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 4.5 percent and 4.0 percent for 2010 and 2011, both with a tolerance interval of ± 1.0 percentage point. The inflation target range for 2010 therefore is 3.5-5.5 percent and for 2011, 3.0-5.0 percent.

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, labor market conditions, monetary and financial market conditions, fiscal developments, and the international environment. A section is devoted to a discussion of monetary policy developments in the last quarter, as well as a comprehensive analysis of the BSP’s view of the inflation outlook for 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 a box article on inflation expectations and the price puzzle in the Philippine transmission mechanism.

The Monetary Board approved this Inflation Report at its meeting on

11 February 2010.

AMANDO M. TETANGCO, JR. Governor

12 February 2010

T

ii

List of Acronyms, Abbreviations, and Symbols AFF Agriculture, Fishery, and Forestry AMCs Asset Management Companies ARMM Autonomous Region of Muslim Mindanao AP Asia Pacific AL Auto Loans BAS Bureau of Agricultural Statistics BES Business Expectations Survey BIS Bank for International Settlements BOC Bureau of Customs BPO Business Processing Outsourcing BTr Bureau of the Treasury 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 CI Confidence Index CPI Consumer Price Index ECB European Central Bank EMBI Emerging Market Bond Index ENSO El Niño Southern Oscillation ERC Energy Regulatory Commission EU European Union FAO Food and Agriculture Organization GDP Gross Domestic Product GNP Gross National Product GRAM Generation Rate Adjustment Mechanism IBL Interbank Loans EIA Energy Information Administration ICERA Incremental Currency Exchange Rate Adjustment FCDA Foreign Currency Differential Adjustment IEA International Energy Agency IMF International Monetary Fund IPP Independent Power Producer KBs Commercial banks LFS Labor Force Survey LPG Liquefied Petroleum Gas LTFRB Land Transportation Franchising and Regulatory Board MEM Multi-Equation Model Meralco Manila Electric Company MISSI Monthly Integrated Survey of Selected Industries MTP Major Trading Partner MW Megawatt NCCP National Council for Commuters Protection NDA National Domestic Assets NFA Net Foreign Assets, National Food Authority NFIA Net Factor Income From Abroad NG National Government NIA National Income Accounts NPC National Power Corporation NPLs Non-performing loans NSO National Statistics Office OECD Organization for Economic Cooperation and Development OMOs Open market operations

iii

OPEC Organization of Petroleum Exporting Countries PBR PCE PMI

Performance-based Rate Personal Consumption Expenditure Purchasing Managers’ Index

PSALM Power Sector Assets and Liabilities Management PSEi Philippine Stock Exchange Composite Index PSS Postal Savings System PSIC Philippine Standard Industrial Classification RB Rural Banks REER Real Effective Exchange Rate RM Reserve Money ROP Republic of the Philippines RP Repurchase RREL Residential and Real Estate Loans RRP Reverse Repurchase SEM Single-Equation Model SDA Special Deposit Account TB Thrift Bank TCS Transportation, Communications, and Storage U/KBs Universal/commercial banks WEO World Economic Outlook

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 (RRP) or its borrowing rate and overnight repurchase (RP) or its 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)5 in consultation with the BSP. For 2010, the headline inflation target has been set at 4.5 percent ± 1.0 percentage point, while for 2011, the inflation target has been set at 4.0 ± 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.

5 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 Bo ard 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 Peter B. Favila

Raul A. Boncan

Juanita D. Amatong

Nelly F. Villafuerte

Alfredo C. Antonio

Ignacio R. Bunye

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 Members 6 Diwa C. Guinigundo

Deputy Governor Monetary Stability Sector

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

Ma. Cyd N. Tuaño-Amador

Assistant Governor Monetary Policy Sub-Sector

Ma. Ramona GDT Santiago Managing Director Treasury Department

6 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

2010 SCHEDULE OF MONETARY POLICY MEETINGS, INFLATIO N REPORT PRESS CONFERENCE AND PUBLICATION OF MB HIGHLIGHTS

Period Advisory

Committee (AC) Meeting

Monetary Board (MB)

Meeting

MB Highlights Publication

Inflation Report (IR)

Press Conference

2 0 1 0

Jan 25 (Mon)

28 (Thu) 14 (Thu)

Feb 25 (Thu)

12 (Fri) a

Mar 8 (Mon) b

11 (Thu)

Apr 19 (Mon)

22 (Thu) 8 (Thu)

May 31 (Mon)

20 (Thu)

7 (Fri) c

Jun 3 (Thu)

Jul 12 (Mon)

15 (Thu) 1 (Thu)

30 (Fri)

Aug 24 (Tue) d

26 (Thu) 12 (Thu)

Sep 23 (Thu)

Oct 4 (Mon)

7 (Thu) 29 (Fri)

Nov 15 (Mon)

18 (Thu) 4 (Thu)

Dec 28 (Tue) e

30 (Thu) 16 (Thu)

a Inflation Report press conference scheduled on the last Friday of January (29 January 2010) will be moved two weeks later (12 February 2010) due to a scheduled AC meeting on 25 January 2010 and MB meeting on 28 January 2010. b There is a scheduled BIS bi-monthly Governors’ meeting on 7-8 March 2010. c Inflation Report press conference scheduled on the last Friday of April (30 April 2010) will be moved one week later (7 May 2010) due to a scheduled AC meeting on 19 April 2010 and MB meeting on 22 April 2010. d AC meeting scheduled on 23 August 2010 (Monday) will be moved to 24 August 2010 (Tuesday). 23 August 2010 is a special non-working holiday. As per Proclamation No. 1841 dated 21 July 2009, 21 August 2010 (Ninoy Aquino Day), which falls on a Saturday, will be moved to 23 August 2010 (Monday nearest 21 August 2010 - Republic Act No. 9492 dated 24 July 2007). e AC meeting scheduled on 27 December 2010 (Monday) will be moved to 28 December 2010 (Tuesday). As per Proclamation No. 1841 dated 21 July 2009, 30 December 2010 (Rizal Day), which falls on a Thursday will be a working day. Rizal Day (30 December 2010) which used to be a holiday will instead be celebrated on Monday, 27 December 2010.

vii

CONTENTS

Overview 1

I. Inflation and Real Sector Developments 3

Prices 3

Aggregate Demand and Supply 10

Aggregate Demand 10

Other Demand Indicators 12 Aggregate Supply 19

Labor Market Conditions 21

II. Monetary and Financial Market Conditions

22

Domestic Liquidity and Credit Conditions 22

Interest Rates 24

Financial Market Conditions

26

Banking System 29

Exchange Rate

33

III. Fiscal Developments IV. External Developments

35

36

V. Monetary Policy Developments

Box Article: Inflation Expectations and the Price P uzzle in the Transmission Mechanism: Philippines

41

44

VI. Inflation Outlook 51

Private Sector Economists’ Inflation Forecasts BSP Inflation Forecasts

Risks to the Inflation Outlook VII. Implications for the Monetary Policy Stanc e

51 53

56

62

1

OVERVIEW7 Average inflation for 2009 falls within target rang e, even as Q4 inflation increases. Headline inflation for 2009 averaged lower at 3.2 percent, well within the Government’s target of 2.5-4.5 percent. Favorable developments in food and energy-related items in the first three quarters of 2009 sustained the inflation downtrend which started in Q4 2008. However, inflation rose in Q4 2009 as weather-related disturbances led to higher prices of food products and as the price of oil increased in the global market. Higher inflation path in Q4 was also partly statistical as base effects which contributed to low inflation readings during the earlier part of the year have started to diminish. Meanwhile, core inflation reflected a downtrend for five consecutive quarters starting Q4 2008 to reach 2.9 percent in Q4 2009 indicating modest demand-side price pressures. The prevailing inflation outlook likewise indicates within-target inflation over the policy horizon, with near-term price pressures expected to remain manageable. Inflation is expected to track a target-consistent path over the policy horizon, with the latest baseline inflation forecasts for both 2010 and 2011 only slightly higher than the forecast in the previous Inflation Report. Risks to domestic inflation are tilted slightly upwards. On the one hand, potential sources of domestic inflationary pressures include supply tightness in key agricultural products, and the pending adjustments in domestic power charges. The impact of the El Niño weather conditions on domestic food supply could also add some pressure on inflation in the near term. On the other hand, downside price pressures are expected to stem from the modest improvement in domestic demand, and well-contained inflation expectations. Large foreign exchange inflows, including from overseas Filipinos’ remittances and foreign investments, could help stabilize the value of the peso and in the process, help contain price pressures from imported commodities. Global price developments relate mainly to the outl ook for global economic activity and developments in world commodity prices. Global inflationary risks are expected to be manageable as some major central banks have signaled their strong commitment to safeguard price stability by preemptively considering the disengagement from crisis intervention measures. At the same time, economic fundamentals, such as moderate improvement in consumer demand, above-average inventory levels and elevated spare capacity are expected to weigh down on global price developments. However, an improvement in market sentiment may prompt a rebound in private demand for advanced economies and pose upside risks to global inflation. In addition, structural weaknesses in the investment and operational environment in the oil and agriculture sectors suggest possible resurgence in commodity prices in the near term once global demand fully recovers. The economy continues to grow in Q4 2009, supported by a resilient domestic demand and the gradual recovery in global economic conditi ons. Latest demand indicators signaled a pick-up in demand activity starting Q4 2009 with vehicle and energy sales increasing and capacity utilization of manufacturing reaching its highest level since 2000. Strong demand from household and government spending provided support to the economy, with real GDP expanding by 1.8 percent year-on-year in the fourth quarter. At the same time, the world economy has shown signs of recovery, with leading indicators in the advanced and emerging economies in Q4 2009 pointing to a resumption of growth with the return of substantial net capital inflows, resilient domestic demand, and strong recovery in external trade. Nevertheless, there remains uncertainty regarding the sustainability of future growth beyond the impact of the stimulus measures.

7 The analyses in this report are based on information as of 31 December 2009.

2

There are clear signs that financial markets have n ormalized. Global financial market activity continued to be driven by growing confidence in the global economic recovery as the steady stream of mostly positive macroeconomic news reassured investors that the global economy had in fact turned around. Exceptionally low policy rates across the globe and fiscal stimulus packages in advanced economies continued to drive the post-crisis rebound in global equity markets. As global credit markets continued to normalize and credit spreads have stabilized, the risk of contagion from global financial stresses has markedly been reduced in domestic financial markets. Philippine sovereign debt spreads narrowed at the end of Q4 relative to the end of Q3 2009. The domestic equities market continued to post gains, and the peso appreciated against the dollar in the foreign exchange market in December 2009, brought about by the reflow of capital to emerging market economies and inflow of OF remittance. The continued expansion in domestic liquidity provi des support to the country’s growth requirements amidst challenging global economic con ditions. Domestic liquidity grew steadily in Q4, fueled by the increase in net foreign assets. Meanwhile, net domestic credit growth reflected the slowdown in the economy, as the pace of credit to both the public and the private sector moderated. Commercial bank lending growth slowed down to single-digit levels starting in July 2009 as lending for production activities was pulled down by the contraction of lending to manufacturing, which in part reflected the negative impact of the global crisis on export demand. Latest data however, reflect some pick up in bank lending, with the strengthening of lending for production activities. Reflecting ample supply of credit, preliminary survey responses of senior bank loan officers in Q4 2009 indicated that overall lending conditions remained basically unchanged compared with the previous quarter. The within-target inflation outlook over the policy horizon, supported by well-contained inflation expectations, positive economic growth, a nd broad stability in domestic financial markets, all suggest that current policy settings remain appropriate. Going forward, the BSP is committed to undertake prompt policy action before inflation pressures begin to manifest, especially if supply-side risks to inflation become persistent. With the expected improvement in the domestic economy alongside the recovery in the global economy by 2010, the BSP will continue to review its support measures in line with its commitment to price stability. The decision to recalibrate the support measures of the BSP will depend on the underlying conditions in the economy, particularly the inflation outlook and expectations about inflation, as well as the speed of recovery in the domestic economy. [On 28 January 2010, the Monetary Board maintained the RRP and RP rates at 4.0 and 6.0 percent, respectively. The Board noted that, with the favorable inflation outlook, keeping policy rates steady would continue to support economic activity. The Monetary Board also decided to set the peso rediscount rate equal to the overnight RRP rate effective 1 February 2010. It will be recalled that the Board approved, effective 2 March 2009, a peso rediscount rate that was 50 basis points lower than the overnight RRP rate as part of a package to liberalize banks’ access to the BSP’s rediscounting facility and ensure the orderly operation of domestic financial markets should global financial conditions worsen. Since the risk of contagion from global financial stresses is markedly reduced, with the sustained stability in global financial markets, the need for more liberalized pricing of rediscounting loans is now less. Continued stability in liquidity conditions also warrants the reversion in pricing.]

