarter 12.6 29.9 48.0 40.9 46.4

Next Quarter 16.6 41.0 40.9 53.0 44.7

Source: BSP

Business Expectations Survey • Business confidence remained positive but

the lower index point for the current quarter, the second time in a row, indicated that more firms expect a slowdown in economic conditions and business activity. This is consistent with the general downtrend in business and consumer confidence among the world’s top economies. The index was lower by 17.3 index points and 33.8 index points compared to the levels in the previous quarter and a year ago, respectively.

• The lower index reflected the decline in

outlook of respondent firms due to: 1) concerns over a possible recession in the US, the country’s major trading partner; 2) volatile crude oil prices; 3) rising prices of goods and services (transportation and communication); 4) high input/ raw material costs; 5) pending wage hikes; and 6) political noise. Expectations of increases in non-oil commodity prices in the global market also contributed to the weaker business outlook.

19

• The business outlook for Q3 2008 at 16.6

percent was similarly lower by 24.4 points quarter-on-quarter and 28.1 points year-on-year.

Consumer confidence declines.

Consumer Expectations SurveyIndex 2008 2007

Q2 Q1 Q4 Q3 Q2

Current Quarter -43.8 -32.1 -33.6 -23.6 -26.0

Next 3 months -26.9 -3.4 -4.6 4.1 -6.7

Next 12 months -20.3 6.6 5.5 7.9 5.8

Source: BSP

Consumer Expectations Survey • Consumer confidence declined anew in Q2

2008. The nationwide overall consumer outlook index (CI) for the second quarter of 2008 decreased to -43.8 percent, down by 11.7 index points quarter-on-quarter and by 17.8 index points year-on-year.16 Reasons cited for the weak outlook were the higher costs of goods and services, higher household expenses, and lower income.

Exports decline.

External Demand Total exports of goods based on BOP17 data went up by 3.1 percent in Q1 2008, a significant deceleration compared to the growth in the same period in 2007 and the previous quarter. More than half of the expansion came from coconut products which contributed 1.7 percentage points to the total export growth for the period. Petroleum products also contributed significantly to export growth due to higher production in Malampaya in anticipation of the scheduled maintenance shutdown in April. Meanwhile, manufactures posted a 1.1 percent decline due to the slack in electronics and garment exports. Aggregate Supply

20

Major production sectors slow down.

On the production side, the services sector remained the main driver of growth, contributing about 3.3 percentage points to GDP growth during the first quarter. Services continued to drive GDP growth in Q1 2008. Finance continued to post the highest year-on-year growth at 12.9 percent followed by trade and transport, communication and services (TCS). Other dwellings and real estate (ODRE) and government services were the only sectors among the services sub-groups which posted an acceleration in the first quarter relative to the same period in 2007. In agriculture, the major gainers were corn, coconut, and banana. Corn continued to experience a double-digit growth at 16.9 percent due to increased harvest area and yield particularly for yellow corn. The intensive use of hybrid and open-pollinated variety seed coupled with high market price of yellow corn had encouraged more farmers to shift to corn farming. Coconut likewise continued to benefit from the higher price of copra since 2007. Coconut production has also recovered from the effects of typhoons in 2006. Meanwhile, rising production costs continued to affect the industry sector particularly manufacturing.

21

Labor Market Conditions Unemployment and underemployment rates rise.

6.0

6.5

7.0

7.5

8.0

8.5

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2

2006 2007 2008

Unemployment Rate

Based on the results of the April 2008 Labor Force Survey (LFS), the unemployment rate rose to 8.0 percent in April 2008 from its year-ago level of 7.4 percent.18 There were 33.5 million Filipinos employed in April out of approximately 36.5 million in the labor force. Total employment dropped by 0.6 percentage point year-on-year. The services sector employed 49.6 percent of the total employed population, while the agriculture and industry sectors accounted for 35.5 percent and 14.9 percent, respectively. The underemployment rate also rose to 19.8 percent in April 2008 from 18.9 percent in the same period last year. Underemployed persons in agriculture accounted for 46.0 percent, services, 38.5 percent, and industry, 15.5 percent.19

II. MONETARY AND FINANCIAL CONDITIONS

Interest Rates

22

2

4

6

8

10

12

14

16

18

20

2000 2001 2002 2003 2004 2005 2006 2007 2008

91-day T-bill rate Overnight RRP Rate Bank Lending Rate (Low-end)

91-day T-bill rate, BSP RRP rate and KBs Lending RateIn percent

The benchmark 91-day T-bill rate as well as the 182-day tenor remained at their Q1 2008 levels of 3.673 percent and 4.670 percent, respectively, as there were no awards for the said tenors during the quarter. The NG cited sufficient revenue to match its expenses as the main reason for the absence of awards. The average rate for the 364-day tenor increased by 121.6 basis points to reach 6.600 during Q2 2008. The increase in the average rate for the 364-day tenor can be attributed to investors’ expectations of higher inflation in the coming months. Meanwhile, the average bank lending rate was almost unchanged at 8.4 percent in the first three months of 2008 compared to the previous quarter. (Q2 2008 WILL BECOME AVAILABLE ON THE 3RD WEEK OF JULY)

23456789

101112

3Mo 6Mo 1Yr 2Yr 3 Yr 4Yr 5Yr 7Yr 10Yr 20Yr 25Yr

Yiel

d in

per

cent

Maturityend Dec 2007end March 2008end-June 2008

Yield of Government Securities in the Secondary MarketIn percent

Yield Curve Secondary market yields for government securities (GS) rose across all tenors by end-June 2008 from end-March 2008. The increase in the yields ranged from 56.7 basis points (6-month GS) to 216.4 basis points (4-year GS). The yield curve shifted upward on news of an imminent recession in the US and the resulting slowdown on the global economy, and the continuing surge in international oil and food prices. The high inflation outturn during the second quarter of 2008 and the negative developments in the US economy also resulted in higher market risk aversion during the period.

Domestic interest rates remain generally flat.

Yields in the secondary market rise.

23

-400.0

-300.0

-200.0

-100.0

0.0

100.0

200.0

300.0

Mar 06 J un 06 Sep 06 Dec 06 Mar 07 J un 07 Sep 07 D ec 07 Mar 08 Jun 08

91-day T -bi ll vs US 90-day LIBOR (be fore tax) 91-day T-bi ll vs US 90-d ay T-bill (before tax)

91-day T -bi ll vs US 90-day LIBOR (after tax) 91-day T-bi ll vs US 90-d ay T-bill (af ter ta x)

Interest Rate Differentialsin basis points

0

1

2

3

4

5

6

7

8

2004 2005 2006 2007 2008

BSP RRP rate US Fed funds rate

BSP RRP Rate and US Fed Funds Rate In percent

Interest Rate Differentials The positive differentials between domestic and US T-bill rates, net of tax, narrowed during Q2 2008 with the rise in the US 90-day T-bill rate. Meanwhile, the after-tax differentials between domestic interest rates and US LIBOR were broadly unchanged compared to the previous quarter. The differential between the BSP's policy interest rate (overnight borrowing or RRP rate) and the target for the federal funds rate widened from 275 basis points in Q1 2008 to 325 basis points in Q2 2008 reflecting the net effect of the BSP's policy rate increase of 25 basis points and the US Fed's 25 basis points reduction in policy rate during the quarter. Adjusted for the risk premium—which is measured by the differential between the 10-year Republic of the Philippines (ROP) note and the 10-year US Treasury note—the positive differential between the BSP’s policy rate and the target for the federal funds rate was broadly unchanged from end-March levels at 28 basis points as of end-June 2008.

Real lending rates turn negative.

2.50

1.20

-1.20

-0.50

1.60

3.60

3.30

0.40

8.00

5.60

-2 0 2 4 6 8 10 12

Philippines

Japan

Singapore

Hong Kong

Thailand

Malaysia

South Korea

Taiwan

India

Indonesia

Average Real Lending Rates: Selected Asian Countries*In percent

The real lending rate—measured as the difference between the median bank lending rate and inflation—turned negative at -3.2 in Q2 2008 from 2.5 in the previous quarter. This was due mainly to relatively higher inflation and broadly steady lending rates during the second quarter. Among a sample of 10 Asian countries, the Philippines' real lending rate ranked the lowest.

Interest rate differentials between Philippine and US rates narrow.

24

Financial Market Conditions

Investors in the local bourse stayed cautious during the second quarter amid various global and domestic economic developments showing high inflation pressures and slowing growth. Meanwhile, ample liquidity in the market improved the appetite for the longer-term government debt instruments.  

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

2000 2001 2002 2003 2004 2005 2006 2007 2008

PSE Composite Index

Stock Market The domestic stock market continued to weaken during the second quarter of 2008 with the Philippine Stock Exchange Composite Index (PSEi) averaging (using monthly closing averages) 2,679.1 index points from the previous quarter’s 3,119.8 index points. Stock trading in the local bourse sustained a downtrend during the quarter as investors stayed cautious amidst unfavorable developments, namely: fears of a prolonged US recession; the global credit crunch and output slowdown; elevated prices of world crude oil and non-oil commodities; and uptick in domestic inflation. Government Securities

Government securities continued to attract an excess of bids as higher interest rates in the financial system continued to fuel demand for one-year T-bills. The amount of oversubscription nearly doubled, from P7.2 billion in the first quarter of 2008 to P14.2 billion in Q2. Average monthly oversubscriptions likewise increased in the second quarter to P2.4 billion relative to the P1.5 billion recorded in Q1 2008. The T-bill offerings were undersubscribed in April but were oversubscribed in May and June. During the quarter, the Bureau of the Treasury (BTr) offered only 364-day T-bills. According to the BTr, the non-issuance of the short-term papers (91-day and 182-day tenors) helped improve the NG's cash flow position due to reduced pressure for the BTr to repeatedly redeem maturing bills during the year.

