The limits and responsibilities of flexible inflation targeting

Last Monday, this paper bannered the now-familiar refrain: sluggish growth and benign inflation give the Bangko Sentral ng Pilipinas (BSP) ample room to cut rates again.

All 16 analysts surveyed expect another 25-basis-point reduction, bringing the policy rate to 4.25%, the lowest in more than three years. The argument appears neat and compelling. Growth has disappointed. GDP averaged only 3.9% and 3% in the third and fourth quarters. Full-year 2025 came in at a modest 4.4%, well below the downgraded 5.5% to 6.5% target and slightly under the BSP’s own 4.6% projection.

Inflation, meanwhile, has remained within the 2% to 4% target band.

So why not cut again?

Because monetary policy is not a reflex. It is a judgment call. And judgment requires asking a harder question:

Has further easing become less effective — and potentially more risky?

THE GROWTH PROBLEM IS NOT PURELY MONETARY
Since the BSP began its easing cycle, policy rates have been reduced by 200 basis points. That is not trivial. It is a substantial accommodation.

Yet growth continued to decelerate.

Private household consumption, nearly 73% of GDP, slowed from 4.9% to 4.6%, even as inflation fell sharply from 3.2% to 1.7%. This should have unleashed purchasing power. Instead, spending remained cautious.

Why?

Because inflation moderating does not mean prices returned to old levels. The absolute price base remains elevated. Households are not reacting to inflation rates; they are reacting to price levels. Food, transport, utilities — these remain expensive relative to income growth.

This is not a monetary malfunction. It is structural.

Logistics inefficiencies. Trade frictions. Supply chain rigidities. Agricultural vulnerabilities. These are beyond the reach of interest rate policy.

Even remittances, over $32 billion in the first 11 months of 2025, did not spark a spending surge. That suggests precautionary behavior and diminished confidence.

Gross capital formation sends an even stronger signal. Investment growth plunged from 7.7% to 2.1%. That is not a rate problem alone. That is a confidence problem.

Liquidity cannot substitute for trust. Interest rate cuts cannot compensate for governance uncertainty. Monetary policy cannot build roads, reform procurement, or restore institutional credibility.

At some point, additional easing yields diminishing returns.

We may already be there.

LIQUIDITY IS ABUNDANT BUT TRANSMISSION IS WEAK
The banking system is unmistakably flush with liquidity. Reserve requirement reductions and policy rate cuts have expanded monetary space. The loans-to-deposit ratio (LDR) improved from 75.2% to 78.2%.

But this improvement is modest relative to the scale of easing.

More troubling is that real lending rates actually rose.

High-end lending rates increased from 9.9% to 10.66%. On the other hand, low-end rates climbed from 4.63% to 5.62%. Meanwhile, average bank lending rates rose from 5.09% in 2024 to 6.22% in the first 11 months of 2025.

In other words, policy easing did not translate into cheaper effective borrowing costs.

Why?

Because banks remain cautious.

Based on BSP senior loan officers survey for the 4th quarter 2025, credit standards, while officially “unchanged” for many, show net tightening under diffusion analysis. Collateral requirements could have remained strict. Loan sizes more conservative. Tenors could be shorter.

This pro-cyclical tightening during down periods weakens monetary transmission.

If liquidity does not translate into credit expansion, the marginal impact of further rate cuts could actually shrink.

And when effectiveness shrinks, risks loom larger.

THE INFLATION RISKS ARE NOT HYPOTHETICAL, THEY ARE BUILDING
The dominant narrative says inflation is benign.

But this may be backward-looking comfort.

The risks ahead are mounting — and they are largely supply-side and cost-push in nature, precisely the type that can quickly unanchor expectations if credibility falters.

For instance, utilities and administered prices are bound to increase. Tollway charges may increase anytime. Power distributors have signaled rate adjustments. Water concessionaires may implement FX-linked and periodic adjustments. These are not marginal items. They feed into transport, logistics, food distribution, and household utility costs. Their second-round effects are powerful.