3

I. INFLATION AND REAL SECTOR DEVELOPMENTS Prices

-1

1

3

5

7

9

11

13

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Headline inflation for 2009 averaged lower at 3.2 percent, well within the Government’s target of 2.5-4.5 percent. Favorable developments in food and energy-related items in the first three quarters of 2009 sustained the inflation downtrend which started in Q4 2008. However, inflation rose in Q4 2009 as weather disturbances led to higher prices of food products and as the price of oil increased in the global market. The increase was also partly statistical as base effects which contributed to low inflation readings during the earlier part of the year have diminished. Meanwhile, core inflation reflected a downtrend for five consecutive quarters starting Q4 2008 to reach 2.9 percent in Q4 2009. These developments indicate that despite moderate underlying demand pressures reflected in the core measure, higher food and energy prices suggest some upturn in headline inflation in the coming months.

Price pressures arise from upward movements in food and non-food inflation.

0

2

4

6

8

10

12

14

Q1Q2Q3Q4Q1Q2Q3Q4Q1Q2Q3Q4Q1Q2Q3Q4Q1Q2Q3Q4Q1Q2Q3Q4Q1Q2Q3Q4Q1Q2Q3Q4

2002 2003 2004 2005 2006 2007 2008 2009

Headline Inflation Core Inflation

Headline and Core Inflation Following four consecutive quarters of deceleration, headline inflation rose to 3.0 percent in Q4 2009 from 0.3 percent in the previous quarter, but was well below the 9.7 percent inflation registered in Q4 2008. Both food and non-food inflation increased in Q4 2009, as fuel prices increased and as weather-related disturbances in September and October affected the supply of commodities in Q4 2009.

2009 average inflation falls within target range, even as Q4 inflation increases. Headline Inflation

Quarterly average in percent (2000=100)

Headline and Core Inflation Quarterly average in percent (2000=100)

4

Core inflation continues to slow down.

Core inflation, an indicator of the long-term trend of inflation, extended its downtrend during the quarter. The official NSO core inflation measure eased further to 2.9 percent in Q4 2009 compared to 3.1 percent in the previous quarter and 7.7 percent in the same quarter a year ago. The alternative measures of core inflation estimated by the BSP reflected an overall downtrend in Q4 2009 compared to the same quarter a year ago. However, relative to the previous quarter, the alternative measures were higher as they tracked the direction of the headline inflation. Core inflation contributed 2.2 percentage points to headline inflation in Q4 2009, higher than the 1.4 percentage-point contribution in Q3 2009, and about a third of Q4 2008 core inflation of 5.9 percentage points. With the renewed increase in year-on-year food and petroleum prices, the non-core CPI items posted a positive contribution to headline inflation at 0.8 percentage point from negative 1.1 percentage points in the previous quarter. Non-core items contributed 3.8 percentage points in the same quarter a year ago. The proportion of CPI components [at the 4-digit Philippine Standard Industry Classification (PSIC) level] showing inflation rates above a given threshold provides an indication as to whether pressures on consumer prices are becoming generalized over time. The number of items with inflation rates greater than the threshold of 4.5 percent (the upper end of the inflation target for 2009) fell further to 37 in Q4 2009 from 43 in the previous quarter. However, these items accounted for a bigger proportion of the CPI basket at 23.0 percent compared to 16.0 percent in the previous quarter. Dividing the CPI basket into food and non-food components revealed that there were 25 food items with inflation rates above the threshold, unchanged from the previous quarter, while 12 non-food commodities posted inflation rates that were higher than the threshold in Q4 2009 compared to 18 items in the previous quarter.

5.2

2.6

1.12.6

5.6

3.9

2.42.9

5.8

3.9

1.83.0

6.3

4.4

3.12.9

2009Q1

Q2

Q3Q4

Alternative Core Inflation MeasuresAlternative Core Inflation Measures

Quarterly averages of yearQuarterly averages of year--onon--year change year change

QuarterQuarterOfficial CoreOfficial Core

InflationInflationTrimmedTrimmed

Mean 1/Mean 1/WeightedWeighted

Median 2/Median 2/Net of Volatile Net of Volatile

Items 3/ *Items 3/ *

2008 6.2 7.6 7.3 7.8Q1 4.1 5.1 4.5 5.2Q2 6.2 7.7 7.4 8.0Q3 6.9 9.6 9.1 9.7Q4 7.7 7.9 8.1 8.1

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

2/ The weighted median represents the middle inflation rate (corresponding to a cumulative CPI weight of 50 percent) in a lowest-to-highest ranking of year-on-year inflation 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 official core inflation, 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

5.2

2.6

1.12.6

5.6

3.9

2.42.9

5.8

3.9

1.83.0

6.3

4.4

3.12.9

2009Q1

Q2

Q3Q4

Alternative Core Inflation MeasuresAlternative Core Inflation Measures

Quarterly averages of yearQuarterly averages of year--onon--year change year change

QuarterQuarterOfficial CoreOfficial Core

InflationInflationTrimmedTrimmed

Mean 1/Mean 1/WeightedWeighted

Median 2/Median 2/Net of Volatile Net of Volatile

Items 3/ *Items 3/ *

2008 6.2 7.6 7.3 7.8Q1 4.1 5.1 4.5 5.2Q2 6.2 7.7 7.4 8.0Q3 6.9 9.6 9.1 9.7Q4 7.7 7.9 8.1 8.1

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

2/ The weighted median represents the middle inflation rate (corresponding to a cumulative CPI weight of 50 percent) in a lowest-to-highest ranking of year-on-year inflation 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 official core inflation, 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

Contribution to Quarterly InflationContribution to Quarterly Inflation

in percent in percent

ItemItemWeight in Weight in Headline Headline

CPICPI

Percentage Contribution to Percentage Contribution to YearYear--onon--Year Headline Year Headline

InflationInflationQ42009

Q3 2009

Q4 Q4 20082008

Core Inflation 81.6 2.16 1.39 5.91Non-core Items 18.4 0.79 -1.05 3.76

Rice 9.4 0.25 -0.36 2.84Corn 0.9 0.00 -0.04 0.23Fruits and

Vegetables5.3 0.62 0.09 0.58

Gas, LPG 1.3 0.12 -0.19 0.01Kerosene 0.3 -0.03 -0.07 0.05Oil, Gasoline and

Diesel1.3 -0.17 -0.48 0.05

Headline Inflation 100.00 2.95 0.33 9.67

Source of Basic Data: NSO, BSP

Contribution to Quarterly InflationContribution to Quarterly Inflation

in percent in percent

ItemItemWeight in Weight in Headline Headline

CPICPI

Percentage Contribution to Percentage Contribution to YearYear--onon--Year Headline Year Headline

InflationInflationQ42009

Q3 2009

Q4 Q4 20082008

Core Inflation 81.6 2.16 1.39 5.91Non-core Items 18.4 0.79 -1.05 3.76

Rice 9.4 0.25 -0.36 2.84Corn 0.9 0.00 -0.04 0.23Fruits and

Vegetables5.3 0.62 0.09 0.58

Gas, LPG 1.3 0.12 -0.19 0.01Kerosene 0.3 -0.03 -0.07 0.05Oil, Gasoline and

Diesel1.3 -0.17 -0.48 0.05

Headline Inflation 100.00 2.95 0.33 9.67

Source of Basic Data: NSO, BSP

5

Weather-related supply disturbances cause food prices to rise.

Prices of agricultural commodities reflect mixed trends.

Food Inflation Food, which accounts for 50.0 percent of the CPI basket, contributed 2.3 percentage points to headline inflation, as weather-related developments disturbed the supply of rice (9.4 percent of the CPI basket) and other food products during the quarter. Food inflation rose to 4.6 percent in Q4 2009 from 1.9 percent in the previous quarter but was significantly lower than the 13.8 percent posted in Q4 2008. Agricultural Commodity Prices Palay prices rose to P14.52 per kilo in December 2009 from P14.15 per kilo and P13.55 per kilo in September 2009 and December 2008, respectively. The increment was attributed mainly to the adverse effects of tropical storms “Ondoy” and “Pepeng.” Special rice prices increased slightly in December 2009 from their year- and quarter-ago levels, reflecting the decline of rice output in Q4 2009. The average price of ordinary rice in December 2009 was higher than the year-ago level, due mainly to supply tightness, especially in calamity-stricken areas. Meanwhile, yellow corn prices decreased in December 2009 from its year- and quarter-ago levels, as corn production increased with the expansion of area harvested.

Inflation Rates for Selected Food Items

Quarterly averages in percent (2000=100)

CommodityCommodity 20092009 20082008

Q4 Q3 Q4Q4 Q3Q3

Food, Beverage and Tobacco 4.6 1.9 9.7 17.0Food 4.7 1.8 13.8 17.9Cereal & Cereal Products 2.6 -2.1 27.3 36.7o/w Rice 2.7 -3.8 30.4 44.0

Corn 0.4 -5.0 26.3 33.0Dairy Products 3.4 5.0 12.7 13.7Eggs 5.9 6.4 5.6 6.1Fish 5.2 6.5 9.6 9.3Fruits & Vegetables 11.7 1.7 10.9 15.3Meat 5.9 2.6 9.4 10.9Misc. Food 3.2 2.7 8.6 9.0Beverages 2.4 3.2 6.5 6.1Tobacco 3.9 3.5 3.8 3.9

Source of Basic Data: NSO, BSP

Inflation Rates for Selected Food Items

Quarterly averages in percent (2000=100)

CommodityCommodity 20092009 20082008

Q4 Q3 Q4Q4 Q3Q3

Food, Beverage and Tobacco 4.6 1.9 9.7 17.0Food 4.7 1.8 13.8 17.9Cereal & Cereal Products 2.6 -2.1 27.3 36.7o/w Rice 2.7 -3.8 30.4 44.0

Corn 0.4 -5.0 26.3 33.0Dairy Products 3.4 5.0 12.7 13.7Eggs 5.9 6.4 5.6 6.1Fish 5.2 6.5 9.6 9.3Fruits & Vegetables 11.7 1.7 10.9 15.3Meat 5.9 2.6 9.4 10.9Misc. Food 3.2 2.7 8.6 9.0Beverages 2.4 3.2 6.5 6.1Tobacco 3.9 3.5 3.8 3.9

Source of Basic Data: NSO, BSP

6

Prices of petroleum products spur increase in non-food inflation.

Non-food inflation Looking at developments in non-food inflation, higher prices of petroleum products in Q4 2009 relative to the previous quarter contributed to the increase in Q4 headline inflation. Higher fuel prices were due largely to the lifting of the price ceiling on these items in mid-November.8 Fuel inflation reversed to 4.3 percent from negative 12.8 percent in the previous quarter, but was lower compared to the same quarter a year ago. The pump prices of unleaded gasoline and diesel were also higher in Q4 2009. Energy Prices The international price of Dubai crude oil was higher by 43.4 percent year-on-year at US$75.43 per barrel in Q4 2009 from an average of US$52.60 per barrel in the same period last year. Prices increased during the review quarter on optimism that oil demand will strengthen the increase due to better economic prospects for US, Japan, and China. On a quarter-on-quarter basis, the international price of Dubai crude oil was also higher by 11.0 percent in Q4 2009 compared to US$67.93 per barrel in Q3 2009 on falling US oil inventories resulting from higher demand for heating oil during winter. The Energy Information Administration (EIA)9 and International Energy Agency (IEA)10 forecast that world oil consumption will grow in 2010 by 1.1 million barrels per day (mbd) and 0.1 mbd, respectively, and that developing economies are expected to account for the bulk of the growth in demand. Given its better-than-expected outlook for 2010, the Organization of Petroleum Exporting Countries’ (OPEC) expects world oil demand to increase by 0.8 mbd.11 In the domestic scene, pump prices of petroleum products were higher compared to the same period last year. The prices of gasoline, kerosene, diesel, and LPG at the end of Q4 2009 rose by P13.00 per liter, P2.61 per liter, P3.42 per liter, and P12.34 per liter, respectively.