Financial markets were affected by heightened risk aversion brought about by worries over the global economy, as well as rising inflation

Stock market sentiment assumes a risk-averse stance.

T-bill oversubscriptions double.

0

20

40

60

80

00

20

40

2000 2001 2002 2003 2004 2005 2006 2007 2008

Oversubscription of T-bill Auctionsn billion pesos

25

Debt spreads widen further on inflation concerns.

Sovereign Bonds and CDS Spreads Debt spreads widened in Q2 2008 relative to Q1 2008 levels due to inflation concerns brought about by the unabated rise in fuel and food prices. Asian financial markets in the region were also worried about the possibility of the Fed ending its rate cuts to contain price increases in the US. In the domestic front, fears stoked by high inflation widened debt spreads significantly. Against this environment, the Philippine credit default swap20 (CDS) spreads, or insurance-like contracts that protect against default or restructuring, rose to 266 basis points as of end-June from the end-March level of 243 basis points. During the same period, the spreads of ROP 2015 bonds over the benchmark 10-year US Treasury notes also widened to 310 basis points as of end-June from 275 basis points in end-March.

Banking System

Philippine banking system remains sound. The Philippine banking industry’s performance during the second quarter was generally favorable and the overall condition remained sound. A summary of important performance indicators showed the banking system’s resilience in spite of persistent concerns of the fallout from the US subprime mortgage crisis and the shocks from world oil and food prices.

26

Banks’ deposit base increases.

Savings Mobilization The banking system’s total deposit liabilities as of end-February 2008 was broadly unchanged at P3.5 trillion compared to its level a year ago. Demand deposits grew by 7.7 percent year-on-year, while savings deposits, which continued to account for half of the banks’ funding base, registered a modest 0.8 percent growth. However, time deposits declined by 3.5 percent from a year ago. Compared to the previous quarter, the banking system’s deposit liabilities declined by 1.8 percent.

Lending Operations Outstanding loans of universal/commerical banks (U/KBs) (including reverse repurchase or RRP placements) expanded by 10.6 percent year-on-year in March 2008, based on preliminary data from the new system of bank reporting recently adopted by the BSP.21 Loans for production purposes grew by 15.7 percent in March, while loans for consumption rose by 4.5 percent during the same period. Production loans were driven largely by credit extended to the financial intermediation (98.8 percent growth) and electricity, gas and water (61.7 percent growth) sectors. Meanwhile, the growth in consumption loans was dominated by the expansion in credit card receivables.

Consumer loans increase.

The combined credit card receivables (CCRs) of U/KBs as well as thrift banks (TBs) as of end-December 2007 increased by 16.5 percent year-on-year to reach P116.1 billion, and by 9.5 percent compared to the end of the previous quarter’s level of P106.0 billion. The ratio of CCRs to the total loan portfolio (TLP) at 5.4 percent was higher than the previous year’s 5.2 percent, but slightly lower than the 5.5 percent recorded during the previous quarter. Of the total CCRs, 14.2 percent was past due, an improvement from the 16.4 percent recorded at end-December 2006.

Growth in bank lending continues.

27

Similarly, U/KBs’ and TBs’ combined auto loans as of end-December 2007 rose by 19.4 percent to P86.2 billion from P72.2 billion in December 2006, and by 3.8 percent from the end-September 2007 level of P83.0 billion. Auto loans accounted for 4.1 percent of TLP, higher than the same period last year at 3.7 percent but lower than the previous quarter’s 4.3 percent. Past due auto loans to total auto loans eased moderately to 5.1 percent from 5.2 percent last year but remained at the same level compared to the previous quarter. U/KBs' real estate loans (RELs) as of end-December 2007 declined slightly by 0.6 percent to P197.7 billion from its year-ago level of P198.9 billion but increased modestly by 2.7 percent compared to the previous quarter’s level of P192.6 billion, resulting in a lower ratio of RELs to TLP at 10.4 percent from the previous year’s 11.5 percent and the previous quarter’s 11.2 percent. The majority or 97.2 percent of total RELs was held by U/KBs’ bank proper, while the remaining 2.8 percent was the account of U/KBs’ trust departments. RELs extended for the construction and development of real estate properties for commercial purposes, including infrastructure projects, comprised the bulk of property loans at 79.9 percent while the balance of 20.1 percent was granted for the acquisition of residential units by individual homeowners/borrowers.

Institutional Developments The total resources of the banking system rose by 2.9 percent to P5.2 trillion as of end-February 2008 from its year-ago level of P5.0 trillion, due mainly to the rise in the cash and loans account. U/KBs accounted for almost 90 percent of the total resources of the banking system.

Resources of the banking system increase.

28

The number of banking institutions (head offices) fell further to 845 as of end-March 2008 from the year-ago level of 861, reflecting the continued consolidation of larger banks as well as the exit of weaker players in the banking system. By banking classification, banks (head offices) consisted of 38 universal/commercial banks (U/KBs), 80 thrift banks (TBs), and 727 rural banks (RBs). Meanwhile, the operating network (including branches) of the banking system increased to 7,743 from 7,704 during the same period last year, reflecting mainly the increase in commercial and rural banks’ branches/agencies. On a quarterly basis, the number of banking institutions as of the period under review was also lower than the 847 registered as of the end of the previous quarter. The banking system’s asset quality continued to improve, with the non-performing loan (NPL) ratio settling at 5.0 percent as of end-March 2008 compared to 5.7 percent a year ago. The availability of more disposition venues for banks to unload their non-performing assets through special purpose vehicle (SPV)-related transactions, joint venture agreements, public auctions and debt write-offs contributed largely to a much lower NPL ratio during the period. The improvement in the NPL ratio during the period was due to the 8.5 percent drop in the level of NPLs, complemented by the 4.3 percent increase in the industry’s TLP. NPLs shrunk to P126.6 billion during the period under review from the previous year’s level of P138.4 billion, while TLP reached P2,530.7 billion from P2,426.6 billion during the same period last year. Compared with other countries in the region, the Philippine banking system’s NPL ratio of 5.0 percent as of end-March 2008 was higher than Indonesia’s 4.4 percent, Malaysia’s 2.8 percent, Thailand’s 3.8 percent, and Korea’s 0.7 percent.22 The lower NPL ratios in Malaysia, Thailand, and South Korea may be traced to the creation of publicly-owned asset management companies (AMCs), which purchased the bulk of their NPLs, a practice which was not resorted to in the Philippines. The loan exposure of banks remained

The number of banks falls due to mergers and consolidations but operating network continues to expand.

Asset quality of banks continues to improve.

29

adequately covered as the banking system’s NPL coverage ratio was steady at 81.1 percent as of end-March 2008, reflecting banks’ diligent compliance with the loan-loss provisioning requirements of the BSP to ensure adequate buffers against unexpected losses. The banking system’s average capital adequacy ratios (CARs) as of end-September 2007 remained strong at 14.7 percent on a solo basis and 15.7 percent on a consolidated basis, which are both higher than the BSP’s 10.0 percent required minimum ratio. The new CARs were calculated based on the revised CAR framework (patterned after Basel 2) for U/KBs and their subsidiary banks and quasi-banks, and the old CAR framework (patterned after Basel 1) for stand-alone TBs and rural and cooperative banks (RB/Coop banks). The new requirements of Basel 2 reduced the CARs of the banking system by 280 basis points and 310 basis points from last quarter’s CARs of 17.5 percent and 18.8 percent on solo and consolidated bases, respectively. The Philippine banking system’s CAR remains comparatively higher than those of Thailand (14.5 percent), Malaysia (13.0 percent), and Korea (12.0 percent). Meanwhile, Indonesia posted the highest CAR in the region at 19.4 percent.23 SDA placements rose by P166.8 billion to P446.8 billion as of end-June 2008 from last year’s level of P280.0 billion. The higher level of SDAs could be attributed to the liquidity management measures implemented by the BSP, which allowed trust entities of BSP-supervised financial institutions to make placements in the SDA facility. Meanwhile, the total volume of banks’ placements with the BSP under the RRP window amounted to P307.3 billion as of end-June 2008, higher than the year-ago level by P112.9 billion.

Placements under the BSP’s SDA facility increase.

30

Exchange Rate

35

40

45

50

55

60

2000 2001 2002 2003 2004 2005 2006 2007 2008

P/US$

Daily Peso-US Dollar Rate

  

Changes in Selected Dollar Rates

Appr./Depr. (-)Year-to-date

30 Jun 08 31 Mar 08

Philippine peso -8.1 -1.1

Thai baht (offshore) -10.4 -4.8

Chinese yuan 6.5 4.2

Malaysian ringgit 1.6 3.9South Korean won -10.5 -5.6 Singaporean dollar 6.4 4.8 New Taiwan dollar 7.1 7.0 Indonesian rupiah 2.0 1.9 Japanese yen 6.6 13.0 Indian Rupee -8.2 -1.3

 

The peso depreciated by 4.8 percent quarter-on-quarter to average P43.00/US$1 in the second quarter of 2008.24 However, on a year-on-year basis, the peso appreciated by 9.1 percent. The peso weakened against the US dollar due to heightened risk aversion brought about by worries over the slowdown of the US economy and its impact on the global economy as well as rising inflation amid increasing oil and food prices. Nonetheless, the depreciation of the peso was tempered by the strong inflow of OF remittances which climbed by 14.5 percent year-on-year to US$5.4 billion as of April 2008.

