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Inflation Accelerates To 5.4% In May As Price Pressures Continue To Build Up

  • Consumer prices rose at a faster pace in May, bringing the inflation rate from 4.9% to 5.4%. The real policy rate has been negative for 20 months.
  • The following table shows the latest inflation forecasts of the central bank for the next two years:
  • Inflation has gone up further in May with food as the main driver, as shown   by the expansion of its contribution from 1.4% to 1.9%. It seems the increase in oil prices and logistics cost is having a spillover effect on food products. The items with the biggest increase in prices for May are vegetables, meat, fish, and corn. Base effects until July may keep food inflation at an elevated level in the coming months. Meanwhile, the contribution of housing and utilities to inflation was almost steady in May, reflecting the slowdown in electricity, gas, and other fuels. Average global oil prices have been steady near $110 for the past 3 months and this has prevented additional upward adjustments in local energy prices.
  • Inflation may go up further in the coming months depending on the behavior of oil. Assuming the average price of oil will stay at $100 until the end of the year, there is a possibility that inflation will peak in early 4Q near 6%. However, there are still a lot of uncertainties surrounding the outlook for oil. The European Union is planning to impose an oil embargo against Russia as a response to its attack in Ukraine. Countries will be competing for other sources of oil in this scenario and prices will most likely soar. Meanwhile, the Peso is expected to weaken further in the coming months considering the surge in import demand. Energy companies will likely incorporate the depreciation of the Peso into the retail cost of oil and electricity. Furthermore, there is a spillover effect on food given the increasing reliance of the country on imported food products like meat and rice.
  •  Inflation in the US slowed down in April, but the market is still expecting aggressive rate hikes from the Federal Reserve in the coming months given the possibility of a slow decline back to the 2% inflation target of the central bank. Hence, there is a compelling need for the BSP to adjust its rates also. The narrowing gap between US and local interest rates may contribute further to the depreciation of the Peso, which may eventually translate to higher inflation.
  • Considering the risks, we expect a 100 bp hike from the BSP from now until the end of the year, which will bring the policy rate to 3.25%. We believe the economy has enough cushion in case the BSP decides to hike its policy rate further. Historical experience has shown that the economy can grow by at least 6% in an environment where the policy rate is around 3%. A more significant risk to growth is inflation and the depreciation of the Peso. So far pent-up demand is supporting household consumption, but a prolonged period of elevated inflation may eventually hurt the consumers. Moreover, demand elements have also started to drive inflation amid the recovery of the economy. Imports have continued to ramp up given the increase in demand, causing the Peso to depreciate. Additional pressure on the Peso has also come from the faster pace of policy tightening by the Federal Reserve. Hiking the policy rate (RRP) will serve as a stabilizing tool that could temper the depreciation of the Peso. Also, this will likely prevent a substantial decline in Dollar reserves that could lead to more volatility in the local markets.

MARKET IMPLICATIONS

  • Upward pressure on local yields might persist given the existing and emerging inflationary pressures. Supply disruptions have kept food prices elevated and could be vulnerable to a surge in transport costs, trade restrictions, the threat of ASF for pork producers, and weather disturbances. Also, substantial Peso depreciation due to import expansion and hawkish Fed policy might force the central bank to make more adjustments in their policy settings.
  • We continue to expect Peso depreciation in the medium term as imports will likely recover once the country has vaccinated a huge percentage of the population. Dollar demand may pick up and keep the exchange rate above the 52 level. Meanwhile, the possibility of tighter Dollar supply may contribute further to Peso depreciation. The Federal Reserve is expected to hike aggressively this year.

FACTS

Consumer prices rose at a faster pace in May, bringing the inflation rate from 4.9% to 5.4%. The real policy rate has been negative for 20 months.

The following table shows the latest inflation forecasts of the central bank for the next two years:

ANALYSIS

  • Inflation has gone up further in May with food as the main driver, as shown   by the expansion of its contribution from 1.4% to 1.9%. It seems the increase in oil prices and logistics cost is having a spillover effect on food products. The items with the biggest increase in prices for May are vegetables, meat, fish, and corn. Base effects until July may keep food inflation at an elevated level in the coming months. Meanwhile, the contribution of housing and utilities to inflation was almost steady in May, reflecting the slowdown in electricity, gas, and other fuels. Average global oil prices have been steady near $110 for the past 3 months and this has prevented additional upward adjustments in local energy prices.
  • Inflation may go up further in the coming months depending on the behavior of oil. Assuming the average price of oil will stay at $100 until the end of the year, there is a possibility that inflation will peak in early 4Q near 6%. However, there are still a lot of uncertainties surrounding the outlook for oil. The European Union is planning to impose an oil embargo against Russia as a response to its attack in Ukraine. Countries will be competing for other sources of oil in this scenario and prices will most likely soar. Meanwhile, the Peso is expected to weaken further in the coming months considering the surge in import demand. Energy companies will likely incorporate the depreciation of the Peso into the retail cost of oil and electricity. Furthermore, there is a spillover effect on food given the increasing reliance of the country on imported food products like meat and rice.
  •  Inflation in the US slowed down in April, but the market is still expecting aggressive rate hikes from the Federal Reserve in the coming months given the possibility of a slow decline back to the 2% inflation target of the central bank. Hence, there is a compelling need for the BSP to adjust its rates also. The narrowing gap between US and local interest rates may contribute further to the depreciation of the Peso, which may eventually translate to higher inflation.
  • Considering the risks, we expect a 100 bp hike from the BSP from now until the end of the year, which will bring the policy rate to 3.25%. We believe the economy has enough cushion in case the BSP decides to hike its policy rate further. Historical experience has shown that the economy can grow by at least 6% in an environment where the policy rate is around 3%. A more significant risk to growth is inflation and the depreciation of the Peso. So far pent-up demand is supporting household consumption, but a prolonged period of elevated inflation may eventually hurt the consumers. Moreover, demand elements have also started to drive inflation amid the recovery of the economy. Imports have continued to ramp up given the increase in demand, causing the Peso to depreciate. Additional pressure on the Peso has also come from the faster pace of policy tightening by the Federal Reserve. Hiking the policy rate (RRP) will serve as a stabilizing tool that could temper the depreciation of the Peso. Also, this will likely prevent a substantial decline in Dollar reserves that could lead to more volatility in the local markets.

MARKET IMPLICATIONS

  • Upward pressure on local yields might persist given the existing and emerging inflationary pressures. Supply disruptions have kept food prices elevated and could be vulnerable to a surge in transport costs, trade restrictions, the threat of ASF for pork producers, and weather disturbances. Also, substantial Peso depreciation due to import expansion and hawkish Fed policy might force the central bank to make more adjustments in their policy settings.
  • We continue to expect Peso depreciation in the medium term as imports will likely recover once the country has vaccinated a huge percentage of the population. Dollar demand may pick up and keep the exchange rate above the 52 level. Meanwhile, the possibility of tighter Dollar supply may contribute further to Peso depreciation. The Federal Reserve is expected to hike aggressively this year.

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