8 See discussion on energy prices for more information on the Government’s price ceiling on petroleum products implemented on 16 October 2009. 9 Energy Information Agency, Short-Term Oil Outlook, December 2009, www. eia.doe.gov 10 IEA, Oil Market Report, December 2009, www.iea.org 11 OPEC Monthly Oil Market Report, December 2009, www.opec.org

Inflation Rates for Selected NonInflation Rates for Selected Non--

Food ItemsFood Items

Quarterly averages in percent (2000=100)Quarterly averages in percent (2000=100)

CommodityCommodity2009 2008

Q4Q4 Q3Q3 Q4Q4 Q3Q3

Non-Food Items 1.3 -1.1 5.9 7.8Clothing 2.0 2.2 5.0 4.6Housing & Repairs 2.1 2.2 5.3 4.9Fuel, Light & Water 0.8 -4.5 5.4 7.1

Fuel 4.3 -12.8 5.9 27.4Light -4.8 -1.5 5.7 -5.7Water 12.0 12.4 3.1 2.6

Services 0.5 -3.7 7.4 12.7Transpo & Comm. -2.4 -10.3 7.7 18.5Miscellaneous 1.9 2.3 2.4 3.3

Source of Basic Data: NSO, BSP

Inflation Rates for Selected NonInflation Rates for Selected Non--

Food ItemsFood Items

Quarterly averages in percent (2000=100)Quarterly averages in percent (2000=100)

CommodityCommodity2009 2008

Q4Q4 Q3Q3 Q4Q4 Q3Q3

Non-Food Items 1.3 -1.1 5.9 7.8Clothing 2.0 2.2 5.0 4.6Housing & Repairs 2.1 2.2 5.3 4.9Fuel, Light & Water 0.8 -4.5 5.4 7.1

Fuel 4.3 -12.8 5.9 27.4Light -4.8 -1.5 5.7 -5.7Water 12.0 12.4 3.1 2.6

Services 0.5 -3.7 7.4 12.7Transpo & Comm. -2.4 -10.3 7.7 18.5Miscellaneous 1.9 2.3 2.4 3.3

Source of Basic Data: NSO, BSP

7

Water rates in Metro Manila are higher in the fourth quarter relative to the third quarter due to an increase in the foreign currency differential component.

Relative to end-Q3 2009, the domestic prices of gasoline, kerosene, diesel, and LPG were also higher by P2.63 per liter, P1.60 per liter, P2.14 per liter, and P4.20 per liter, respectively. During Q4, the prices of gasoline, kerosene, and diesel were raised six times; and the price of LPG, three times. The import tariff on specific crude and refined petroleum products remained at three percent from October to December 2009, as the average prices of Dubai crude and diesel remained below the trigger price levels during the period. Meanwhile, the estimated future prices of Dubai crude oil, based on movements in Brent crude oil futures, suggest a higher path for 2010 and 2011 relative to a quarter ago on expectations of a recovery in global oil demand. Transportation In the transport sector, petitions for a minimum jeepney fare increase remain pending with the Land Transportation and Franchising Regulatory Board (LTFRB). The Alliance of Concerned Transport Operators and Pasadang Masa filed separate petitions with the LTFRB for a fare increase of P1.00 and P0.50 (to be added to the existing P7.00), respectively, in August 2009. [A hearing to discuss these petitions was set for February 2010 while another petition to increase the taxi fare in Metro Manila was filed on 26 January 2010]. Water The Metropolitan Waterworks and Sewerage System-Regulatory Office (MWSS-RO) allowed Manila Water to adjust its foreign currency differential adjustment (FCDA) charge from P0.21 to P0.40 per cubic meter, an increase of P0.19 per cubic meter. Meanwhile, Maynilad will adjust its FCDA from P0.09 to P0.36 per cubic meter, an increase of P0.27 per cubic meter. This will translate into a slight increase in water rates quarter-on-quarter for both Manila Water and Maynilad by 0.9 percent and 1.1 percent, respectively. However, on a year-on-year basis, Maynilad water rates will still be lower by 2.7 percent while the rates of Manila Water will be higher by 12.6 percent.12

12The difference in the direction of water rates is due to the rate rebasing of the Manila Water Company, Inc (MWCI). According to MWCI, the rate rebasing was necessary to recover capital expenses in the next 15 years. Rate rebasing is a process done by the MWSS every five years to review the service improvement plan and evaluate the required

8

The new billing rules on mobile calls which adopt a six seconds per pulse instead of one minute per pulse voice call unit took effect on 6 December 2009.

Telecommunications Telecommunications companies (telcos), citing technical difficulties, were not yet able to implement the new billing rules. Meanwhile, the NTC will continue to pursue the reduction in interconnection charges from P0.35 to P0.15 on short message service (SMS) and from P4 per minute to P1.50 per minute on voice calls. If the access charges will be reduced, the SMS retail rate may go down anywhere between P0.40 to P0.60 per text from the current P1.00. In July, the National Telecommunications Commission (NTC) issued new policies to support consumer welfare. These new rules cover: 1) prepaid cards, increasing the validity period per amount purchased; 2) broadcast messaging service, addressing the issue on spam; and 3) voice calls reducing the unit of billing to six seconds per pulse instead of one minute per pulse.

Retail electricity rates sustain downward trend.

Power Retail electricity rates sustained the general downward trend from the previous quarter due to lower National Power Corporation (NPC) and WESM rates, stable fuel costs, and stronger peso. The NPC, which supplies about 40 percent of Meralco’s electricity requirements and 70 percent of the country’s requirements, was able to reduce its rates during the second half of the year, when the onset of the rainy season allowed it to optimize the use of its hydroelectric power plants.13 Meanwhile, the system loss cap14 for distribution utilities (DUs), which was reduced effective January 2010, could help lower electricity rates. The ERC has set the system loss cap for DUs at 8.5 percent from 9.5 percent. The Power Sector Assets and Liabilities Management (PSALM) is also pursuing the selection of independent power producer administrators (IPPAs) to meet the last precondition for open access and retail competition as stated in the Electric Power Industry Reform Act. In December 2009, PSALM successfully bid out the management of the contracted capacities of

capital investment to implement the plan. This is the second time the MWSS and Manila Water have undertaken this exercise, the first one being in 2002. 13 Power generated from such power plants is considerably cheaper than that from geothermal or coal-fired power plants. 14 The system loss cap is the limit by which a DU is allowed to recover from its customers the cost of the energy that is delivered to its system by its power suppliers, but which energy is not actually metered as being sold to its customers, either because it is lost in the transmission through the power lines or is pilfered by unscrupulous persons. The lower system loss cap approved by the ERC for implementation starting next year translates directly to a lower system loss charge for end-users whose DUs are incurring system losses above the mandated cap.

9

However, upside pressures on electricity rates stemming from pending petitions with ERC remain.

the San Roque, Bakun, and Benguet hydropower plants, moving closer to achieving the last precondition of open access and retail competition in the Philippines.15 With its latest success in the IPPA bidding, PSALM has now bid out 43.8 percent of its IPP contracts in the Luzon and Visayas grids, or 2,145.75 MW of the total 4,904.55-MW capacity in the area. There remain potential sources of upside pressures on electricity rates stemming from pending petitions with the ERC. These include: (1) the PSALM’s petition to recover NPC’s stranded contract cost and debts, and (2) NPC’s petition to recover actual and incremental fuel, IPP and foreign exchange rate fluctuation costs under the 14th and 13th generation rate adjustment mechanism (GRAM) and the 13th and 12th incremental currency exchange rate adjustment (ICERA).

15 As stipulated in the EPIRA, PSALM is required to privatize at least least 70% of the contracted capacities of the IPPs in the Luzon and Visayas grids before open access and retail competition can commence.

10

Aggregate Demand and Supply The economy continues to post positive growth. GDP and GNP Growth Rates Annual Growth in Real Terms (%)

0

1

2

3

4

5

6

7

8

9

10

2002 2003 2004 2005 2006 2007 2008 2009

GDP GNP

Household and government spending boost aggregate demand while gross capital formation and exports decline.

Amidst the global economic downturn and recent natural calamities, the Philippine economy showed its resiliency as it continued to grow in the fourth quarter of 2009, albeit at a slower pace relative to the year-ago level. The Gross Domestic Product (GDP) posted a modest expansion of 1.8 percent year-on-year in Q4 2009 from 2.9 percent in the same period in 2008. Output expansion was driven mainly by the steady growth of household spending and the accelerated expansion of government spending. Tempering the overall growth is the continued contraction of exports and capital formation. On the production side, growth was driven by services and industry, which offset the contraction of agriculture. The continued, though significantly decelerated, growth of remittances from overseas workers, supported the Gross National Product (GNP), which registered a 2.4 percent growth in Q4 2009, a moderation from the 6.7 percent growth in the same period in 2008. Meanwhile, seasonally-adjusted estimates of GDP point to an accelerating growth momentum, with GDP expanding by 0.9 percent quarter-on-quarter in Q4 2009 from 0.8 percent in Q3 2009. This confirms that, while the performance of aggregate demand components remained uneven, the Philippine economy is on a growth trajectory. Full-year GDP growth was at 0.9 percent, within the Government’s full-year growth target range of 0.8-1.8 percent. Aggregate Demand Expenditures by major economic sectors Household spending remained relatively resilient notwithstanding the calamities that hit the country. In Q4 2009, personal consumption expenditure (PCE) posted a 5.1 percent growth, a slight acceleration from the 5.0 percent registered in Q4 2008. Food expenditure, which comprises over half of the

11

Domestic Demand (annual growth in real terms)

-25

-20

-15

-10

-5

0

5

10

15

20

25

2002 2003 2004 2005 2006 2007 2008 2009

Private Consumption Govt. Spending Fixed Investment

total PCE, continued to grow albeit less steeply than the comparable period in 2008 as prices remained relatively stable due to price-mitigating measures implemented by the government. Household furnishings and operations, transportation and communication as well as miscellaneous expenses also contributed significantly to PCE growth. Government spending provided strong support to growth due in part to the government’s relief and rehabilitation efforts in the aftermath of tropical storm and initial election-related spending by the government. Government consumption expanded by 12.1 percent in Q4 2009, a significant increase from the year-ago growth rate at 2.6 percent. Meanwhile, growth in capital formation remained in negative territory for the fifth consecutive quarter, declining in Q4 2009 by 0.8 percent from a contraction of 13.1 percent in Q4 2008, as investments in all of its subsectors decreased. In particular, investment in construction contracted with the deferment of some housing projects in 2009 and the glut in office space. The slow recovery in global demand also continued to hit the country’s exports through the fourth quarter, as exports contracted by 10.0 percent year-on-year. Nonetheless, this was lower than the 11.5 percent decline in the comparable period in 2008 as demand for some export products picked up in the fourth quarter, including finished electrical machinery, transmission apparatus, and iron agglomerates.

Economic Performance

Growth rate (in percent)

Sector 2009 2008

Q4 Q3 Q4By expenditure itemPersonal consumption 5.1 3.2 5.0Government Consumption 12.1 8.1 2.6Capital Formation -0.8 -12.1 -13.1

Fixed Capital Formation -1.6 -0.9 0.1

Exports -10.0 -13.0 -11.5

Imports -2.5 0.1 5.0

Source: NSCB

Economic Performance

Growth rate (in percent)

Sector 2009 2008

Q4 Q3 Q4By expenditure itemPersonal consumption 5.1 3.2 5.0Government Consumption 12.1 8.1 2.6Capital Formation -0.8 -12.1 -13.1

Fixed Capital Formation -1.6 -0.9 0.1

Exports -10.0 -13.0 -11.5

Imports -2.5 0.1 5.0

Source: NSCB

12

Land values are lower.

0

20,000

40,000

60,000

80,000

100,000

120,000

2001 2002 2003 2004 2005 2006 2007 2008 2009

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

Makati Ortigas

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

Other Demand Indicators Various economic indicators also showed improvements, particularly in vehicle and energy sales, capacity utilization of manufacturing, and business expectations. Meanwhile, activity in the property market remained subdued in Q4 2009 due to the ongoing correction. Property Prices

The latest report from Colliers International indicated that, quarter-on-quarter, implied land values16 were lower in Q3 2009. Year-on-year, implied land values showed a decline of 5.5 percent and 5.1 percent for the Makati Central Business District (CBD) and Ortigas Center, respectively, in Q3 2009. Land values were also lower in emerging business districts such as the Bonifacio Global City (BGC).

16In the absence of reported closed transactions, implied land values based on trends are used by Colliers International to monitor prices.

13

Makati CBD office and residential vacancy rates increase.