Relative to the end-2007 level, the peso depreciated by 8.1 percent to close at P44.9/US$1 on 30 June 2008.25 The depreciation of the peso was in line with the movements of the Korean won, Thai baht, and Indian rupee which depreciated by 10.5 percent, 10.4 percent, and 8.2 percent, respectively, vis-à-vis the US dollar relative to their end-2007 closing levels. Meanwhile, other selected Asian currencies maintained their strength against the US dollar, led by the New Taiwan dollar’s 7.1 percent appreciation. Volatility, as measured by the coefficient of variation of the daily average exchange rates, is higher at 2.5 percent in the second quarter relative to 0.4 percent in the previous quarter as the peso moved within a wider range of P41.53/US$1 - P44.76/US$1. On a quarter-on-quarter basis, the peso gained external price competitiveness in the second quarter against the baskets of currencies of major trading partners (MTPs) and competitor countries. The real effective exchange rate (REER) index of the peso, which measures the external price competitiveness of the peso, decreased by 2.9 percent, 1.0 percent and 0.2 percent against the baskets of currencies of MTPs and competitor countries in the broad and narrow series, respectively.

The peso depreciates.

31

.

The nominal depreciation of the peso offset the negative impact of the positive inflation differential against the MTPs and competitor countries in the broad series while the narrowing inflation differential negated the appreciation of the peso in the narrow series of competitor countries. Meanwhile, on a year-on-year basis, the peso lost some external price competitiveness in the second quarter as the REER index of the peso increased by 7.4 percent, 12.9 percent and 13.9 percent against the baskets of currencies of MTPs and competitor countries in the broad and narrow series, respectively. Despite the depreciation, the peso is expected to continue to remain broadly steady in 2008 on the back of the projected sustained dollar inflows from OF remittances, export earnings and foreign direct investments. However, higher risk aversion on worries over the slowdown of the US economy as well as increasing market uncertainty on concerns over rising oil and non-oil commodity prices could weigh on the peso. The overall direction of the peso’s movement will still be very much influenced by risk aversion towards emerging markets, including the Philippines, which will depend on the overall impact of surging oil and food prices on the economy.

32

Monetary Aggregates

Based on data generated from the new system of bank reports,26 domestic liquidity or M3 grew as of end-March 2008 to 9.6 percent year-on-year from 9.2 percent as of end-December 2007. On a quarter-on-quarter basis, however, domestic liquidity growth was lower at 2.6 percent as of end-March 2008 from 8.5 percent in the quarter ending December 2007. The expansion in the year-on-year growth of domestic liquidity continued to be driven by the increase in net foreign assets (NFA), particularly those of the BSP, as banks registered a reduction in their NFA. M3 growth was tempered by the decline in net domestic assets (NDA), which contracted although at a slower pace of 1.4 percent in March. The NDA declined as the Net Other Items account (which includes SDAs and RRPs) continued to reflect a large negative balance. Credit extended to the public sector grew by 10.3 percent as of end-March 2008, a reversal of the 2.3 percent contraction reported as of end-December 2007. Meanwhile, credits extended to the private sector registered a slower growth of 2.6 percent from 7.2 percent as of end-December 2007. Year-on-year growth in reserve money (RM), a narrower measure of monetary aggregates, accelerated to 11.8 percent as of end-May from 4.6 percent as of end-March 2008.27

Liquidity growth rises.

33

The deficit of the National Government (NG) for the first semester of 2008 stood at P18.0 billion, less than half the P41.0 billion deficit for the same period last year. This was also lower than the program deficit for Q1-Q2 2008 by P23.0 billion. Revenue collections for January-June grew by 11.7 percent to P570.0 billion compared to P510.3 billion for the same period last year. It also exceeded the P561.7 billion program for the first semester. Of this amount, the Bureau of Internal Revenue (BIR) and the Bureau of Customs (BOC) contributed P389.8 billion and P117.0 billion, as their collections grew by 16.4 percent and 27.0 percent, respectively, compared to the same period last year. On the other hand, revenue collections from the Bureau of the Treasury (BTr) declined by 11.5 percent to P29.5 billion from 33.3 billion in the comparable period last year. Revenues from other offices also went down to P33.7 billion. Meanwhile, the cumulative expenditures for the first semester grew by 6.7 percent to P588.0 billion compared to the same period in 2007 but was P14.7 billion lower than the program for Q1-Q2 2008. Excluding interest payments, total disbursements increased by 6.0 percent to P447.0 billion. Interest payments also rose by 8.7 percent to P141.0 billion.

Fiscal Developments First semester fiscal deficit lower than year-ago and program levels.

14.7

8.3

23.0

Program vsActual

602.7

561.7

-41.0

Q1-Q2 2007Program

11.7510.3570.0Revenues

6.7

56.1

Percent Change

-41.0-18.0Surplus/(Deficit)

551.3588.0Expenditures

20072008

Source: BTR

January-June

National Government Fiscal PerformanceJanuary-June 2008In billion pesos

14.7

8.3

23.0

Program vsActual

602.7

561.7

-41.0

Q1-Q2 2007Program

11.7510.3570.0Revenues

6.7

56.1

Percent Change

-41.0-18.0Surplus/(Deficit)

551.3588.0Expenditures

20072008

Source: BTR

January-June

National Government Fiscal PerformanceJanuary-June 2008In billion pesos

34

III. External Developments The current surge in commodity prices appears to be the biggest threat to global growth.

Indicators point to a US recession in 2008 despite Q1 2008 growth.

Higher oil and non-oil commodity prices have resulted in an “income crunch” across the world. The recent run-up in commodity prices comes in the face of the weakness in US economic activity and global financial market volatility, which are already causing a slowdown in global expansion.28 Emerging market economies, however, have so far been less affected by the financial market strains and have continued to grow at a strong pace—particularly China and India—although economic activity is beginning to moderate in other Asian economies. The risks to the inflation outlook remain on the upside, and the concern is that persistently high inflation in emerging economies may require tightening of policies going forward and affect regional growth adversely. Revised estimates of US real GDP for Q1 2008 increased at an annual rate of 0.9 percent compared to the previous estimate of 0.6 percent. Exports of goods and services, federal government spending, and private inventory investment drove GDP growth, but were mainly offset by declines in the growth of PCE for services.29 Although the economy managed to churn positive growth in Q1 2008, leading indicators point to a higher probability of recession for the rest of 2008. Non-farm payroll employment declined further by 49,000 in May 2008, after contracting by 28,000 in April 2008 due to continued job losses in the construction, manufacturing, and retail trade sectors. Unemployment increased further to 5.5 percent in May, from 5.0 percent in the previous month.30 Adding to this, the consumer confidence indices by the Conference Board and University of Michigan fell markedly in May, with both indices falling below 60 index points for the first time in many months.31 Yet, consumption has consistently remained positive. Retail sales have increased at a solid pace over the past three months, in part because the tax rebate boosted sales during the period.

35

Analysts, however, believe that the strength in consumer spending will prove to be fleeting as the rebate effect fades while shocks from weak housing and tight credit persist.32 On price developments, headline inflation rose to 4.4 percent in Q2 2008 compared to 4.1 percent in the previous quarter. Of late, the focus has shifted away from the credit and housing shocks towards the impact of surging commodity prices on domestic inflation. In fact, the Fed has been signaling growing concerns on inflation as well as uncertainty over the inflation outlook, which prompted it to keep its target for the federal funds rate at 2.0 percent during its latest meeting on 25 June 2008. According to the Eurostat’s first estimate, Euro area real GDP increased by 0.8 percent in Q1 2008 from 0.3 percent in Q4 2007. Domestic demand, excluding inventories, made a strong contribution to real GDP growth during the quarter. On survey indicators, euro area consumer confidence declined notably in May 2008, sustaining its downward movement which started in mid-2007, partly reflecting a worsening of consumers’ expectations regarding unemployment. Meanwhile, the Purchasing Managers’ Index (PMI) for the manufacturing sector fell further in May to 50.6 index points, which was only slightly above the threshold, indicating positive growth. A similar picture is conveyed by the European Commission’s industrial confidence indicator, which continued to decline in the first five months of 2008.33 On price developments, inflation showed a marked rebound in May, rising back to the peak of 3.6 percent that was reached in March, from 3.3 percent in April, driven mainly by strong contributions from both energy and food components, arising from the surge in oil and food commodity prices in the global markets.34

Euro area growth weakens.

36

In its latest estimate, Japan’s Cabinet Office revised the GDP numbers for Q4 2007 from 0.9 percent down to 0.6 percent, confirming the slowdown observed at the end of last year. However, according to the first preliminary estimate, real GDP grew by 0.8 percent quarter-on-quarter in Q1 2008, supported by a strong expansion of exports and by sustained private consumption. Nevertheless, survey indicators suggest that the economy may already be in a downturn. Consumer confidence in May reached its lowest level since December 2001. The index fell from 35.2 in April to 33.9 in May. Inflationary pressure is building as commodity prices continue to increase, with the headline inflation rising to 2.2 percent in May from 0.8 percent in April. Higher food and fuel prices and sluggish wages continue to weigh on consumption while business investment could weaken if the global financial market turbulence intensifies and credit conditions tighten further.35 Despite the severe snowstorms in January and February and a narrowing trade surplus, China’s GDP grew by a stronger-than-expected 10.6 percent year-on-year in Q1 2008. However, the Sichuan earthquake is likely to reduce Q2 growth as local production, transportation and communication have all been disrupted, and as pressures on inflation intensify down the road.36 Inflation declined to 7.7 percent in May, from 8.5 percent in April. India's economic growth has slowed somewhat of late and was at its weakest pace since 2005 in Q1 2008 as the highest interest rates in six years discouraged consumer spending and investment, while a more complex global environment reduced the possibilities for expanding India's exports.37

Growth momentum in Japan slows.

Rising inflation poses downside risks to Asian economic growth.

37

For most of Asia, economic activity remains fairly buoyant, but growth in the rest of the world is slowing sharply. The International Monetary Fund (IMF) notes that given its extensive trade and financial linkages with the rest of the world, Asia is unlikely to decouple.38 The concern has now shifted to persistence of cost-push inflation shocks, as this may hurt growth in the medium term. Headline inflation is rising sharply, particularly in India, Indonesia, Singapore, and Thailand.

