The BSP tightens: Investing in policy credibility

By the time this article is published, the Bangko Sentral ng Pilipinas (BSP) will have raised its policy rate once again. Sustaining a restrictive monetary policy was widely anticipated by financial markets and, under current circumstances, is correct and unavoidable.

The BSP’s latest decision comes at an interesting moment. Several developments might have argued for some caution rather than further tightening.

Caution rather than further tightening?

Inflation slowed from 7.2% in April to 6.8% in May. The US Federal Reserve, under Chairman Kevin Warsh, has paused its own tightening cycle, reducing pressure on emerging-market central banks to match US policy moves. Domestically, the reorganization of the Philippine Senate has largely ended weeks of political uncertainty and restored some degree of policy predictability. Even the international geopolitical environment appears marginally less threatening following the US-Iran peace agreement that reopened the Strait of Hormuz to commercial shipping.

We think otherwise, and we believe the BSP also saw these developments differently.

Rather than viewing the May inflation print as the beginning of a sustained disinflation process, monetary authorities likely regarded it as a single data point insufficient to establish a trend. Inflation remains elevated, core inflation continues to edge upward, and second-round effects are becoming increasingly visible across the economy.

Nor did the Federal Reserve’s pause necessarily provide a compelling reason for complacency. While the Fed left policy rates unchanged, it simultaneously removed earlier language that had hinted at eventual easing and signaled that additional tightening could still be warranted should inflation risks persist. A pause, in other words, was not a pivot.

The domestic political environment offered no stronger basis for optimism. The Senate may have returned to business, but institutional normalcy should not be confused with policy certainty. The reconfigured chamber remains politically divided, and, based on actual floor deliberation the other day, legislative proceedings could yet become a venue for political repositioning rather than constructive policymaking.

Even the apparent breakthrough in the Middle East came with important qualifications. Markets welcomed the US-Iran peace agreement, but few could ignore President Donald Trump’s own warning that, “If they don’t behave, we’ll go right back to dropping bombs right smack in the middle of their head.” Such remarks underscore the fragility of the arrangement and the possibility that geopolitical risks remain merely dormant rather than resolved.

CAUTION FRAUGHT WITH UNCERTAINTY
Viewed through this lens, the BSP’s latest rate increase was not a response to improving conditions. It was a recognition that many of the factors cited as reasons for caution were themselves surrounded by considerable uncertainty. The challenge confronting policymakers was therefore not whether risks had disappeared, but whether they had diminished enough to justify relaxing vigilance.

The BSP’s answer appears to have been no.

Therefore, the decision to tighten policy reflects a recognition that monetary policy must respond not only to current inflation but also to future inflation risks. The central bank’s principal concern today is not necessarily the inflation that has already occurred. It is the inflation that households, businesses, and financial markets expect to occur over the next one to two years.

That distinction is crucial.

RESPONDING TO FUTURE INFLATION RISKS
Inflation may have moderated in May, but it remains well above the BSP’s target range. Five-month inflation alone averaged 4.9% and the remaining months point to sustained elevation of price movements. More importantly, there are growing signs that inflationary pressures are becoming more deeply embedded in the economy. The increase in core inflation from 3.9% to 4.1% suggests that price pressures are no longer confined to a limited number of supply-constrained sectors. Wage adjustment proposals, transport fare petitions, and electricity rate increases indicate that second-round effects are gradually emerging.

Once inflation begins influencing expectations and behavior, it becomes far more difficult to contain. Workers demand higher wages because they expect future prices to rise. Businesses raise prices because they anticipate higher costs. Consumers accelerate purchases because they fear goods will become more expensive. Inflation then becomes self-reinforcing.

Preventing that process is one of the most important responsibilities of an inflation-targeting central bank.

DETERIORATING INFLATION OUTLOOK
To be sure, the BSP’s challenge is compounded by the possibility that the inflation outlook itself may be deteriorating. Current forecasts already indicate that inflation will remain above target over the policy horizon. There is a growing possibility that these projections may have been revised upward during yesterday’s meeting on monetary policy.

Of course, the external environment remains a major source of risk.

While the US-Iran agreement has reduced immediate fears of military escalation, the durability of the arrangement remains uncertain. President Donald Trump himself highlighted this uncertainty when he warned that military action could resume if Iran fails to comply with the agreement. Such statements remind markets that geopolitical risks have been postponed rather than eliminated.

More importantly, Iran’s decision to impose charges on vessels transiting the Strait of Hormuz introduces a new inflationary channel. Even if global oil supplies continue flowing uninterrupted, higher shipping costs will eventually be reflected in transportation expenses, energy prices, and the broader cost structure of international trade. In an economy that remains heavily dependent on imported fuel and intermediate goods, such developments cannot be ignored.

This is where the BSP’s policy calculus becomes clearer.

BEYOND AN INFLATION-GROWTH TRADEOFF
The central bank may no longer be confronting a simple inflation-versus-growth tradeoff. In fact, economic growth appears to be losing momentum. A widening negative output gap suggests that demand-side pressures are weakening and that the economy may be better positioned to absorb additional monetary restraint than in previous years.

Ironically, slower growth may provide the BSP with greater room to maintain a restrictive policy stance. When demand conditions are softening, the incremental impact of tighter policy on economic activity becomes more manageable. The cost of acting may therefore be lower than the cost of inaction.

The real danger lies elsewhere.

INFLATION EXPECTATIONS VULNERABLE
If inflation expectations become unanchored, the BSP could eventually be forced into a much more aggressive tightening cycle. History repeatedly shows that restoring credibility after expectations have drifted upward is significantly more costly than preserving credibility in the first place. What begins as a modest inflation problem can quickly become a credibility problem, and definitely, credibility is far more difficult to rebuild.

This explains why today’s policy decision should not be viewed primarily through the lens of current inflation data. The BSP’s action is fundamentally about risk management. It reflects a judgment that the probability of inflation remaining elevated outweighs the risk of modestly weaker growth.

Indeed, the latest rate increase may ultimately be remembered less for its effect on borrowing costs than for the signal it sends. It demonstrates that the BSP remains prepared to act even when headline inflation begins to ease, provided the risks to future inflation remain significant.

That signal matters because monetary policy operates as much through expectations as through interest rates. Central banks influence economic behavior not merely by changing the cost of money but by shaping beliefs about future inflation and future policy actions.

The BSP’s task today is therefore larger than lowering inflation. It is preserving confidence in the inflation-targeting framework itself. The latest rate increase is best understood as an investment in that credibility.

For now, inflation has eased. But expectations remain vulnerable. In the BSP’s judgment, that vulnerability, not the latest inflation print, is what justified another round of monetary tightening.

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.