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

0

100

200

300

400

500

600

700

2001 2002 2003 2004 2005 2006 2007 2008 2009

Office Rental Value Residential Rental Value

Vacancy Rates The monthly office vacancy rate in the Makati CBD at 6.9 percent was higher in Q3 2009 compared to the quarter- and year-ago levels. Meanwhile, the residential vacancy rate at 8.1 percent during the quarter was lower compared to Q2 2009 but higher than a year ago. In the office sector, vacancy continued to increase as tenants moved to cheaper and newer locations. In the residential sector, vacancy rates declined in the absence of new projects turned over in 2009 coupled with an increase in demand for short-term leases (3-6 months). Demand for smaller units in non-luxury condominium units increased in Q3 2009, while that for luxury condominium units declined slightly. Rental Values

Monthly office rents in the Makati CBD reached P630.7/sq.m. in Q3 2009, lower by 4.4 percent than the levels in the previous quarter.17 According to Colliers, the higher vacancy in premium grade and grade A buildings pushed the average Makati CBD rents further downward, benefiting locators who were renewing their lease contracts during the year. Landlords had aggressively discounted asking rents in six months to attract new tenants for their vacant spaces. Rental correction would be expected to taper off at the end of the year until vacancy stabilizes.

Office rental values in Q3 2009 fell below the 1997 levels for premium grade offices. In real terms, office rental values are about 41.3 percent of the comparable levels in 1997.

� Monthly rents for 3-bedroom condominium

units in the Makati CBD declined by 2.4 percent to P551/sq.m. from the previous quarter. Colliers noted that landlords of bigger and older luxury condominium units in the CBD area may adjust further in the near term due to competition from newer buildings in fringe areas including Rockwell and BGC. Moreover, the growing preference towards smaller 1- and 2-bedroom units in Makati could affect rents for luxury 3-bedroom units in the CBD area.

17 This was computed as the average of the rental values for the Premium, Grade A and Grade B segments. Premium refers to office space with capital values of P75,000/sq.m. and above; Grade A, between P65,000 and P75,000/sq.m.; and Grade B, P65,000/sq.m. and below.

Vacancy Rates, Makati CBD (%)

2009 2008

Forecast Year-On-Year Growth (%)

2009 2010

Q3 Q2 Q3 Q4*

5.28.8

Q1* Q2

Office 6.9 5.7 2.4 6.1 7.0

Residential (all grades) 8.1 8.8 6.9 7.1 7.5

Source: Colliers International Research* Forecast from previous quarterly reports.

Vacancy Rates, Makati CBD (%)

2009 2008

Forecast Year-On-Year Growth (%)

2009 2010

Q3 Q2 Q3 Q4*

5.28.8

Q1* Q2

Office 6.9 5.7 2.4 6.1 7.0

Residential (all grades) 8.1 8.8 6.9 7.1 7.5

Source: Colliers International Research* Forecast from previous quarterly reports.

14

Residential rental values were above their 1997 levels in nominal terms but were only about 59.9 percent of their 1997 levels in real terms.

15

Vehicle sales rise significantly.

-10.0

-5.0

0.0

5.0

10.0

15.0

20.0

25.0

30.0

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4

2008 2009

Quarterly Sales of Passenger Cars*Year-on-year change in percent

*First two months of the quarter.

-15.0

-10.0

-5.0

0.0

5.0

10.0

15.0

20.0

25.0

30.0

35.0

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4

2008 2009

Quarterly Sales of Commercial Vehicles*Year-on-year change in percent

*First two months of the quarter.

-30.0

-20.0

-10.0

0.0

10.0

20.0

30.0

40.0

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4

2008 2009

Quarterly Sales of Trucks and Buses*Year-on-year change in percent

*First two months of the quarter.

Vehicle Sales Year-on-year passenger car sales bounced back, growing by 12.8 percent in the first two months of Q4 2009 (October-November) after two consecutive contractions in the comparable period starting Q2 2009. This was also a reversal of the 2.2 percent decline in the same period a year ago. Likewise, on a quarter-on-quarter basis, passenger car sales grew by 11.6 percent in Q4 2009 (October-November), higher than the 6.6 percent growth in the previous quarter and a turnaround from the 8.1 percent contraction in the same quarter in 2008. According to the Chamber of Automotive Manufacturers of the Philippines, Inc., sales spiked as many consumers opted to replace their typhoon-damaged units, supported by strong remittances from overseas Filipinos—which could boost nominal spending—as well as the aggressive promotions and attractive financing packages offered by banks.

Year-on-year sales of commercial vehicles jumped in the first two months of Q4 2009, growing by 30.9 percent, higher than the 9.4 percent growth recorded in Q3 2009 (July to August), and reversing the 8.0 percent decline in the same period a year ago. On a quarter-on-quarter basis, sales of commercial vehicles also expanded by 16.0 percent, reversing the 3.0 percent decline in the same period a year ago. The sale of vehicles was also stronger in Q4 2009 than the 9.2 percent quarter-on-quarter growth in Q3 2009. Likewise, year-on-year sales of trucks and buses increased significantly by 34.5 percent in the first two months of Q4 2009 from 3.4 percent in the previous quarter. Sales decreased by 9.4 percent in the comparable period in 2008. Quarter-on-quarter sales also grew by 15.8 percent in Q4 2009 (October-November), albeit lower than the 20.6 percent growth posted in the previous quarter but a reversal of the 11 percent quarter-on-quarter decline a year ago.

16

Energy sales slow down as consumption across all major sectors declines.

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4

2008 2009

Quarterly Meralco Power SalesYear-on-year change in percent

Capacity utilization rises to its highest level since 2000.

75.0

76.0

77.0

78.0

79.0

80.0

81.0

82.0

83.0

84.0

2007 2008 2009

Monthly Average Capacity Utilization for Manufactur ingIn percent

Nov 200982.6 pct

Manufacturing activity continues to decline in October 2009, albeit less steeply compared to previous months. Volume and Value Indices of Manufacturing Production year-on-year change in percent

-30

-25

-20

-15

-10

-5

0

5

10

15

20

2007 2008 2009

Volume of Production Value of Production

Power Sales

Year-on-year energy sales growth slowed down to 3.6 percent in Q4 2009, lower than the year- and quarter-ago growth rates of 3.9 percent and 4.2 percent, respectively. The deceleration in energy sales growth reflected the lower consumption growth from the residential and commercial sectors due to specific events that took place during the review period. According to Meralco, aside from the typhoons, technical troubles in Dolores Substation of the National Grid Corporation of the Philippines also prompted Meralco to manually drop loads for safety. Meanwhile, quarter-on-quarter energy sales decreased by 2.1 percent in the fourth quarter, a reversal of the 4.0 percent growth posted in the previous quarter. Capacity Utilization Average capacity utilization in manufacturing in Q4 2009 rose to its highest level since year 2000, reaching 82.6 percent in November 2009 and sustaining an uptrend since February 2009, based on the rates presented in the NSO’s Monthly Integrated Survey of Selected Industries (MISSI).

Volume and Value of Production Based on MISS data, the value of production index (VAPI) remained on a double-digit year-on-year downtrend, falling by 11.2 percent. Meanwhile, the volume of production index (VOPI) posted a slower decline of 6.4 percent year-on-year in October after the 11.2 percent decline in September.

17

Business sentiment improves further.

Survey results show a decline in overall consumer confidence quarter-on-quarter, but an improvement year-on-year.

Business Expectations Survey Q4 2009 Business Expectations Survey results showed a sustained improvement in business sentiment for the third consecutive quarter for both the current and next quarter outlook. The improvement was seen relative to the last quarter as well as the quarter a year ago. Business sentiment improved further in Q4 2009 as the overall confidence index (CI) rose by 3.6 index points to 22.0 percent from 18.4 percent (revised) in the previous quarter. It continued to improve in Q1 2010 with a CI of 34.0 percent after it climbed to 33.7 percent (revised) in the past quarter. The optimism reflected expectations of better economic performance in the current and next quarters, with clearer indications of improving conditions in the global economy.

Consumer Expectations Survey The nationwide consumer confidence index (CI) for the fourth quarter of 2009 at -36.0 percent declined quarter-on-quarter by 4.1 index points but improved year-on-year by 4.3 index points. The decline came amid lack of jobs and low income prospects for households. The impact of the devastation and the rise in prices caused by typhoons Ondoy and Pepeng took its toll on Filipino consumers.

Business Expectations Survey

Index 2009 2008

Q4 Q3 Q2 Q4 Q3 Q2

Business Outlook Index

Current Quarter 22.0 18.4r -2.6 -6.8 -12.9 12.6

Next Quarter 34.0 33.7r 13.7 -0.5 16.6 16.6

‘r revisedSource: BSP

Business Expectations Survey

Index 2009 2008

Q4 Q3 Q2 Q4 Q3 Q2

Business Outlook Index

Current Quarter 22.0 18.4r -2.6 -6.8 -12.9 12.6

Next Quarter 34.0 33.7r 13.7 -0.5 16.6 16.6

‘r revisedSource: BSP

-20.3

-26.9

-43.8

Q2

Consumer Expectations SurveyConsumer Expectations Survey

Index 2009 2008

Q4 Q3 Q2 Q4 Q3

Current Quarter

-36.0 -31.9 -34.2 -40.3 -52.8

Next 3 months

-10.5 -3.7 -13.2 -11.2 -25.1

Next 12 months

-0.8 -0.9 -7.6 -10.7 -23.9

Source: BSP

-20.3

-26.9

-43.8

Q2

Consumer Expectations SurveyConsumer Expectations Survey

Index 2009 2008

Q4 Q3 Q2 Q4 Q3

Current Quarter

-36.0 -31.9 -34.2 -40.3 -52.8

Next 3 months

-10.5 -3.7 -13.2 -11.2 -25.1

Next 12 months

-0.8 -0.9 -7.6 -10.7 -23.9

Source: BSP

18

Exports of Goods (BOP data)Growth rate (in percent)

Commodity Group2009 2008

Q3 Q2 Q3

Coconut products -22.7 -57.8 26.0

Sugar and Products 32.6 -14.5 -51.9

Fruits and Vegetables -3.7 -6.0 0.5

Other Agro-based products

-8.9 -25.9 29.3

Forest products 62.4 -12.4 -46.5

Mineral products -58.0 -49.4 34.6

Petroleum products -88.4 -59.4 78.2

Manufactures -15.9 -25.5 -0.2

Special transactions -40.0 -43.6 13.8

Total Exports, as per NSO Foreign Trade Statistics

-21.5 -28.9 4.1

Conceptual and coverage adjustments

-11.8 -2.8 8.3

Total Exports, BPM5 -22.0 -29.4 4.3

Source: BSP

Imports of Goods (BOP data)Growth rate (in percent)

Commodity Group2009 2008

Q3 Q2 Q3

Capital Goods -18.4 -27.4 0.2

Raw Materials & Intermediate Goods

-20.6 -28.7 0.9

Mineral Fuels & Lubricant

-49.2 -44.7 44.0

Consumer Goods -40.7 -13.1 64.6

Special Transactions -29.9 -22.4 7.1

Total Imports1/ -29.2 -30.0 13.9

Conceptual and coverage adjustments

-80.1 -71.6 131.9

Total Imports, BPM5 -29.8 -30.4 14.6

1/ Include valuation adjustments to NSO data

Source: BSP

External Demand

Exports The performance of exports continued to reflect the broad slowdown in global demand. Latest available balance of payments (BOP) data showed a less negative growth in Q3 2009 compared to the previous quarter, but indicated a reversal of the positive growth posted in Q3 2008. The contraction was led by manufactures, which dropped by 15.9 percent and contributed 13.3 percentage points to the decline in exports. Exports of electronic products led the decline. Other major contributors to the decline were mineral products, particularly copper, and petroleum products.

Imports Mirroring the trend in exports, imports of goods likewise contracted, reflecting the weakness in the industrial sector in Q3 2009. Total imports declined by 29.8 percent year-on-year in the third quarter, a reversal of the 14.6 percent growth in Q3 2008. Inputs of all major commodity groups declined year-on-year in the last three months of 2009. The value of inward shipments of mineral fuels, lubricants, and related materials decreased by 49.2 percent and contributed 10.8 percentage points to the contraction of imports, due in part to the lower prices of petroleum crude and other mineral fuels. Imports of raw materials and intermediate goods as well as consumer goods also contributed significantly to the decline.

19

Services and industry contribute positively to output growth.