Following these developments, several developed and emerging market economies have either maintained or tightened policy settings recently. The Federal Reserve decided to keep its target for the federal funds rate at 2 percent during its last meeting on 25 June 2008. The Bank of England (BOE) likewise kept its policy rates unchanged at 5 percent, noting that the inflation risks have moved to the upside.

The central banks of Taiwan, Indonesia, Thailand, Russia and the Euro region hiked their policy rates while the Bank of Canada canceled a previously telegraphed rate cut. In light of the continued increases in the prices of energy and some other commodities and the elevated state of some indicators of inflation expectations, uncertainty about the inflation outlook remains high so that the bias is towards a more restrictive policy stance.

Central banks around the world adopt a tightening bias.

38

IV. Monetary Policy Developments

4

5

6

7

8

9

10

11

2002 2003 2004 2005 2006 2007 2008

Overnight RRP Rate Overnight RP Rate

BSP Policy Interest RatesIn percent

During its 24 April meeting, the Monetary Board decided to keep the key policy interest rates at 5 percent for the overnight borrowing or reverse repurchase (RRP) facility and 7 percent for the overnight lending or repurchase (RP) facility. The interest rates on term RRPs and RPs were also left unchanged.

In deciding to keep the BSP’s key policy rates steady, the Monetary Board noted that prevailing price and output conditions suggested that the stance of monetary policy remained appropriate at that time. Depending on the movements in oil and non-oil commodity prices, it was projected that inflation could settle above the 2008 inflation target range but will be within the 3.5 percent ± 1.0 percentage point target range for 2009. The factors driving inflation had come mostly from the supply side, and the use of monetary instruments against such influences had limited effect compared with direct supply-side intervention measures.

The BSP decides to keep monetary policy settings steady at the start of the quarter.

Prevailing price and output conditions in April suggest that the monetary policy stance is still appropriate.

39

While the balance of risks to prices is tilted toward the upside, the global slowdown could reduce demand pressures.

By the end of the quarter, however, the BSP decides to tighten monetary policy due to persistent price pressures,...

… higher inflation expectations, and several indications of second-round effects.

The inflation outlook therefore calls for preemptive policy action against emerging second-round effects and rising inflation expectations via a measured policy response.

The Monetary Board observed that the balance of risks to the inflation outlook was tilted to the upside. Core inflation has drifted upward, with the March 2008 reading at its highest level since November 2006. The pending requests for wage and transport fare adjustments could raise the upside risks to inflation coming from demand-side pressures. On the other hand, the consensus view of a prolonged slowdown in the US economy, and the resulting weaker outlook for global economic growth, could reduce demand pressures and moderate price increases in global oil and non-oil commodities.

During its 5 June policy meeting, however, the Monetary Board decided to increase by 25 basis points the BSP’s key policy interest rates to 5.25 percent for the overnight borrowing or reverse repurchase (RRP) facility and 7.25 percent for the overnight lending or repurchase (RP) facility. The interest rates on term RRPs, RPs, and SDAs were also increased accordingly. In its assessment, the Monetary Board noted that emerging baseline forecasts, which reflect more recent data on inflation and output, indicated a likely breach of the inflation target for 2008. The BSP forecasted 2008 average inflation to reach 7.0-9.0 percent. For 2009, average inflation was expected to decline to 4.0-6.0 percent. The BSP believed that there were already indications of supply-driven pressures beginning to feed into generalized pricing behavior. Given the early evidence of second-round effects, as indicated in the uptrend in core inflation, rising prices of services, upward shift in inflation expectations, and the earlier-than-expected wage adjustments, the Monetary Board recognized the need to act promptly to rein in inflationary expectations.

Since monetary policy affects economic variables with a time lag, the policy measure undertaken will help address risks to inflation in 2009. In addition, the buoyancy of domestic demand suggested some room for a measured policy response. Favorable conditions arising from a respectable and still solid domestic growth as well as a strong external payments situation indicated that the economy can withstand a measured tightening.

40

V. INFLATION OUTLOOK Private Sector Economists’ Inflation Forecasts

Results of the Q2 2008 survey on inflation forecasts showed higher inflation expectations for both 2008 and 2009.39 The mean inflation forecast for 2008 was higher at 8.8 percent compared to the previous quarter’s 4.9 percent. The upward adjustment in inflation expectations stemmed mainly from the acceleration in fuel and food prices, the impact of which has already started to feed into the prices of other goods (such as fastfood meals) and services (such as transportation). Analysts noted that additional inflationary pressures could come from the rising global prices of metals and steel for construction as well as alternative fuel sources such as coal and natural gas. Meanwhile, contrary to expectations of a strong currency as a downside risk to inflation in the previous quarter, the depreciation of the peso (almost ten percent year-to-date) could support inflation as it will translate to higher import costs. For 2009, the survey also showed a higher mean inflation forecast of 6.1 percent compared to the previous quarter’s 4.2 percent. Citing base effects, most analysts expect inflation to peak in the third quarter of 2008. The mean inflation forecast of analysts is 10.6 percent for Q3 2008 and 10.2 percent for Q2 2008. Based on the probability distribution of respondents’ forecasts, there is a 31.7 percent chance that average inflation for 2008 will be within 8.1-9.0 percent and a 31.2 percent chance that inflation will be within 9.1-10.0 percent. This indicated that there are expectations that inflation will be above the 4.0 percent (±1.0 percentage point) target for 2008. Consistent with the survey conducted by the BSP, the Asia Pacific Consensus Forecasts40

for Philippine inflation also showed rising expectations during the quarter in review. As of June 2008, inflation for 2008 is now forecast at 7.3 percent, higher than the 5.1 percent forecast in April 2008 and 4.4 percent in June 2007.

Private sector forecasts are higher for 2008 and 2009.

8.8

6.1

2.0

3.0

4.0

5.0

6.0

7.0

8.0

9.0

10.0

2006 Q4 2007 Q1 2007 Q2 2007 Q3 2007 Q4 2008 Q1 2009 Q2

Mean Inflation Forecasts by Private Sector Economists/AnalystsIn percent

2008

2009

Private Sector Forecasts for Inflation (as of July 2008)Annual Percent Change

2008 2009Q3 Q4 Full year Full year

ATR Kim Eng Securities 9.0 7.5 7.5 6.0Banco de Oro 10.5 9.5 8.5 6.5Bank of America 10.0 9.6 8.7 4.8Bank of the Philippine Islands 11.4 11.0 9.3 6.0Citibank 11.1 10.6 9.2 5.9Deutsche Bank 10.8 9.4 8.8 6.2Development Bank of Singapore 10.7 10.6 9.0 4.8Economist Intelligence Unit 9.1 8.7 8.3 5.5HSBC 10.5 9.0 8.3 6.4IDEA 10.8 11.6 9.3 9.9ING Bank 10.5 9.8 8.8 5.2Lehman Brothers 10.0 9.2 8.5 4.5Metrobank 10.7 10.9 9.2 -RCBC 12.0-12.5 13.0-13.5 10.0-10.5 6.0-8.0

Median Forecast 10.6 9.7 8.8 6.0Mean Forecast 10.5 10.0 8.8 6.1High 12.3 13.3 10.3 9.9Low 9.0 7.5 7.5 4.5Number of observations 14 14 14 13

Memo Item:Government Target 4.0±1.0 3.5±1.0

31.7 31.132.2

0.0

5.0

10.0

15.0

20.0

25.0

30.0

35.0

<0 1.0-2.0 2.1-3.0 3.1-4.0 4.1-5.0 5.1-6.0 6.1-7.0 7.1-8.0 8.1-9.0 9.1-10.0 >10.0

2008 2009

Probability Distribution For Analysts' Inflation Forecasts* 2008 and 2009

*Probability distributions were averages of those provided by 13 respondents. (Source: BSP Survey)

41

Box Article: Measuring Inflation Expectations in the Philippines

The forward-looking nature of inflation expectations necessitates a careful and thorough understanding of how these are formed by economic agents, who are composed primarily of business people, consumers, financial investors, and even private economists. For the Philippines, there are several indicators of inflation expectations. One such indicator is the yield curve, which reflects information on expected inflation. In addition, the BSP conducts quarterly consumer and business expectations surveys, which are aimed at generating indicators of overall business sentiment, the economic outlook, and the inflation outlook of households and businesses. In addition, the BSP conducts a quarterly survey of private analysts which are reported in its quarterly inflation report. The report is a major tool for communicating the BSP’s readings and outlook on the inflation environment. Monthly surveys conducted by Asia Pacific Consensus and Bloomberg also provide good sources of inflation expectations. Consumer and Business Expectations Survey The BSP conducts expectations surveys every quarter and publishes results in two reports. The first one is the Business Expectations Report which contains results of the quarterly Business Expectations Survey (BES) conducted by the BSP to generate indications of overall business sentiment, including the sector’s inflation outlook. The second one is the Consumer Expectations Report (on the Consumer Expectations Survey or CES), which captures the economic outlook, including on inflation, of consumers as an indication of the country's future economic condition.41 For both the BES and CES, the main measure of expectations is the confidence index (CI). The CI or diffusion index measures the net difference between respondents saying business or economic conditions are favorable and those saying they are unfavorable. It is computed as the percentage share of respondents that answered in the affirmative less the percentage share of respondents that answered in the negative for a given indicator. A positive CI indicates a favorable view, except for the average inflation rate and the average peso-borrowing rate, where a positive CI indicates the opposite. The BES was launched in 2001 while the CES commenced in 2004. Starting with the NCR initially, the CES covered the whole country in 2007. Using the diffusion indices, the BSP has tracked that business expectations on price changes move more widely than those of consumer expectations. Since the CES diffusion index has a short time series, its correlation with actual inflation could not be estimated yet.