For another, rice policy is being reversed. Any tightening of rice import policies or tariff reversion risks immediate price pressure. Rice carries heavy weight in the consumer basket. Even modest increases have outsized inflation expectation effects.

The exchange rate is also vulnerable. The recent stabilization of the peso was not purely structural. It was partly driven by expectations that the easing cycle is nearing its end. If the BSP continues cutting while the US Federal Reserve remains cautious, the interest differential narrows. Capital flows respond quickly to that differential. A weaker peso feeds directly into higher fuel prices, imported food inflation, higher cost of imported capital goods and production inputs.

Imported inflation is not theoretical. It is immediate.

And once the exchange rate narrative shifts from “stable” to “weakening,” expectations could adjust rapidly.

We also have to reckon with positive base effects. The whole year 2025 is characterized by extremely low inflation. The base effects would be positive in 2026. Moreover, December 2025 inflation was elevated. That could help push the forecast for early 2026. Combined with cost pressures, the probability of breaching the upper end of the 2% to 4% target band increases.

The BSP’s December forecast of 3.2% inflation for 2026 may now prove optimistic.

Finally, inflation expectations are poised to be unhinged. Flexible inflation targeting works because expectations remain anchored. But expectations are forward-looking. If households see rising tolls, higher electricity bills, water rate adjustments, rice price pressures, and a weakening peso, they do not parse output gaps or core inflation models.

Households adjust expectations upward. Once expectations drift, restoring credibility requires sharper tightening later. Prevention is cheaper than correction.

THE COST OF MISCALIBRATION
Flexible inflation targeting (FIT) involves calibrated response.

The BSP has done commendable work since 2002 anchoring price stability while acknowledging growth and financial stability concerns.

But flexibility does not mean asymmetry.

If policy leans too heavily toward growth support when transmission is impaired and inflation risks are rising, credibility can erode gradually, then suddenly.

A central bank’s greatest asset is not liquidity. It is credibility. And credibility is cumulative, but fragile.

The output gap may still be negative. But if additional easing does little to close it while materially raising inflation and currency risks, the trade-off becomes unfavorable.

MONETARY POLICY CANNOT CARRY THE ECONOMY ALONE
There is a deeper institutional question here.

If structural and governance bottlenecks are restraining investment and productivity, should monetary policy continue compensating even if there is nominal scope?

Doing so risks asset mispricing, peso instability, imported inflation, and future abrupt tightening cycles. We have to recall that monetary policy can buy time. But it cannot manufacture confidence.

If fiscal reforms, supply-side improvements, and institutional clarity lag, monetary accommodation becomes a blunt instrument applied to a structural wound.

Eventually, the wound demands surgery, not anesthesia.

THE STRATEGIC PAUSE IS NOT WEAKNESS, IT IS STRENGTH
A pause at this stage would not signal policy exhaustion.

It would signal recognition of diminishing marginal returns, awareness of rising inflation asymmetry, commitment to credibility preservation, and respect for exchange rate stability.

The BSP can always ease again if data deteriorate meaningfully.

But reversing an inflation resurgence or stabilizing a disorderly peso is far more costly. Sometimes the most forceful move a central bank can make is restraint. Flexible inflation targeting demands agility, not momentum for its own sake.

The BSP has shown flexibility before: easing when necessary, tightening when required, stabilizing when markets trembled.

The moment now calls not for reflex, but for resolve.

Growth is important. But price stability and the credibility that underpins it is indispensable.

And once credibility slips, no number of basis points can easily restore it.

Diwa C. Guinigundo is the former deputy governor for the Monetary and Economics Sector, the Bangko Sentral ng Pilipinas (BSP). He served the BSP for 41 years. In 2001-2003, he was alternate executive director at the International Monetary Fund in Washington, DC. He is the senior pastor of the Fullness of Christ International Ministries in Mandaluyong.