Economic Performance

Growth rate (in percent)

Sector 2009 2008

Q4 Q3 Q4By industrial originAgriculture, Fishery & Forestry -2.8 1.5 2.9

Agriculture and Fishery -2.8 1.4 2.9Forestry 0.7 10.3 7.4

Industry 1.1 -5.0 5.3Mining and quarrying 17.0 26.9 18.2Manufacturing 1.3 -7.8 3.4Construction -5.8 0.9 14.5Electricity, gas and water 0.5 -6.3 3.8

Services 4.2 3.8 1.3

Transport., Comm., & Storage 1.9 -1.5 4.5Trade 3.5 4.4 0.0Finance 11.0 11.5 -4.6O. Dwellings & real estate 0.3 -2.3 1.7Private services 6.1 4.4 2.4Government services 3.4 6.6 6.2

Source: NSCB

Aggregate Supply On the production side, the services sector remained the main pillar of support to economic growth, expanding by 4.2 percent year-on-year in Q4 2009, higher than the 1.3 percent growth registered in the last three months of 2008. Services, which represented 49.3 percent of total GDP, contributed about 2.0 percentage points to GDP growth. Accelerated growth in retail trade and private services, particularly recreational services and personal services, as well as the rebound of finance supported the growth in the sector. Industrial output also grew, albeit less steeply, by 1.1 percent in Q4 2009 from 5.3 percent in Q4 2008. However, the fourth quarter performance of the sector, was a turnaround after three consecutive quarters of contractions. The industry sector, which represented about 31.6 percent of GDP grew with the uptrend in the production of manufactured products, particularly electrical machinery, petroleum products, food, and furniture and fixtures. Mining and quarrying also provided support to the expansion of industrial output as it continued to post double-digit growth for the fifth consecutive quarter. Meanwhile, the growth of construction in Q4 2008 was reversed in Q4 2009. Agriculture, fishery and forestry (AFF) declined in Q4 2009, reflecting the impact of a series of tropical storms that damaged production of most crops, livestock and poultry as well as fishery. AFF, which accounted for 19.2 percent of GDP, contracted by 2.8 percent in the fourth quarter from the year-ago growth level 2.9 percent. Palay production fell by 13.9 percent from a contraction of 2.2 percent in Q4 2008. Other crops which suffered a decline in productions include pineapple, rubber, cabbage, and calamansi. Similarly, livestock and poultry declined by 0.7 percent and 1.9 percent, respectively, in the fourth quarter, a reversal of the 1.4 percent and 4.5 percent growth in the same period in 2008. The decline in livestock was on account of the lower number of stock fatteners and weather-related disturbances. Meanwhile, hog production was affected by swine flu and cholera, due in part to the flood events brought by tropical storm Ondoy and typhoon Pepeng.

20

The Food and Agriculture Organization’s (FAO) December 2009 Food Outlook forecast world cereal production in 2009 to be 2.2 MMT (including rice in milled terms), only 2.0 percent below the previous year’s highest global record, and was expected to be the second largest crop on record. Most of the reduction was with coarse grain and rice output, estimated to decrease by 3.0 and 1.9 percent in the same period, respectively, while wheat production was seen to fall only slightly below the previous year’s record level. The decline in 2009’s cereal output was largely due to smaller plantings, partly in response to generally lower cereal prices after the previous year’s exceptionally high levels that prompted many farmers to bring extra land into production, but was also due to adverse weather conditions in a number of major cereal-producing countries. The 2009 global rice output was forecast at 675 MMT, 1.9 percent lower than the record 688 MMT in 2008. Adverse weather conditions and earthquakes impaired production in several countries in Asia, including India, Taiwan, Japan, Nepal, Pakistan, and the Philippines. In contrast, the outlook remained generally favorable for Cambodia, China, Korea, Iran, Myanmar, Thailand, and Vietnam. Despite the contraction, rice production in 2009 would still stand out as the second highest after the record 2008 season. Furthermore, plantings of the secondary crops may well expand beyond current expectations, as witnessed in 2008, which would boost global production in 2009 further.

21

Labor Market Conditions Unemployment is slightly lower.

0.0

5.0

10.0

15.0

20.0

25.0

30.0

6.0

6.5

7.0

7.5

8.0

8.5

9.0

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

2006 2007 2008 2009Unemployment rate, SA Underemployment

Unemployment and Underemployment Rate

Generally improved labor market conditions could have also contributed to the improvement of domestic demand during the quarter. On a quarter-on-quarter basis, both unemployment and underemployment rates were lower at 7.1 percent and 19.4 percent in October 2009 compared to July 2009. On an annual basis, however, unemployment and underemployment rates were higher in October 2009 relative to the comparable figures in 2008. Meanwhile, the total number of employed persons in Q4 2009 fell by 0.1 percent and 2.2 percent, respectively, compared to Q3 2009 and Q4 2008. The October LFS showed that the services sector employed 51.5 percent of the total employed population, while the agriculture and industry sectors accounted for 34.0 percent and 14.5 percent, respectively.

22

II. MONETARY AND FINANCIAL MARKET CONDITIONS Domestic Liquidity and Credit Conditions Liquidity growth is broadly steady.

The expansion of domestic liquidity provided support to the economy’s growth requirements, amidst difficult global economic conditions. Domestic liquidity or M3 continued to grow steadily in November 2009 at 12.0 percent year-on-year (y-o-y) compared to 11.6 percent in end-September. The expansion in liquidity continued to be fueled by the sustained growth in net foreign assets (NFA), reflecting the BSP’s continued build up of its international reserves, with strong inflows from OF remittances, as well as banks settling a significant portion of their foreign liabilities.

Bank lending continues to grow.

Stable credit conditions were also reflected by the trend of lending by commercial banks. The growth of commercial banks’ outstanding loans of commercial banks, net of banks’ reverse repurchase agreements (RRPs) placements with the BSP slowed down to single-digit levels starting in July 2009, as lending for production activities were pulled down by the contraction of loans to the manufacturing sector, reflecting in part the negative impact of the global financial crisis on export demand. As of end-November 2009, the growth of loans outstanding strengthened to 6.6 percent from the 5.9 percent growth posted at end-September 200918. Bank lending growth continued to be driven by loans across most major production activities.

18 Bank lending including RRPs likewise grew modestly at 2.6 percent compared to the 6.1 percent growth posted at the end of the previous quarter.

23

Consumer loans reflect modest growth in consumer spending. Meanwhile, overall credit standards remain basically unchanged in Q4 2009.

Consumer loans declined in end-November, 2009 at 3.8 percent from 6.9 percent as of end-September 2009, as households paid down debt, which is common during a downturn. In general, preliminary results of the senior bank loan officers’ survey in Q4 2009 indicated that overall lending conditions remained basically unchanged compared with the previous quarter. The results applied to both lending to enterprises (about 88 percent or 14 banks out of 16) and households (about 70 percent or 7 out of 10).

A smaller portion of respondents indicated that lending conditions of their corporate borrowers were somewhat tightened. In contrast, the number of respondents that reported tighter credit standards to household borrowers rose during the review period from the previous quarter. As in the previous survey, majority of respondents said demand for loans from both enterprises and households remained basically unchanged in the latest survey. However, a number of respondents said demand for loans decreased somewhat. The decline in the demand for loans may be reflective of households’ and companies’ tendency to deleverage in times of subdued growth. In addition, reductions in the cost of capital market finance may have also encouraged more companies to raise funds via the capital markets and pay down bank debt, thereby decreasing their demand for new loans. Meanwhile, there were no significant differences observed across borrower categories in Q4 2009 versus the third quarter in 2009.

24

II. MONETARY AND FINANCIAL MARKET CONDITIONS Interest Rates

Interest rates reflected a general decline as liquidity remained ample. Yields on the 91-day and 182-day Treasury bill (T-bill) rates reflected declines to reach an average of 3.85 percent and 4.12 percent, respectively in Q4 2009. Meanwhile, the 364-day T-bill rate rose marginally to average 4.46 percent during the review period, on higher inflation expectations.

Yield Curve Secondary market yields reflect market participants’ views on the future path of policy rates, as well as other factors, including sentiment on fiscal developments in the country. Yields increased across a wide range of maturities except for the 20- and 25-year tenors as of end-December 2009 relative to end-September 2009. Yields were higher on dampened sentiment following the Philippine government’s announcement that the 2009 budget deficit may further swell to P260 billion, or P10 billion higher than the earlier forecast, due to the estimated damage caused by the recent weather disturbances that visited the country.

Domestic interest rates decline. 91-day T-bill rate and BSP RRP rate In percent

2

3

4

5

6

7

8

2007 2008 2009

91-day T-bill rate Overnight RRP Rate

Yields in the secondary market increase across all tenors during the quarter.

2

3

4

5

6

7

8

9

10

11

12

3M o 6Mo 1Y r 2Y r 3 Yr 4Yr 5 Yr 7Y r 10 Yr 20Yr 25Y r

Yield in percent

Maturity

end -June 2009 end -Sep 2009 end -Dec 2009

Y ield of G overnment Secur ities in the Secondary M ar ketIn percent

25

Interest rate differentials in basis points

-400.0

-300.0

-200.0

-100.0

0.0

100.0

200.0

300.0

400.0

500.0

600.0

700.0

Mar 07 Jun 07 Sep 07 Dec 07 Mar 08 Jun 08 Sep 08 Dec 08 Mar 09 Jun 09 Jul 09 Aug 09 Sep 09 Dec 09

RP 91-day T-bill vs US 90-day LIBOR (before tax) RP 91-day T-bil l vs US 90-day T-bil l (before tax)

RP 91-day T-bill vs US 90-day LIBOR (after tax) RP 91-day T-bil l vs US 90-day T-bil l (after tax)

BSP RRP Rate and US Fed Funds Rate In percent

0

1

2

3

4

5

6

7

8

2004 2005 2006 2007 2008 2009

BSP RRP rate US Fed funds rate Real lending rate declines on higher inflation.

Interest Rate Differentials The average positive differentials between domestic and US T-bill rates, net of tax, narrowed in Q4 2009 relative to Q3 2009, due to the larger decline in the domestic interest rate compared to the fall in the US T-bill rate. Similarly, the after-tax differential between RP T-bill and US LIBOR rates was marginally lower during the quarter, given the bigger decline in the RP 91-day T-bill rate compared to that for the corresponding US LIBOR rate. Meanwhile, the differential between the BSP's policy interest rate (overnight borrowing or RRP rate) and the US federal funds target rate remained at 375 basis points in Q4 2009, reflecting the unchanged monetary policy stance of both the BSP and the US Fed during the review quarter. Adjusted for the risk premium—which is measured as the differential between the 10-year Republic of the Philippines (ROP) note and the 10-year US Treasury note—the average spread between the BSP’s policy rate and the US federal funds target rate, however, continued to widen to 149 basis points relative to 102 basis points in Q3 2009. This development may be traced to the sustained decline in the risk premium given the large decline in the yield of the 10-year RP note compared to the minimal increase in the yield of the 10-year US note over the same period. The uptrend in inflation led the real lending rate—measured as the difference between the average bank lending rate and inflation—to ease to 3.6 percent in December 2009 from 7.3 percent in September 2009. The real lending rate of the Philippines ranked seventh highest (from being the third highest in September 2009) in a sample of 10 Asian countries, while Indonesia at 10.2 percent registered the highest real lending rate during the quarter.

Both the interest rate differentials between Philippine and US T-bills and policy interest rates narrow.

26

Financial Market Conditions

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Global financial market activity continued to be driven by growing confidence in the global economic recovery as the steady stream of mostly positive macroeconomic news reassured investors that the global economy had in fact turned around. Exceptionally low policy rates across the globe and fiscal stimulus packages in advanced economies continued to drive the post-crisis rebound in global equity markets19. As global credit markets continued to normalize and credit spreads have stabilized, the risk of contagion from global financial stresses has markedly been reduced in domestic financial markets. Stock Market With increasing investor confidence in the global economic recovery coupled with ample liquidity in the system, investors returned to the local equities, market, helping reduce the cost of capital for firms. The Philippine Stock Exchange Composite Index (PSEi) averaged 2,986.7 index points during the quarter, higher by 5.6 percent than the previous quarter’s 2,827.8 index points and by 54.6 percent over the 1,931.8 index-point average registered during the same period a year ago. Upbeat trading in Wall Street influenced the generally positive mood in local stock market activity. Optimism that there could be an immediate resolution to the Dubai crisis, which started around the last week of November 2009 also contributed to the positive mood. Other markets in the US, Europe, and Asia also traded on a generally positive note during the quarter, as investors positioned for 2010 with optimism that the year will be better.

19 Bank for International Settlements Quarterly Report, December 2009 available at www.bis.org

Bullish tone in the local stock market continues.