- 20.0 - 10.0

0.010.0 20.0 30.0 40.0 50.0 60.0 70.0 80.0

Q 2 Q 3 Q 4 Q 1 Q 2 Q 3 Q 4 Q 1 Q 2 Q 3 Q 4 Q 1 Q 2 Q 3 Q 4 Q 1 Q 2 Q 3 Q 4 Q 1 Q 2 Q 3 Q 4 Q 1 Q 2 Q 3 Q 4 Q 1 .

2001 2002 2003 2004 2005 2006 2007 2008

CES Diffusion Index , NCR BES Diffusion Index, Philippines

CES and BES Diffusion Indices on Expected Price Changes Four Quarters Ahead

Index Points

Survey Period:

42

A comparison of the BES diffusion index to actual inflation (four quarters ahead) reveals that, in general, the index changes more often than actual inflation itself. Although the index could predict the direction of actual inflation, it could not give an estimate of the magnitude of expected changes in actual inflation. At times, the diffusion index correctly moved along with actual inflation 12 months ahead (e.g., uptrend in 2003 Q3 and Q4) but there were also several periods when the index more closely tracked current inflation (e.g., a downtrend in end-2001 and an uptrend in end-2007).

Yield Curve Traditional measures of inflation expectations are contained in the yields of various securities in the financial market. This is based on the fact that inflation expectations influence the shape of the yield curve by affecting expected short-term interest rates. For example, when investors revise their

expectations about long-term future inflation rates upward, the yield curve is projected to steepen. This is so because since investors are concerned about their real returns, they would naturally demand nominal returns that are high enough to protect them against expected inflation. Term spreads, based on the yield curve, serve as another proxy for inflation expectations in the absence of sufficient time series data. One term spread (forecast 9-12 months ahead) may be defined as the differential between the yields of one-year bonds and the 91-day T-bill rate. In the chart on actual inflation vs. the term spread, it can be observed that the term spread could correctly move up with the actual inflation (12 months forward), e.g., in March 2002 or in June 2003. It also moved down with actual inflation (12 months forward), e.g., in October 2005. However, there were also some periods when spreads did not predict future inflation well, especially when there were shocks in commodity prices. Such weakness could be due to the following: 1) the presence of other inter-temporal risks incorporated in the premium between different yields; and 2) information among bond investors may not be fully available 12 months earlier.

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

-20.0

-10.0

0.0

10.0

20.0

30.0

40.0

50.0

60.0

70.0

Q2

Q3

Q4

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

Q1 .

2001 2002 2003 2004 2005 2006 2007 2008

BESDiffusion Index, PhilippinesActual Inflation

Current Inflation, Philippines

BES Diffusion Index on Expected Inflation, Current Inflation andActual Inflation (Four Quarters Ahead)Diffusion Index Inflation Rate

Survey Period:

0

2

4

6

8

10

12

14

0.00

0.50

1.00

1.50

2.00

2.50

3.00

2002

2003

2004

2005

2006

2007

2008

Term Spread(364-day Minus 91-day T-bill Rate)

Actual Inflation (one-year ahead)

Term Spread vs. Actual Inflation (one year ahead)

Percentage Points(for Term Spread)

In Percent(for Inflation Rate)

Term Spread Date:

43

In a previous study, the coefficient of the three-month term spread (182-day vs. 91-day T-bill rate) was found to be significant and positive, so that a larger differential is associated with a rise in the inflation rate. Moreover, the differential enters with a lag of four months, so that the differential turns out to be a good indicator of what happens to inflation four months hence. The lag has an intuitive basis: inflation developments up to three months ahead are covered by what happens to the 91-day T-bill rate, while the gap between the 182-day and 91-day T-bill rate covers what is expected to happen to inflation after three months.42 BSP Survey of Private Forecasters Following the adoption of inflation targeting, the BSP started to look at the market’s view of inflation as represented by private analysts’ inflation forecasts. One way was to conduct a survey along with the publication of its inflation report.

Looking at the historical movements of forecasters’ expectations over time, the trend of the forecasts generally moved along with actual inflation (annual average for the following year). This is a good indication that the information contained in the survey is a good measure of inflation expectations. Presently, the survey also gathers not only respondents’ deterministic forecasts, but also information in probabilistic terms, particularly on the probabilities attached to the various ranges of inflation.

A comparison of the resulting mean forecasts of the BSP survey with current inflation (actual inflation during the quarter when the survey is done) reveals that private sector forecasts follow the path of the said current inflation. In general, this observation is common among the other measures of expectations. (Mankiw, 2003)

8.8 % Forecast

for 2008 Q2

9.7 %Actual Inflationf

or 2008 Q2

0

2

4

6

8

10

12

2001 Q4 2002 Q4 2003 Q4 2004 Q4 2005 Q4 2006 Q4 2007 Q4Survey Periods

Private ForecastsActual Inflation

Private Sector Mean Inflation Forecasts and Current Month Inflation2001 Q4 - 2008 Q2

Percent

2

3

4

5

6

7

8

2003 Q2 2004 Q2 2005 Q2 2006 Q2 2007 Q2 2008 Q2Survey Period

Private Sector Mean Inflation Forecasts (Next Year) and Actual Inflation (Full year average), 2003 Q2 - 2008 Q2

Actual Inflation (Full-year average)

Mean Forecast for Next Year's Annual Inflation

In percent

44

AP Consensus / Bloomberg

For a more frequent reading of market analysts’ inflation expectations, one can look at other surveys conducted by private organizations such as AP Consensus and Bloomberg. Fortunately, both surveys are done on a monthly basis. The mean forecasts from AP consensus have tracked actual inflation considering that a lot of information is already available with the minimal (one month) lag within which the actual values are predicted.

Meanwhile, the results from the Bloomberg survey more closely followed the movements of the corresponding actual inflation (one month ahead). The narrower deviation of the Bloomberg mean forecasts over actual inflation stemmed from the fact that the lag between the time the forecasts are done and the release date of actual inflation is relatively short (less than one month). Thus, respondents to this survey have a lot of information available to them when they make their forecasts.

0

1

2

3

4

5

6

7

8

9

Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08

Next Year Forecast Actual Inf lation (Annual)

Asia Pacific Consensus Economics Survey Forecasts and Actual Inflation (followingyear's average), January 2002-June 2008

in percent

SurveyPeriod:

0.0

2.0

4.0

6.0

8.0

10.0

12.0

Average Forecast High-end Forecast

Low-end Forecast Actual Inflation

Bloomberg's One-Month Ahead Forecast and Actual Inflation (in the following month)Januar 2006 - June 2008

45

Conclusion The wide range of available measures of expectations provides policymakers with important information on how stakeholders react to evolving price conditions. If these measures indicate that expectations are already persistent, then they signal to monetary authorities that there is a possible emergence of inflation inertia. At the same time, the different measures of expectations can be used by the BSP to test whether its actions in terms of transparency and accountability have been effective in strengthening the inflation-targeting framework by anchoring inflation expectations. This can be done by comparing the BSP’s targets against expectations. If expectations should be observed to have increasing causal relationship with the inflation target, then one can conclude that inflation expectations would have a significant degree of dependence or anchoring on the BSP’s inflation target. References: Beechey, Meredith J., Johannsen, Benjamin K, and Levin, Andrew T., 2008. “Are Long-Run Inflation

Expectations Anchored More Firmly in the Euro Area in the United States?,” Finance and Economics Discussion Series 2008-23, (Division of Research & Statistics and Monetary Affairs, Federal Reserve Board, Washington, D.C.)

BSP, Business Expectations Survey, various issues, Manila, Philippines, available at

www.bsp.gov.ph. BSP, Inflation Report, Second Quarter 2002, Manila, Philippines, available at www.bsp.gov.ph. Cespedes, Luis F., Kumhof, Micheal, and Parrado, Eric, 1987, “Pricing Policies and Inflation Inertia,”

IMF Working Paper 03/87, (Washington: International Monetary Fund). Garner, Alan C., 1987, “The Yield Curve and Inflation Expectations,” Economic Review,

September/October 1987. Mankiw, Gregory N., Reis, Ricardo and Wolfers, Justin, 2003, “Disagreement About Inflation

Expectations,” Working Paper 9796, (National Bureau of Economic Research, Cambridge, Massachusetts).

Pfajfar, Damjan and Santoro, Emiliano, 2006, “Heterogeneity and Learning in Inflation Expectation

Formation: An Empirical Assessment,” Universita’ Degli Studi Di Trento-Departimento Di Economia Discussion Paper No. 7.

46

Box Article: Understanding the Dynamics of Inflation Expectations

I. Introduction The current literature on inflationary processes has emphasized the importance of forward-looking factors such as inflation expectations. Inflation expectations have significant effects on the economy in that they are mainly responsible for the price-wage setting behaviors and asset allocations of economic agents, placing them at the core of the inflation process. In an inflation-targeting regime, inflation expectations play a central role in gauging the effectiveness of monetary policy. The inflation target itself serves as the anchor for monetary policy. Thus, a disanchoring of inflation expectations can refer to a situation wherein the public’s inflation expectations move away from the central bank’s inflation target. Of particular importance is the threat of a wage-price spiral. Since workers care about real wages, expectations of higher inflation may lead to more demands for wage increases, pushing up employers’ costs and eventually creating the self-fulfilling prophecy of higher inflation. Yet, little is known of how economic agents’ inflation expectations are derived and how these views influence pricing decisions. Thus, modeling economic agents’ inflation expectations and the factors that drive them provides important information for understanding the inflationary process. II. Review of Related Literature

Cerisola (2005), in his assessment of the role of fundamental determinants of survey inflation expectations, showed that the adoption of inflation targeting has helped anchor expectations, with the dispersion of inflation expectations declining considerably. This meant that the inflation target could have helped shape inflation expectations over time. The relative importance of past inflation in determining expectations was fairly low, and the overall evidence did not suggest substantial inertia in the inflation process. Meanwhile, Brischetto (1999) found that inflation expectations appeared to be directly affected by monetary policy. Inflation expectations fell a few months after the policy rate increases. In his study of inflation expectations in Australia, the surveyed households, although unclear about the mechanism by which monetary policy affects inflation, thought that a monetary policy move by the central bank could have an effect on future inflation. Interestingly, Celasun (2004) recognized that an improvement in primary fiscal balances played an important role in shaping inflation expectations, suggesting that during stabilization episodes, priority should be given to building fiscal credibility by strengthening public finances. Mankiw (2003) found that the real unemployment rate is a significant determinant in expected future inflation. III. Inflation Expectations in the Philippines In the Philippines, there are several measures of inflation expectations. Traditionally, inflation expectations can be inferred from financial prices, particularly from the yield curve. Inflation expectations influence the shape of the yield curve by affecting expected short-term interest rates. For example, when investors revise their expectations about long-term future inflation rates upward, the yield curve is projected to steepen. This is so, because investors are concerned about their real returns, and they would naturally demand nominal returns that are high enough to protect them against expected inflation. On the other hand, there are the survey-based measures of expectations. The BSP conducts consumer and business expectations surveys every quarter. These surveys generate indications of overall business sentiment, the economic outlook and the inflation outlook of consumers and businessmen, which are generally used as an indication of the country's future economic conditions.

47

The BSP’s adoption of inflation targeting as the framework for monetary policy in 2002 has highlighted the importance of closely monitoring the market’s view of inflation and inflation expectations. The BSP surveys full-year inflation forecasts (for both the current year and the next) of market analysts from the investment houses and commercial banks and publishes the results in the BSP’s quarterly inflation report. Meanwhile, the Asia-Pacific Consensus Economics and Bloomberg survey forecasts for the current month. These survey data have proven to be indispensable tools in measuring expectations as they offer a unique way of assessing the credibility of the inflation targeting framework as the BSP formally submits itself to the judgment of financial markets through its public commitment to the inflation target. The method of eliciting information has progressed over the years. From a purely deterministic forecast, most respondents to the survey have started to give out information in probabilistic terms, so that the BSP is able to come up with a probability distribution of the private analysts’ forecast for the quarter. Looking at the historical movements of inflation expectations over time, it appears that the BSP’s actions in terms of transparency and accountability have been effective in strengthening the inflation targeting framework by anchoring inflation expectations. Inflation expectations have been more stable with the adoption of inflation targeting, but were past the target during the years 2004 and 2005, when oil prices were hitting new highs. This means that based on historical evidence, expectations tend to veer away from the target during episodes of large, adverse supply shocks.

2

3

4

5

6

7

8

2003 Q2 2004 Q2 2005 Q2 2006 Q2 2007 Q2 2008 Q2Survey Period

Private Sector Mean Inflation Forecasts (Next Year) and the Inflation Target (Full year average), 2003 Q2 - 2008 Q2

Private Sector Mean Inflation Forecasts (Next Year)

Inflation Target Range

48

IV. Empirical Findings Following Cerisola (2005), a reduced-form equation on changes in inflation expectations was estimated to capture the macroeconomic determinants that could influence shifts in economic agents’ inflation expectations.43 The model basically assumes Calvo pricing, i.e., firms’ constraints on their price changes are exogenous. In the aggregate, inflation expectations are driven by past expectations about future inflation, past inflation, the inflation target, and monetary policy—as proxied by real interest rates. Additionally, variables reflecting real marginal costs of production are included, suggesting that past marginal production costs should be important in driving inflation expectations. The specification of the inflation expectations equation estimated here uses deviations of the real effective exchange rate and real wages from their trend values as proxies for real marginal costs. These relationships are represented in an ordinary least squares (OLS) equation as follows44:

DLOG(INFEXP) = α0 + α1*DLOG(INFEXP(-1)) + α2*DLOG(INF) + α3*DLOG(INFTARGET) +

α4*D(FISCAL(-3)) + α5*RINT(-1) + α6*WAGEDEV + α7*REERDEV + AR(3) + AR(4)

where: INFEXP(-1) = lagged 1-year ahead expected inflation rate45 INF = current year-on-year inflation rate INFTARGET = 1-year ahead inflation target RINT(-1) = lagged BSP policy rates (real) FISCAL(-3) = lagged National Government fiscal balance as a percent of GDP

WAGEDEV = Real wage gap (real wage deviation from trend, where the trend was approximated through a Hodrick-Prescott filter) REERDEV = Real exchange rate gap (real exchange rate deviation from trend)

49

Dependent Variable: DLOG(INFEXP) Method: Least Squares Date: 07/17/08 Time: 16:36 Sample (adjusted): 2002M09 2008M06 Included observations: 70 after adjustments Convergence achieved after 10 iterations

Coefficient Std. Error t-Statistic Prob.

C 0.014912 0.013709 1.087763 0.2811 DLOG(INFEXP(-1)) -0.243874 0.108365 -2.250483 0.0281

DLOG(INF) 0.245019 0.072978 3.357456 0.0014 DLOG(INFTARGET) 0.337496 0.149924 2.251109 0.0281

D(FISCAL(-3)) -0.003008 0.001314 -2.289881 0.0256 RINT(-1) -0.014859 0.004207 -3.531869 0.0008

WAGEDEV 0.003032 0.001040 2.915427 0.0050 REERDEV -0.012184 0.003335 -3.653536 0.0005

AR(4) 0.337993 0.127605 2.648750 0.0103 AR(3) 0.176802 0.131278 1.346776 0.1831

R-squared 0.505023 Mean dependent var 0.001908 Adjusted R-squared 0.430777 S.D. dependent var 0.068523 S.E. of regression 0.051698 Akaike info criterion -2.955223 Sum squared resid 0.160362 Schwarz criterion -2.634009 Log likelihood 113.4328 Hannan-Quinn criter. -2.827633 F-statistic 6.801984 Durbin-Watson stat 2.010935 Prob(F-statistic) 0.000001

Inverted AR Roots .83 -.08-.77i -.08+.77i -.68

The results show that economic agents’ past expectations (i.e., past forecast of the 1-year ahead inflation) from one month ago are important variables in explaining shifts in expectations. As a basic indicator of the “backward-looking” nature of expectations, the negative coefficient of past values of inflation expectations implies that forecasters tend to adjust their current predictions by shifting the direction from the previous forecast. This is not impossible considering that if agents had previously raised their own expectations, there is a general tendency to revise downwards the forecasts in the following periods (first month in this case). In other words, when expectations were increasing one period ago, there is a general tendency for current expectations to go to the opposite direction. This is consistent with the notion of adaptive expectations, wherein the simple current expectations of future inflation reflect past expectations. This allows current expectations to adjust according to the gap between actual inflation and previous expectations. Meanwhile, the actual current inflation appeared to be a significant indicator affecting current expectations. The current value of actual inflation has kept its role in driving expectations. This is evident in the resulting positive coefficient of actual inflation. It takes effect almost immediately, which could be due to the persistence (inertia) of inflation where economic agents continue to remain cautious of inflationary risks associated with higher inflation (Cespades 2003). In addition, the inflation targets announced by the monetary authorities appeared to be significant. Given that the coefficient is significantly positive, this means that current inflation expectations are well anchored to the inflation target.

50

As in the studies done by Cerisola (2005), Celasun (2004), and Sargent and Wallace (1987), fiscal policy was observed to be an important factor in affecting inflation although the impact comes with a lag. In the current OLS estimate, the lag is three months, or one quarter. This is partly explained by the fact that the data on fiscal ratios (surplus and GDP) are usually released with a lag (one month for government surplus/deficit and one quarter for GDP). Thus, the final fiscal surpluses (as part of GDP) one quarter ago is used by agents in the current period for forming their expectations for next year. In addition, for forecasters, the more important information considered in their forecasts is the consistency of fiscal/GDP performance over time and not necessarily the latest fiscal data. This is reasonable considering that a longer lag in fiscal imbalances could be a better signal for judging the government’s commitment to fiscal sustainability and therefore provide an expected future path of fiscal balances, which affects financial market pricing in the near term (Cerisola 2005). As expected, the coefficient is negative, indicating that greater fiscal surplus reduces inflationary expectations. Meanwhile, both the real wage gap and the real exchange rate gap were significant. Naturally, higher wage gaps—where actual real wages deviate from the potential real wage of the economy—raise future inflation expectations following a rise in actual real wages brought on by a higher increase in nominal wages compared to inflation. Meanwhile, a widening real effective exchange rate (REER) gap implies that the REER is increasing more than what the economy can handle. An increasing REER suggests that imports have become relatively cheaper, therefore, production costs could decline. In the Philippines, almost all manufactured products which are either for domestic and export purposes contain a certain amount of import component, therefore, an appreciation in the REER minimizes firms’ marginal costs and hence pulls down inflation expectations in the future. A crucial result is the impact of the BSP’s overnight policy rates to the private sector’s inflation expectations. The results confirm that the stance of monetary policy is a significant determinant in charting expected future inflation. This means that past increases (decreases) from one period ago in policy interest rates tend to lower (raise) inflation expectations. This is an important result with practical implications. The observed importance of the monetary policy stance in determining shifts in expectations strengthens the belief that current monetary policy actions (albeit involving small amounts of changes in policy rates) are an effective tool for giving a signal to the market on the central bank’s prospective actions and therefore solicit an immediate reaction from the market as they take into account in their expectations the central bank’s view of the inflation path and the corresponding monetary policy action in order to achieve the target. A 1 percent increase in real interest rates will lead to a .01-unit change in the percent change in the expected inflation rate. Also note that there is no lag in the impact of monetary policy since the estimated coefficient does not model the monetary policy channel per se but on the factor affecting current expectations. In addition, although monetary policy has larger lags in terms of its impact on actual inflation, its impact on expectations is more precipitous. In fact, the impulse response of inflation expectations to an increase in the real interest rate over a two-year period shows that expectations drop considerably in the first month after the monetary policy change i.e., an increase in policy rates. Expected inflation starts out low in the first month but goes back up in the second month. Subsequently, the impact of this monetary policy move dissipates starting in the third month. This implies that policy rates can signal and affect expectations instantly during the first period, but to combat inflation persistence, there is a need for follow up actions after the initial increase in policy rates.