27

Oversubscription of T-bill Auctions In billion pesos

0

20

40

60

80

100

120

140

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Government Securities Liquidity in the financial system as well as market preference for the safe instruments continued to fuel demand for government securities as banks continued to place excess funds in Treasury bills. However, the amount of oversubscription appeared to have moderated, from P95.4 billion in the third quarter to P61 billion in the last quarter. Government securities dealers’ concerns were mainly focused on fiscal developments in the country. The government, however, reassured the market that there are available options to increase its funding requirements to cover additional spending for the restoration of facilities damaged by the calamities. Such options included tapping the international capital market through the issuance of samurai and global bonds.

28

Debt spreads tighten with improvement in global economic indicators.

Sovereign bonds and CDS spreads Debt spreads generally narrowed at the end of Q4 relative to the end of Q3 2009 as Dubai World began talks to restructure less than half of its debt. China’s significant growth in its manufacturing sector likewise provided support for the market, and higher commodity prices added to optimism that a recovery in developing economies will be sustained. Meanwhile, Fitch Ratings has not revised its stable outlook for Philippine debt issuances since May 2009.20 The EMBI+ Philippine spread or the extra yield for holding Philippine bonds over US bonds tightened to 198 basis points in end-December 2009 compared to 264 basis points and 541 basis points recorded at the end of the previous quarter and end-December 2008, respectively.

20 Fitch Ratings kept the Philippines’ ‘BB’ rating for its long-term foreign currency-denominated issuances, ‘BB+’ for its peso denominated long-term debt papers, ‘B’ short-term issuer default rating, and ‘BB+’ country ceiling on 7 May 2009.

29

Banking System

Philippine banking system remains stable. Banks’ deposit base increases.

The Philippine banking system remained sound and stable during the last quarter of the year. The system’s asset base has been expanding steadily, supported by sustained growth in deposits. Profitability of the banking system has moderated, but bank capitalization remained adequate at levels above both the BSP-regulatory requirement and the international (BIS) standard. Savings Mobilization Philippine banks’ intermediation activities depended mainly on deposit-taking activities for its funding sources. During the quarter, banks’ funding conditions generally improved, with total deposits1 at P3.4 trillion as of end-November 2009, increasing by 11.0 percent higher from its year-ago level, and by 4.7 percent from that of the preceding quarter. Savings deposits, which continued to account for nearly half of the funding base, grew by 3.6 percent quarter-on-quarter. Year-on-year savings deposits grew by 13.5 percent, slightly lower compared to the 14.4 percent growth registered during the end of the previous quarter. Similarly, demand and time deposits recorded year-on-year growth rates of 16.8 percent and 4.1 percent, respectively. Quarter-on-quarter, demand and time deposit rates grew by 1 percent and 9.2 percent, respectively.

1 Total peso-denominated deposits.

30

Resources of the banking system expand due to the rise in debt securities Mergers and consolidations reduce the number of banks, but operating network continues to expand. Asset quality of banks continues to improve.

Institutional Developments Total resources of the banking system rose by 7.2 percent to P6.1 trillion as of end-October 2009 from the year-ago level of P5.7 trillion. The increase was due mainly to the rise in debt securities. U/KBs continued to account for almost 90 percent of the total resources of the banking system. The number of banking institutions (head offices) fell further to 797 as of end-September 2009 from the year-ago level of 835, indicating the continued consolidation of banks as well as the exit of weaker players in the banking system. By banking classification, banks (head offices) consisted of 38 U/KBs, 73 TBs, and 686 rural banks (RBs). Meanwhile, the operating network (including branches) of the banking system increased to 7,914 from 7,811 during the same period last year, reflecting mainly the increase in commercial and rural banks’ branches/agencies. The banking system’s asset quality continued to improve as the non-performing loan (NPL) ratio eased further to 3.9 percent as of end-November 2009 compared to 4.3 percent a year ago. Banks’ observance of prudent lending standards and modest growth in loans helped them in maintaining minimal exposure to bad debts. The lower NPL ratio was likewise due to the 3.0 percent decline in the levels of NPLs complemented by the 5.4 percent expansion in the industry’s TLP. NPLs declined to P118.7 billion from the previous year’s level of P122.3 billion, while TLP expanded to P3.0 trillion from P2.9 trillion for the same period last year.

31

Meanwhile, the NPL ratio of U/KBs fell further to 3.3 percent as of end-November 2009, an improvement from the 3.8 percent ratio registered a year ago. The Philippine banking system’s NPL ratio of 4.0 percent was comparatively lower than Indonesia’s 4.4 percent but higher than Thailand’s 3.0 percent, Malaysia’s 1.9 percent and South Korea’s 1.5 percent.21 The lower NPL ratios of Malaysia 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 adequately covered as the banking system’s NPL coverage ratio was higher at 90.0 percent as of end-October 2009. The ratio was indicative of banks’ continued compliance with the loan-loss provisioning requirements of the BSP to ensure adequate buffers against unexpected losses.

21 Sources: Various central bank websites and GFSR, Indonesia (Banking system, November 2009); Malaysia (Banking system, November 2009); Thailand (Financial institutions, September 2009); and Korea (Financial system, March 2009).

32

Banks remain adequately capitalized, exceeding prescribed levels set by the BSP and the BIS.

Banks continue to strengthen their capital positions. In aggregate, the average capital adequacy ratios (CAR) remaining strong at 14.8 percent on a solo basis and 15.7 percent on a consolidated basis as of end-June 2009, higher than the comparable March 2009 ratios. The increase in the banking system’s CARs was driven by the higher growth of qualifying capital relative to the growth of risk weighted assets (RWA). The industry’s CAR continued to exceed the statutory level set by the BSP at 10.0 percent and the BIS standard at 8.0 percent. The Philippine banking system’s CAR remains comparatively higher than those of Malaysia (14.6 percent), and Korea (12.9 percent) but lower than Indonesia (17.8 percent). Meanwhile, Thailand posted the highest CAR in the region at 18.4 percent. 22

22 Sources: Various central bank websites, Malaysia (Banking System, November 2009); Korea (Banking System, March 2009); Thailand (Average Full Branch, September 2009) and Indonesia (KBs, September 2009).

33

Exchange Rate

35

40

45

50

55

60

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

P/US$

Daily Peso-US Dollar Rate

The peso appreciated by 3.0 percent to average P46.77/US$1 in the fourth quarter of 2009 from P48.15/US$1 in the previous quarter.23 Compared with the P48.44/US$1 average in the fourth quarter of 2008, the peso appreciated by 3.6 percent. The peso strengthened against the U.S. dollar during the review period on improved risk appetite for high-yielding assets due to expectations that the global economy is starting to recover. Strong dollar inflows from overseas Filipinos’ (OFs) remittances as well as sustained foreign inflows also accounted for the peso’s general appreciating trend. The peso’s appreciation during the quarter was in line with the movements of most regional currencies which strengthened against the U.S. dollar due to increased risk appetite for higher yielding assets. On a year-to-date basis, the peso appreciated against the US dollar by 2.9 percent on 29 December 2009 as it closed at P46.20/US$1, moving in tandem with other Asian currencies.24 Meanwhile, volatility, as measured by the coefficient of variation of the daily average exchange rates, is higher at 0.9 percent in the fourth quarter of 2009 compared with the 0.7 percent in the third quarter due to the strengthening of the peso against the U.S. dollar during the period.

23 Dollar rates or the reciprocal of the peso-dollar rates were used to compute for the percentage change. Figures

were based on reference rates. 24 Based on the last done deal in the afternoon.

The peso appreciates.

Changes in Selected Dollar Rates

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

31 Dec** 30 Sep 09*

Philippine peso 2.9 0.3

Thai baht (onshore) 4.1 3.7

Chinese yuan 0.0 0.0

Malaysian ringgit 1.2 -0.1

South Korean won 8.2 7.0

Singaporean dollar 1.8 1.1

New Taiwan dollar 2.5 2.1

Indonesian rupiah 18.2 15.0

Japanese yen -2.6 1.0

Indian Rupee 4.9 2.3

Source: Bloomberg, Reuters and PDEX*As of 4:00 p.m.,30 September 2009

**As of 4:00 p.m., 31 December 2009

Changes in Selected Dollar Rates

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

31 Dec** 30 Sep 09*

Philippine peso 2.9 0.3

Thai baht (onshore) 4.1 3.7

Chinese yuan 0.0 0.0

Malaysian ringgit 1.2 -0.1

South Korean won 8.2 7.0

Singaporean dollar 1.8 1.1

New Taiwan dollar 2.5 2.1

Indonesian rupiah 18.2 15.0

Japanese yen -2.6 1.0

Indian Rupee 4.9 2.3

Source: Bloomberg, Reuters and PDEX*As of 4:00 p.m.,30 September 2009

**As of 4:00 p.m., 31 December 2009

34

On a real, trade-weighted basis, the peso gained some external price competitiveness in the fourth quarter of 2009, relative to the previous quarter, against the basket of currencies of competitor countries.25 The real effective exchange rate (REER) index of the peso against the baskets of currencies of competitor countries in the broad and narrow series decreased quarter-on-quarter by 1.8 percent and 2.4 percent, respectively.26 This developed due to the nominal depreciation of the peso against these currencies combined with the narrowing inflation differential against the competitor countries during the review period. However, the peso lost some external price competitiveness during the review period against the basket of currencies of major trading partners (MTPs). The REER index of the peso against the basket of currencies of the MTPs increased to 2.6 percent due to the combined effect of the nominal appreciation of the peso against these currencies and the widening inflation differential against the MTPs. Similarly, on a year-on-year basis, the peso also gained some external price competitiveness against the competitor countries in the broad and narrow series in the fourth quarter of 2009 as the REER index of the peso decreased by 4.1 percent and 6.0 percent, respectively. However, the peso lost some external price competitiveness against the basket of currencies of MTPs during the review period as the REER index of the peso against this basket increased by 1.6 percent.

25 The basket of the major trading partners is composed of the currencies of US, Japan, the Euro area and the United

Kingdom. The broad basket of competitor countries comprises the currencies of Singapore, South Korea, Taiwan, Malaysia, Thailand, Indonesia and Hong Kong while the narrow basket is composed of the currencies of Indonesia, Malaysia and Thailand only.

26 The REER index represents the Nominal Effective Exchange Rate (NEER) index of the peso, adjusted for inflation rate differentials with the countries whose currencies comprise the NEER index basket. A decrease in the REER index indicates some gain in the external price competitiveness of the peso, while a significant increase indicates the opposite. The NEER index, meanwhile, represents the weighted average exchange rate of the peso vis-à-vis a basket of foreign currencies.

35

The January-November 2009 fiscal deficit reached P272.5 billion, more than four times higher than the P66.7 billion deficit in the comparable period last year. This already exceeded the P250 billion programmed deficit for the full year by P22.5 billion. In response to the global financial crisis and the calamities that occurred in the last quarter of the year, the government undertook stimulus spending measures to rehabilitate flood-damaged infrastructure and support households affected by the calamities. However, the decline in revenue collections led to a breach of the deficit target for 2009. In view of this, the government fiscal consolidation plans to target a smaller deficit to GDP ratio. This will also be anchored on increased revenues from the Bureau of Internal Revenue (BIR) and Bureau of Customs (BOC), as well as privatization initiatives. As the economy recovers from the global financial turmoil, and as public sector finances perform better in the coming years, the government intends to begin reducing its deficit figure and achieve a balanced budget by 2013.

III. FISCAL DEVELOPMENTS

The January-November 2009 fiscal deficit rises fourfold compared to the same period in 2008.

National Government Fiscal PerformanceJanuary-November 2009

In billion pesos

January-November Percent Change

Q1-Q4 2009Program

Program vsActual

2009 2008

Surplus/(Deficit) -272.5 -66.7 308.7 -250.0 23.0

Revenues 1,021.7 1,081.6 -5.5 1,239.2 -59.9

Expenditures 1,294.2 1,148.3 12.7 1,489.2 -340.9

Source: BTR

National Government Fiscal PerformanceJanuary-November 2009

In billion pesos

January-November Percent Change

Q1-Q4 2009Program

Program vsActual

2009 2008

Surplus/(Deficit) -272.5 -66.7 308.7 -250.0 23.0

Revenues 1,021.7 1,081.6 -5.5 1,239.2 -59.9

Expenditures 1,294.2 1,148.3 12.7 1,489.2 -340.9

Source: BTR

36

IV. EXTERNAL DEVELOPMENTS The world economy recovers. US economic activity expands.

Global inflationary risks are expected to be manageable as some major central banks have signaled their strong commitment to safeguard price stability by preemptively considering the disengagement from crisis intervention measures. At the same time, economic fundamentals, such as moderate improvement in consumer demand, above-average inventory levels and elevated spare capacity are expected to weigh down on global price developments. However, an improvement in market sentiment may prompt a rebound in private demand for advanced economies and pose upside risks to global inflation. In addition, structural weaknesses in the investment and operational environment in the oil and agriculture sectors suggest possible resurgence in commodity prices in the near term once global demand fully recovers. US GDP grew in the third quarter by 2.2 percent (revised from 2.8 percent) in annualized terms, following three quarters of negative growth. The pick-up in economic activity was reflective mainly of a rebound in consumer spending, as government stimulus measures supported private demand temporarily27. In particular, residential investment posted its first increase since late 2005, in line with the positive developments in the US housing market. Year-on-year, however, US GDP remains in negative territory at -2.6 percent. For Q4 2009, output continued to improve as the Institute of Supply Management’s manufacturing PMI stood at 55.9 in December from 53.6 in November. The unemployment rate (not seasonally adjusted) was at 9.7 percent in December, higher than the 9.4 percent rate in November. Non-farm payroll employment declined by 85,000 jobs in December, after an increase of 4,000 jobs in November. The largest job losses in December were registered in the construction, manufacturing, and wholesale trade, while jobs were added in the areas of temporary help services and health care28.