51

-.020

-.016

-.012

-.008

-.004

.000

2 4 6 8 10 12 14 16 18 20 22 24

Response of DLOG(INFEXP) to Generalized OneS.D. RINT(-1) Innovation

V. Conclusion

Some of the factors that drive inflation expectations in the Philippines were identified in the estimated model. A key result was that monetary policy actions from one month ago appeared to be a significant determining factor in the 1-year ahead future expected inflation. Equally important is the result that inflation expectations moved along with the inflation target. This suggested that conditions under the inflation targeting framework help anchor expectations. Increases in the marginal cost of production—as proxied by real wage and the exchange rate gap—were also significant, as increasing production costs naturally exerts upward pressure on consumer prices. Similarly, the recent fiscal consolidation program of the government contributed largely to the forming of inflation expectations. Lastly, the change in the percent-change of current inflation and inflation expectations (with a one-month lag) played vital roles in the shifting of inflation expectations. It is important to note that even though inflation expectations are basically forward-looking indicators, the dynamics in the Philippines indicate that shifts/movements in expectations are still affected by past values of expected inflation by economic agents. Cespades (2003) notes that this “backward-looking approach”, is a natural occurrence when there is a history of high inflation or inflation persistence, as in the case of the Philippines. Considering that inflation expectations have far-reaching effects on the macroeconomy and have a considerable impact on the significance of other channels of transmission of monetary policy, monetary authorities need to act promptly to rein in any surge in inflation expectations. Timely action to prevent inflation expectations from being disanchored will reduce the need for aggressive policy adjustments later on and, in turn, minimize output costs. This can be done through the central bank’s careful communication strategy and strong credibility, which will have a strong impact on the formation of inflation expectations. Prudent management of inflation expectations will complement direct monetary policy action and reduce the need for more aggressive monetary policy adjustments.

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References: Brischetto. Andrea and Gordon De Brouwer, 1999, “Householders’ Inflation Expectations”, Reserve Bank of Australia Research Discussion Paper, 1999-03. Calvo, Guillermo, 1983, “Staggered Prices in a Utility Maximizing Framework,” Journal of Monetary

Economics, No. 12. Vol. 3, pp. 383–98. Celasun, Oya, R. Gaston Gelos, and Alessandro Prati, 2004a, “Obstacles to Disinflation: What is the

Role of Fiscal Expectations?” Economic Policy, Vol. 19 (October), pp. 441–81. ———, 2004b, “Would ‘Cold Turkey’ Work in Turkey?,” IMF Staff Papers, Vol. 51, No. 3,pp. 493–

509. Cerisola, Martin and Gelos, R. Gaston, 2005, “What Drives Inflation Expectations in Brazil? An

Empirical Analysis,” IMF Working Paper 05/109 (Washington: International Monetary Fund). Gali, Jordi and Mark Gerter, 1999, “Inflation Dynamics: A Structural Econometric Analysis,” Journal

of Monetary Economics, Vol. 44 (October), pp. 195–222. Pfajfar, Damjan and Santoro, Emiliano, 2006, “Heterogeneity and Learning in Inflation Expectation

Formation: An Empirical Assessment,” Universita’ Degli Studi Di Trento-Departimento Di Economia Discussion Paper No. 7

Nimark, Kristoffer P., 2005, “Calvo Pricing and Imperfect Common Knowledge, A Forward Looking

Model of Rational Inflation Inertia,” European Central Bank Working Paper Series No. 474 (April), (Frankfurt am Main, Germany)

Gulyas, Erika Gulyás and Startz, Richard Startz, 2006, “The Phillips Curve: Forward-Looking

Behavior and the Inflation Premium,” (Department of Economics, University of Washington, Seattle, Washington)

Mankiw, Gregory N., Reis, Ricardo and Wolfers, Justin, 2003, “Disagreement About Inflation

Expectations,” Working Paper 9796, (National Bureau of Economic Research, Cambridge, Massachusetts)

53

BSP Inflation Forecasts

Emerging baseline forecasts indicate that inflation could settle above the 2008 and 2009 targets.

The emerging baseline forecasts indicate an elevated inflation path over the policy horizon. Compared with the outlook in the previous Inflation Report and depending on the outcome of near-term movements in prices, the current inflation outlook shows a hump-shaped path that could settle above the targets for 2008 and 2009. Price pressures have increased even as they are projected to ease starting late 2008. This developed as concurrent and interrelated shocks to the economy—such as the persistent surge in oil prices and spikes in commodity prices—have contributed to elevated inflation readings. The pass-through from global prices is continuing and the global non-oil commodity price hikes appear prolonged and are expected to take longer to unwind. Importantly, second-round effects have set in, as evident in the surge in core inflation, and a rise in inflation expectations has been perceptible from surveys and term spreads. Demand Conditions Compared with the previous Inflation Report, selected indicators suggest a slight moderation in demand conditions. GDP grew at a slower pace of 5.2 percent in Q1 2008 relative to the previous quarter’s 6.4 percent. Electricity consumption by the residential sector declined and vehicle sales slowed down due to rising fuel costs. Moreover, business and consumer confidence declined in the first quarter and employment conditions have weakened. However, other demand indicators remained firm such as the increase in property prices, the decline in vacancy rates, and the double-digit growth for imported consumer goods. Meanwhile, minimum wage and COLA adjustments were approved in thirteen (13) out of seventeen (17) regions effective June 2008. Supply Conditions Agricultural output grew by 3.0 percent in Q1 2008, a slowdown relative to the year- and quarter-ago growth rates. The continued, albeit slower, expansion was supported by production increases, higher market prices of selected crops, and the intervention measures of the Department of Agriculture (DA). The DA has teamed up with the International Rice Research Institute (IRRI) in carrying out plans to raise the country’s palay harvests and attain 98 percent self-sufficiency in rice by 2010.

54

The DA also aims to further increase palay yields through a subsidy program to encourage farmers to plant hybrid seeds and use more organic fertilizers. In the international oil market, both spot and futures prices of crude oil surged in the second quarter of 2008 due to supply uncertainties, coupled with growing demand from emerging market economies, the depreciation of the US dollar, and heightened geopolitical tensions. In the domestic market, both the pump prices of gasoline products and diesel increased by P13.00 per liter while that of LPG increased by of P3.45 per liter in Q2 2008 relative to the end of Q1 2008. In addition, the two percent tariff on specific crude and refined petroleum products in the first quarter of 2008 had been reduced to zero by the second quarter of 2008. Electricity rates of Meralco were generally higher in the second quarter due to higher prices in the Wholesale Electricity Spot Market (WESM), and increases in transmission charges and generation rates. Meanwhile, second quarter water rates were lower vis-à-vis the first quarter due to the approval of the

Output Gap Estimates The balance of demand and supply conditions, as captured by the output gap (or the difference between actual and potential output) provides an indication of potential inflationary pressures in the near term. Inflation tends to rise (fall) when demand for goods and services exert pressure on the economy’s ability to produce goods and services, i.e., when the output gap is positive (negative). Based on revised GDP data, preliminary estimates yielded an output gap of 3.3 percent in Q1 2008, which is slightly higher than the Q4 2007 estimate of 3.2 percent. The positive output gap along with steadily rising core inflation is suggestive of demand-based inflationary pressures.

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Key assumptions for the inflation forecasts

Inflation expectations The results of the BSP’s latest survey among private sector economists and analysts indicate higher inflation expectations for both 2008 and 2009 compared to the previous survey. The expected inflation rate for 2008 increased to 8.8 percent from 4.9 percent in the previous quarter’s survey, while the expected inflation rate for 2009 rose to 6.1 percent from 4.2 percent. Higher inflation expectations were also evident in the second quarter Consumer Expectations Survey (CES) and Business Expectations Survey (BES). The BSP’s baseline inflation forecasts indicate a higher path over the policy horizon relative to the previous quarter’s estimates. The forecasts are generated from the BSP’s single equation model (SEM) and the multi-equation model (MEM), and are based on the following assumptions:

a. Real GDP growth of 5.7-6.6 percent for 2008 and 6.1-7.0 percent for 2009.46

b. A budget deficit of 1.0 percent and 0.5

percent of GDP for 2008 and 2009, respectively.

c. Headline overnight RRP rate of 5.25 percent

from July 2008 to December 2009.

d. 91-day T-bill rate of 7.0 percent in 2008 and 5.5 percent in 2009.47

e. International crude oil prices which are

consistent with the latest BSP projections (as of 2 July 2008, based on the estimated future prices) of US$120.01 per barrel for 2008 and US$137.28 per barrel for 2009.

f. Increase in nominal wage of 5.5 percent in

June 2008 and 6.5 percent in June 2009.

g. Endogenously determined exchange rate in the BSP’s Multi-Equation Model through purchasing power parity and interest parity relationships.

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Risks to the Inflation Outlook The continued volatility of oil prices, the uptrend in the global prices of non-oil commodities, and potential further increases in utility rates, transport fares and wages are the main upside risks to inflation. However, there are downside risks as well such as the potential adverse impact on domestic demand of the global economic slowdown.

The risks to the inflation outlook may be presented graphically through a fan chart. The fan chart depicts the probability of different inflation outcomes based on the central projection (corresponding to the baseline forecast of the BSP) and the risks surrounding the inflation outlook.

Latest Inflation Profile

The fan chart shows the probability of various outcomes for inflation over the forecast horizon. The darkest band depicts the central projection, which corresponds to the BSP’s baseline inflation forecast. It covers 25 percent of the probability. Each successive pair of bands is drawn to cover a further 25 percent of probability, until 75 percent of the probability distribution is covered. The bands widen (i.e. “fan out”) as the time frame is extended, indicating increasing uncertainty about outcomes. The band in wire mesh depicts the inflation profile as of Q1 2008.

The current fan chart depicts an elevated inflation path relative to that of the previous quarter.

The elevated inflation path reflects mainly the impact of the higher-than-projected inflation outturns for Q2 2008 and the uptrend in the world prices of oil and food commodities. The central projection is expected to accelerate in Q3 and Q4 of 2008 due mainly to base-year effects of low inflation during the comparable period in 2007 and the higher estimated path of future world oil prices. The central projection is expected to decelerate in the first quarter of 2009 on the back of a more favorable outlook for agricultural production and moderate liquidity growth which are expected to help offset inflationary pressures from increases in world prices of both oil and non-oil commodities.

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The volatility in world oil prices remains a key risk to the inflation outlook.

This outlook is subject to some uncertainty as depicted by the widening bands of the fan chart over time. Upside risks to the projected inflation path continue to dominate downside risks as illustrated by the wider bands above the central projection compared to those below it. The main upside risks to the inflation outlook consist of higher world oil prices; the uptrend in food commodity prices; further adjustments in wages and transport fares and cost-push pressures in utility rates. On the other hand, there are downside risks which could come from the modest growth of domestic liquidity and the possibility of weaker domestic demand in line with the global economic slowdown. In the short term, the weakening of the US dollar, the onset of the hurricane season in North and Central America, the start of the driving season in the US, heightened geopolitical tensions, and limited oil inventories are likely to continue to support prices. For the longer term, both the International Energy Agency (IEA) and the US Energy Information Administration (EIA) anticipate the overall picture of sustained demand growth and tight global supply to continue. 48 Growing demand by non-OECD countries led by China is expected to offset weaker consumption in OECD nations. On the supply side, the US EIA expects slow growth in non-OPEC production, leaving oil consuming nations to rely more on OPEC supply.49 Notably, it revised downward its estimates of both non-OPEC and OPEC oil production in 2010 by 1.1 million barrels per day and 400,000 barrels per day, respectively, relative to its projections last year.

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Prevailing projections for global and domestic agricultural output are favorable, but upside risks to inflation from higher food prices remain.

The Food and Agricultural Outlook (FAO) forecasts world cereal production in 2008 to increase by 3.8 percent, with the bulk of the increase coming from wheat (up 8.7 percent). The coarse grains and rice sectors are expected to expand by 1.6 percent and by 2.3 percent, respectively.50 The FAO noted however that depleted old wheat stocks, increasingly scarce US supplies, and prevailing export restrictions continue to provide some support to global wheat prices despite favorable production prospects. In the coarse grains sector, both spot and futures prices of maize have been trending upward since the beginning of the year, given strong demand and expectations of tighter maize supplies particularly in the US. Based on the current supply and demand forecasts for the 2008/09 season, maize prices could be expected to remain high according to the FAO. Meanwhile, global rice market conditions could ease over the next few months as new crops are being harvested in both the South and North Hemispheres.51 However, the FAO stated that world rice quotations are likely to remain strong at least until October-November, when the bulk of the 2008 paddy crops will start being marketed. Over the longer term, world prices are unlikely to fall back to the pre-2007 levels, because of rising costs and the need for several countries to rebuild stocks. Third quarter domestic palay output is expected to be 9.5 percent higher than the year-ago level, due to prospects of an early onset of rainfall, the restoration and rehabilitation of irrigation facilities, greater availability of seed subsidy, and higher palay prices. High costs of fuel, fertilizer and irrigation, however, are likely to continue to support domestic rice prices.

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Further adjustments in utility rates, transport fares and wages may contribute to inflationary pressures.

There are possible sources of both increases and decreases in electricity rates in the near term. Upside risks include the following: (1) rising fuel prices; (2) constraints on coal supply; (3) a weaker peso; (4) Meralco’s petition to retrieve under-recoveries from lifeline subsidies, which would raise power rates by P0.40/kwh over one year; (5) the increase in Meralco’s distribution charge starting this year by P0.08/kwh and by P0.10/kwh each year until 2011 under the performance-based rate (PBR) application; (6) higher transmission charges related to Meralco’s petition to recover advances made to TransCo; (7) the latter’s petition to recover typhoon-related losses incurred in 2006; and (8) the readjustment in the WESM settlement price following the ERC ruling on the price manipulation issue. Downward pressures on power rates could stem from: 1) NPC’s petition for the 9th GRAM and 8th ICERA, which could result in rebates for Luzon and Mindanao customers; 2) PSALM’s initial prepayment of NPC’s loan obligations; 3) the potential shift in power use to off-peak periods with the implementation of the time-of-use scheme; and 4) the possible implementation of the open access system for ecozones. Meanwhile, transport groups are reportedly planning to file petitions for further fare hikes. On the other hand, the proposed P2.00/liter fuel subsidy and other government interventions aimed at mitigating the impact of rising oil prices on the transport sector could temper further transport fare increases. Further wage increases may add to inflationary pressure. This year, the NWPC has approved minimum wage and COLA adjustments in 13 out of 17 regions effective June. The increases granted turned out to be lower than the amounts petitioned and are in line with the wage increases imputed in the BSP’s baseline inflation forecasts. However, proposals for a legislated wage increase of P125 for private sector employees and salary adjustments for public sector employees through the Government Classification and Compensation Act remain pending with Congress.

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VI. IMPLICATIONS FOR THE MONETARY POLICY STANCE

The persistence and magnitude of the supply shocks from rising food and energy prices and their second-round effects could require the BSP to act promptly to rein in inflationary pressures. Global food prices continue to fuel inflation, even as world prices of food products have started to fall. Nevertheless, the upside risks to inflation over the next few months remain substantial. Against the backdrop of a U.S. recession, current inflation could affect domestic economic growth.

Current baseline inflation forecasts indicate that inflation would exceed their 2008 and 2009 targets. Headline inflation in June at 11.4 percent reached the highest seen in more than a decade, once again principally driven by soaring food prices. Core inflation is rising, the clamor for additional increases in transport fares continues, while the minimum wage and COLA adjustments in thirteen (13) out of seventeen (17) regions have been approved effective June 2008. Ensuring a steady decline in inflation and the management of second-round effects may require a more restrictive monetary policy stance until headline inflation slows down. Market players expect that food prices will come down markedly over the next few months as global food prices (particularly rice) have started to show some signs of flattening. However, there may be some lag before the momentum in prices is reversed52, and, even then, year-on-year price increases will remain elevated. Rising oil prices pose a growing risk. The increase in world oil prices is far from over. Hence, the pass-through from global oil prices to local pump prices will continue. Given that the Philippines is a net importer of crude oil, higher oil prices have a multi-pronged impact, affecting the economy adversely through four channels53: 1) rising inflation; 2) slower growth; 3) higher trade deficits; and 4) weaker fiscal position. The sharp pick-up in inflation since the beginning of the year coupled with the lower peso value of remittances has reduced disposable income, resulting in a slowdown in domestic consumption growth. The weakening of external demand has also become visible with the negative contribution of exports to growth, influenced largely by the decline in the exports of electronic products.

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Over the medium term, the pressure from higher energy and import prices on real incomes and subsequently on output growth poses a downside risk to future inflation. However, concurrent increases in food, energy, and other commodity import prices are likely to continue driving inflation up in the near term. Moreover, the effects of the recent peso depreciation on domestic inflation could emerge in the coming months. Prudence dictates the need for a policy stance that will guide inflation expectations without disrupting the market. In this respect, recent developments in the pricing behavior and the underlying inflation trends are of particular concern to the BSP in the coming months. It may be necessary to continue to pursue a more restrictive monetary policy should the price-setting behavior deteriorate even further than what has been assumed under the baseline inflation forecasts. A proactive central bank policy that responds firmly to inflationary shocks retains market confidence and helps in stabilizing macroeconomic conditions. [Subsequently, in July, the Monetary Board raised the BSP’s key policy interest rates by 50 basis points to 5.75 percent for the overnight borrowing or reverse repurchase (RRP) facility and 7.75 percent for the overnight lending or repurchase (RP) facility. The Monetary Board believed that a more decisive monetary action was necessary as price pressures have increased and second-round effects have already set in.]

Rising food and energy prices together with slower growth continue to shape the outlook for inflation, but the balance of risks remain on the upside. Monetary policy therefore needs to focus on containing the upside risks to inflation, the second-round effects, and elevated inflation expectations.

The BSP Inflation Report is published every quarter by the Bangko Sentral ng Pilipinas. The report is available as a complete document in pdf format, together with other general information about inflation targeting and the monetary policy of the BSP, on the BSP’s website:

www.bsp.gov.ph/monetary/inflation.asp If you wish to receive an electronic copy of the latest BSP Inflation Report, please send an e-mail to bspmail@bsp.gov.ph. The BSP also welcomes feedback from readers on the contents of the Inflation Report as well as suggestions on how to improve the presentation. Please send comments and suggestions to the following addresses:

By post: BSP Inflation Report

c/o Department of Economic Research Bangko Sentral ng Pilipinas

A. Mabini Street, Malate, Manila Philippines 1004

By e-mail: bspmail@bsp.gov.ph