27 U.S. Bureau of Economic Analysis, available at www.bea.gov 28 US Bureau of Labor Statistics, available at www.bls.gov

37

Euro area’s real quarter-on-quarter GDP growth returns to positive territory in Q3 2009, while the latest survey indicators suggest continued positive real GDP growth for Q4 2009.

The Conference Board Consumer Confidence Index improved further in December. The Index now stands at 52.9 (1985=100), up from 50.6 in November, as expectations for the short-term future increased to the highest level in two years. A more optimistic outlook for business and labor market conditions was the driving force behind the increase in the index29. On the domestic price front, inflation continued to rise to 2.7 percent year-on-year in December 2009 from 1.8 percent in the previous month, with dissipating base effects from higher energy prices in the previous year. Nevertheless, the recovery in the US is still subject to much uncertainty, as relatively subdued labor market conditions and households’ need to rebuild their savings and pay off debt accumulated over recent years are likely to continue to put downward pressure on consumption30. Euro area real GDP increased by 0.4 percent (quarter on quarter) in the Q3, after a 0.2 percent decline in Q2. The increase in euro area real GDP in Q3 was due to positive contributions from inventories and, to a lesser extent, from net exports and government consumption, which were partly offset by contractions in private consumption and investment. Year-on-year growth in real GDP for Q3 remains at -4.1 percent from -4.8 percent in Q2 2009.

29 http://www.conferenceboard.org/economics/consumerConfidence.cfm 30 European Central Bank Monthly Bulletin, December 2009

38

Survey data for Q4 2009 indicate that private consumption is likely to remain subdued in the coming months. Retail trade confidence and consumer confidence have increased recently but still remain at low levels. The increase in consumer confidence mainly comes from an improvement in consumers’ assessment about the general economic situation and less pessimistic views on the unemployment situation31. Business surveys suggest that growth rates of industrial activity remained positive in Q4 2009. The composite PMI for the euro area increased again in December at 54.2—a level that is clearly above the theoretical threshold value of 50. Meanwhile, The euro area unemployment rate rose to 10.0 percent in November, the highest rate since December 1998. According to surveys, employment expectations have recovered recently but remain at low levels. With regards to price developments, annual inflation stood at 0.5 percent in November, up from -0.1 percent in October. The increase in overall HICP inflation in recent months has mostly reflected upward base effects stemming from the drop in global commodity prices in the second half of 2008.

31 European Central Bank Monthly Bulletin, January 2010

39

The Japanese economy picks up in Q3 2009. In emerging Asia, the process of recovery from the global downturn continues in Q3 2009.

Japanese real GDP grew by 1.2 percent in Q3 2009, corresponding to the highest quarter-on-quarter (seasonally adjusted) growth rate in more than two years. While quarterly real GDP growth was driven, in particular, by net exports in Q2 2009, GDP growth in Q3 2009 was mainly supported by domestic demand and net exports. Advanced data for Q4 output performance indicate further improvements. Japan’s manufacturing PMI (seasonally-adjusted) registered 53.8 in December, up from 52.3 in November, pointing to a steady increase in the Japanese manufacturing output. December’s survey in fact signaled that output and new business rose at accelerated rates. In addition, the rate of expansion for new export orders was the sharpest since July 2004—reflecting mainly buoyant demand from China. On price developments, November 2009 annual CPI inflation declined by 1.9 percent following a contraction of 2.5 percent in October. The main drivers of price developments are base effects related to petroleum products and considerable economic slack. Emerging Asian economies’ GDP growth were buoyed by the fiscal stimuli and expansionary monetary policies, the return of substantial net capital inflows, favorable developments in asset and real estate markets. In China, Q4 2009 GDP growth soared to 10.7 percent year-on-year, from 9.1 percent in the previous quarter, driven mainly by government fiscal stimulus to boost infrastructure investment and private investments.

40

On price developments, inflation turned positive at 0.6 percent in November from -0.5 percent in October. Other emerging and developing Asian economies such as Hong Kong, India, Korea, Taiwan, and Thailand showed rising industrial production in Q3 2009. The overall strength of banking sectors in the region also limited the impact of the financial crisis. Prospectively, the outlook for output in emerging economies continues to be positive, as the PMI for emerging markets posted at 55.9 in Q4 2009, was way above the threshold level of 50. For countries that have released December CPI, inflation rose, and was higher than the expected consensus forecast in Indonesia, Korea and the Philippines. The rise in inflation was due mainly to the rebound in commodity prices, which have a significant weight in Asian CPI baskets. Nevertheless, there seems to be a consensus among central banks in the region that current monetary policy settings appear to be appropriate and that monetary authorities will continue to provide support to economic activity.

41

BSP Policy Interest Rates In percent

3

4

5

6

7

8

9

10

11

2004 2005 2006 2007 2008 2009

Overnight RRP Rate Overnight RP Rate

…as current monetary policy settings remsin appropriate…

The Monetary Board maintained policy rates at 4 percent for the overnight borrowing or reverse repurchase (RRP) facility and 6 percent for the overnight lending or repurchase (RP) facility during the quarter. The interest rates on term RRPs, RPs, and special deposit accounts (SDAs) were also left unchanged. The Monetary Board’s decision to maintain policy rates in Q4 2009 was based on its assessment that current monetary settings remained appropriate. Inflation forecasts continued to follow a target-consistent path over the policy horizon, with underlying demand and supply pressures generally muted during the review period. Growth readings for the domestic economy were moderate and uneven, and for the global economy, sluggish and protracted as significant fragilities lingered. The BSP also noted that given the uncertainty in the strength of the global economic recovery, caution needed to be exercised in assessing the impact of global developments on the Philippines.

The Monetary Board maintains policy settings throughout the quarter.

V. MONETARY POLICY DEVELOPMENTS

42

The Monetary Board notes that upside risks were tilted only slightly upward, but forecasted inflation remains manageable.

During the November meeting, the BSP noted that upside risks to the inflation outlook have persisted while downside risks have diminished. Upside risks included a stronger-than-expected rebound in global economic activity and its potential tightening effect on commodity supply-demand balances; adverse weather conditions due to El Niño; increases in utility rates due to cost recoveries; and a delayed unwinding of large stimulus programs in advanced economies. Unaccounted damages caused by typhoons Ondoy and Pepeng were also considered as potential risks to inflationary pressures in the near term. Meanwhile, downside risks to the projected inflation path consisted of a stalled global economic recovery and its pull on commodity prices, as well as the impact on consumer prices of the recent appreciation of the peso. In December, new information suggested that the stabilizing global economy had tilted the risks to the inflation outlook slightly upward. The BSP noted, however, that even after accounting for the upward shift in futures commodity prices, forecasted inflation remained manageable. Inflation expectations were also well contained. At the same time, recent demand and credit indicators affirmed the earlier assessment that the domestic economic activity remained subdued, keeping price pressures in check over the near term. In addition, the BSP considered that the limited demand-based pressures, as evidenced by the stable core inflation, supported the case for keeping policy rates unchanged.

43

Meanwhile, the extensive macroeconomic stimulus and other policy measures undertaken by advanced economies provided upside risks to the inflation outlook. Downside risks included the appreciation of the peso—which could dampen inflationary pressures—and sustained strong inflow of foreign capital. The reduction in the system loss cap effective January 2010 could also temper electricity costs going forward. Nevertheless, the still-favorable inflation environment provided room for maintaining policy rates given tentative signs of recovery. However, macroeconomic conditions remained fragile as seen in the uneven performance of the aggregate demand components. The expansion in aggregate consumption was driven largely by consumer spending and the stimulative spending of the government, while private capital formation and exports contributed negatively to growth. Reflecting the relatively weak economic growth trajectory, bank lending, particularly in credit-intensive sectors such as manufacturing, expanded quite modestly despite the substantial easing of banks’ lending rates. These all added support to the argument for keeping policy rates unchanged to lift investment and credit activity for as long as the inflation outlook would allow.

44

Inflation Expectations and the Price Puzzle in the Philippine Transmission Mechanism 32

1. Introduction and Literature Review Recent empirical literature makes use of the vector autoregression (VAR) approach to assess the transmission mechanism of monetary policy. The VAR methodology’s advantage over other analytical approaches is that it recognizes explicitly that there is simultaneity between monetary policy and macroeconomic developments—that monetary policy changes affect relationships in the macroeconomy—and therefore need to be captured in a dynamic setting. Representing the transmission process using VAR also eliminates empirical issues on how to correctly specify a monetary policy shock, because the impulse responses in a VAR directly represent the response of each variable given changes in another variable and vice versa.

Studies which employed VAR models to investigate the empirical effects of monetary policy via the transmission channels have come up with a “price puzzle”--a result that reflects an initially higher level of inflation in response to tighter monetary policy (Hanson, 2000). It is regarded as “puzzling” because macroeconomic models cannot explain the result theoretically. Some studies propose the inclusion of commodity prices as a variable to resolve the puzzle because this variable contains information that helps forecast inflation to varying degrees, depending on the characteristics of the economy in question. However, variables that forecast inflation do not always resolve the puzzle. Alternatively, inflation expectations are also used as an explanatory factor, claiming that it is the omission of expected inflation is from the VAR equation that accounts for the puzzling response of the price level to a monetary policy shock. The presence of a price puzzle is important because it casts doubts on the possibility of correctly identifying a monetary policy shock. As Castelnuevo and Surico (2006) explains, the result of this omission is that a policy tightening in anticipation of future inflation could be wrongly interpreted as a policy shock, creating a strong correlation between a tightening of policy and a rise in inflation: the price puzzle.33

32 This article is an excerpt from a forthcoming BSP Review article by Laura B. Fermo, Monetary Policy Research Group, Department of Economic Research. 33 Dakila and Paraso (2004), for example, looked into the interest rate channel in the Philippines by obtaining coefficients under a general to specific modeling methodology using PC Give with a validation under a Vector Error Correction (VEC) system and saw an initial increase in the inflation rate up to the eighth quarter after a monetary policy shock.

45

The main objective of this paper is to use VAR analysis to examine the presence of price puzzles observed in the monetary transmission process using four channels and provide an assessment on whether inflation expectations would resolve such price puzzles empirically. This study will also try to assess the implications related to the inclusion of inflation expectations in the transmission channels. 2. Data and Methodology

In this exercise, VARs will be estimated to examine the presence of a price puzzle in four channels of monetary transmission, namely, the interest rate, credit, asset price, and exchange rate channels, and examine the effect of including inflation expectations in the VARs.

The following is the representation of the transmission channels using VAR: Interest Rate Channel: OG_SVAR, d(CPI), 91Tbill, ERRP34 The Credit Channel: OG_SVAR, dCPI, dCredit, 91TBill, ERRP The Asset Price Channel: OG_CES, dCPI, d(PHISIX), TBill91, ERRP35 The Exchange Rate Channel: OG_CES36, dCPI, real effective exchange rate

(REER), TBill91, ERRP The VAR analysis in this paper borrows largely from the study of Gochoco-Bautista (2005) and replicates the VAR systems and methodology of Ahmed, Shah, Agha, and Mubarik for Pakistan (2005) in representing the different channels of transmission.37 For the indicators used in the study, the data ranged from January 1985 to December 2008. Prior to estimation, all the variables were adjusted for seasonality using X12 in Eviews, and the different transformations of each (such as growth rates, logs, differentiated, or dlog forms) were examined for stationarity using both basic and various more stringent stationarity criteria from Eviews. An important assumption in the study as a whole is that the effective RRP rate (ERRP) is the main policy rate and the 91-day Tbill rate is the main conduit by which the policy rate affects the rest of the economy. This is based on the findings of Dakila and Claveria (2006) which showed that a one-time shock in the RRP rate by one percentage point leads to a maximum increase in the 91-day T-bill rate of 0.70 percentage point in the second month and dissipates thereafter.

34 OG_SVAR is the output gap estimates under the SVAR methodology; d(CPI) is changes to the CPI level; 91Tbill is the 91-day Tbill rate; ERRP is the effective RRP rate (After the removal of the tiering system in 2007, the ERRP rate coincides with the RRP rate) 35 OG_CES is the output gap estimates under the CES production function approach. We have used this output gap series because the SVAR series produces VAR results with at least one unit root. Meanwhile, dPHISIX are changes in the Philippine stock market price index. 36 Ibid. 37 This methodology allows for minimal restrictions on how monetary shocks affect the economy, which is a distinct advantage. In addition, the approach recognizes the dependence of monetary policy on other economic variables and vice versa (Ahmed, et al., 2005). We will be using here a standard unrestricted VAR methodology.The VAR models were identified using the “recursive” Choleski decomposition. The Choleski ordering for the variables is based on basic economic theory, the assumptions about the dynamic structure of the economy, and is in part guided by the Granger causality tests we have conducted prior to estimation. The results are reliable only if the estimated VAR correctly represents the true process, that is, if the stability condition that no unit root lies outside the unit circle is satisfied. If the VAR, for instance, has a unit root in it then impulse responses will be biased. Thus, all VAR systems in the study were subjected to standard unit root tests and were pursued only if the stability condition was satisfied. For each of the four channels estimated in this paper, impulse response functions will be presented to see how the variables react to changes in the policy rate.

46

-.012

-.008

-.004

.000

.004

.008

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

Response o f F_OG_SVAR to TBILL91

-.012

-.008

-.004

.000

.004

.008

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

Response of F_OG_SVAR t o ERRP_SA

-.10

-.05

.00

.05

.10

.15

2 4 6 8 10 12 14 1 6 18 20 22 24

Response of D(CPI_SA) to TBILL91

-.10

-.05

.00

.05

.10

.15

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

Response of D(CPI_SA) to ERRP_SA

-0.4

0.0

0.4

0.8

1.2

1.6

2 4 6 8 10 12 14 1 6 18 20 22 24

Response of TBI LL91 to ERRP_SA

-1

0

1

2

3

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

Response of ERRP_SA t o TBILL91

Response to Cholesky One S.D. Innovat ions ± 2 S.E.

Impulse Resp onse Functions of the Transmission Channel VARs

Figure 1. Interest Rate Channel. Full Period 1988-2008

Figure 2. Interest Rate Channel. Subperiod 1988-2001

Figure 3. Interest Rate Channel. Subperiod 2002-2008

-.02 0

-.01 5

-.01 0

-.00 5

.00 0

.00 5

.01 0

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

Response o f F_OG_ SVAR to TBILL91

- .020

- .015

- .010

- .005

.000

.005

.010

2 4 6 8 10 12 1 4 16 18 20 22 2 4

Response o f F_OG_SVAR to ERRP_SA

-.4

-.3

-.2

-.1

.0

.1

.2

.3

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

Response o f D(CPI_SA) to T BILL9 1

-.4

-.3

-.2

-.1

.0

.1

.2

.3

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

Response o f D(CPI_SA) to ERRP_SA

-.4

.0

.4

.8

2 4 6 8 10 12 1 4 16 18 20 22 24

Re sponse of T BI LL91 to ERRP_SA

-.4

-.2

.0

.2

.4

2 4 6 8 10 12 14 16 1 8 20 22 24

Response of ERRP_SA to T BILL9 1

Response to Cholesky One S.D. In nova tions ± 2 S.E.

Figure 4. Credit Channel. 2000-2008

-. 015

-.010

-.005

.000

.005

.010

2 4 6 8 10 12 14 1 6 18 20 22 24

R espon se of F_O G _ S VA R t o TB ILL91

-.015

-.010

-.005

.000

.005

.010

2 4 6 8 10 1 2 14 16 18 20 2 2 24

R espon se of F_O G _SV AR to E R RP _ SA

-.4

-.3

-.2

-.1

.0

.1

.2

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

Re spons e of D(C PI_ S A ) to T BIL L 91

-.4

-.3

-.2

-.1

.0

.1

.2

2 4 6 8 10 12 14 16 18 2 0 22 24

Respon se of D (C PI_ S A) t o E RR P_S A

-8,000

-4,000

0

4,000

8,000

12,000

2 4 6 8 10 12 14 16 1 8 20 22 24

R espo nse o f D(C R ED IT_ S A) t o T BIL L9 1

-8,000

-4,000

0

4,000

8,000

12,000

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

R esp on se o f D(C RE DI T_S A) t o ER RP _S A

Respons e to Cholesky One S.D. Innovations ± 2 S.E.

Figure 5. Asset Price Channel. 1988 to 2008

-.0 04

-.0 03

-.0 02

-.0 01

.0 00

.0 01

.0 02

1 2 3 4 5 6 7 8 9 10 11 12

Response of F_OG_CES to TBILL91

- .004

- .003

- .002

- .001

.000

.001

.002

1 2 3 4 5 6 7 8 9 1 0 11 12

Res ponse of F_OG_CES to ERRP_SA

- .0 8

- .0 4

.0 0

.0 4

.0 8

1 2 3 4 5 6 7 8 9 10 11 12

Response of D(CPI_SA) to TBILL91

-. 08

-.04

.00

.04

.08

1 2 3 4 5 6 7 8 9 10 11 12

Response of D(CPI_SA) to ERRP_SA

-40

-20

0

20

40

1 2 3 4 5 6 7 8 9 10 11 12

Response of D(PHISIX_SA) to TBILL91

-40

-20

0

20

40

1 2 3 4 5 6 7 8 9 10 11 12

Respon se of D(PHISIX_SA) t o ERRP_SA

Respon se t o Cholesky One S.D. Innova tions ± 2 S.E.

Figure 6. Exchange Rate Channel. 1994 to 2008

-. 006

-.004

-.002

.000

.002

.004

2 4 6 8 10 1 2 14 16 18 20 2 2 24

Response of F_OG_SVAR to TBILL91

-.006

-.004

-.002

.000

.002

.004

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

Response of F _OG_SVAR t o ERRP_SA

-.12

-.08

-.04

.0 0

.0 4

.0 8

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

Response of D(CPI_SA) t o TBI LL91

-.12

-.08

-.04

.00

.04

.08

2 4 6 8 10 12 14 16 1 8 20 22 24

Response of D(CPI_SA) to ERRP_SA

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

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

Response of REER to TBILL91

- 1.5

- 1.0

- 0.5

0.0

0.5

1.0

1.5

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

Response of REER to ERRP_SA

Res pons e to Ch olesky One S.D. Inno vation s ± 2 S.E.

- .006

- .004

- .002

.000

.002

.004

.006

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

Response of F_OG_SVAR to TBILL91

-.006

-.004

-.002

.000

.002

.004

.006

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

Response o f F_OG_SVAR t o ERRP_SA

-.15

-.10

-.05

.00

.05

.10

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

Response of D( CPI_SA) t o TBILL91

-.15

-.10

-.05

.00

.05

.10

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

Response of D(CPI_SA) to ERRP_SA

-0.4

0.0

0.4

0.8

1.2

2 4 6 8 10 1 2 14 16 1 8 20 22 24

Respo nse of TBI LL91 to ERRP_SA

- 0.5

0.0

0.5

1.0

1.5

2.0

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

Response of ERRP_SA to TBILL 91

Response to Cholesky One S.D. Innovations ± 2 S.E.

47

-.005

-.004

-.003

-.002

-.001

.000

.001

.002

5 10 15 20

Response of F_OG_CES to ERRP_SA

- .08

- .04

.00

.04

.08

.12

5 10 15 20

Response of APCONS_IE to ERRP_SA

-.100

-.075

-.050

-.025

.000

.025

.050

5 10 15 20

Response of D(CPI_SA) to ERRP_SA

- .03

- .02

- .01

.00

.01

.02

.03

5 10 15 20

Response of LOG(PHISIX_SA) to ERRP_SA

Response to Cholesky One S.D. Innovations ± 2 S.E.

-.006

-.005

-.004

-.003

-.002

-.001

.000

.001

5 10 15 20

Response of F_OG_CES to ERRP_SA

-.12

-.08

-.04

.00

.04

.08

5 10 15 20

Response of APCONS_IE to ERRP_SA

-.100

-.075

-.050

-.025

.000

.025

.050

5 10 15 20

Response of D(CPI_SA) to ERRP_SA

-1 .6

-1 .2

-0 .8

-0 .4

0 .0

0 .4

5 10 15 20

Response of REER to ERRP_SA

Response to Cholesky One S.D. Innovations ± 2 S.E.

Figure 7. Interest Rate Channel with Inflation Expectations. 1998 to 2008

Figure 8. Credit Channel with Inflation Expectations. 2000 to 2008

Figure 9. Asset Price Channel with Inflation Expectations. 1998 to 2008

Figure 10. Exchange Rate Channel with Inflation Expectations. 1998 to 2008

-.008

-.006

-.004

-.002

.000

.002

1 2 3 4 5 6 7 8 9 10

TBILL91 ERRP_SA

Res ponse of F_OG_SVAR to Cholesky

One S.D. Innovations

-.16

-.12

-.08

-.04

.00

.04

1 2 3 4 5 6 7 8 9 10

TBILL91 ERRP_SA

Response of D(CPI_SA) to CholeskyOne S.D. Innovations

-.20

-.15

-.10

-.05

.00

.05

.10

1 2 3 4 5 6 7 8 9 10

TBI LL91 ERRP_SA

Response of APCONS_IE t o CholeskyOne S.D. Innovat ions

-.015

-.010

-.005

.000

.005

.010

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

Response of F_OG_SVAR to ERRP_SA

- .3

- .2

- .1

.0

.1

.2

.3

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

Response o f D(CPI_SA) to TBILL91

-.3

-.2

-.1

.0

.1

.2

.3

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

Response o f D(CPI_SA) to ERRP_SA

-6,000

-4,000

-2,000

0

2,000

4,000

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

Response of D( CREDIT_SA) to TBILL91

-6,000

-4,000

-2,000

0

2,000

4,000

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

Response of D(CREDIT_SA) to ERRP_SA

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

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

Response of BLOOM_IE to ERRP_SA

Response to Cholesky One S.D. Innovations ± 2 S.E.

48

3. Analysis of Results The results of the VAR estimation show that the price puzzle appears in three out of the four VAR systems (please see impulse responses in Figures 1 to 6). Specifically, there is a short, but nonetheless positive, response of price changes after a rise in the ERRP or in the T-bill rate. We also found some other “puzzles”: Positive ERRP changes resulted in an early positive response in the level of stock prices, a real depreciation or a rise in the REER, and some unconventional results for the credit channel.38 Several iterations of each VAR system with a “puzzle” have not been able to arrive at the expected or desired results--different combinations on the years of coverage, iterations on the transformation of the variables, or iterations of the different definition for the variable (specifically for the output gap variables) were either unable to change the puzzling results or produced VARs that did not satisfy the unit root condition. However, the addition of a variable representing inflation expectations in the VARs was able to either improve or resolve the various puzzles at varying degrees (on price, output, stock price changes, and the exchange rate) in the VAR exercises conducted. The indicators for inflation expectations have used were the Asia Pacific Forecasts (APIE) for the VAR equations for the interest rate, asset price and exchange rate channels and Bloomberg’s inflation expectations survey results for the credit channel (please see impulse responses in Figures 7 to 10). The inclusion of the inflation expectations variable resulted in VAR results that more or less represented what was expected in theory, especially under the asset price and exchange rate channels. 4. Policy Implications

The inclusion of a variable on inflation expectations in the VAR systems gave us a better picture of the transmission process by which monetary policy affects real variables in the Philippines. With inflation expectations as an added variable, we find that the price puzzle and the “output puzzle” (under the interest rate channel) have been minimized to almost nil in the first two to three months. In the case of the credit channel, the response of credit to market interest rates are now negative and stable as theory suggests, in contrast to the fluctuating and volatile response of credit to the 91-day T-bill rate in the case without inflation expectations. Meanwhile, the response of credit to changes in the ERRP retains a very small “puzzle” for only the first two months, but of much smaller magnitude than in our earlier credit channel VAR system without inflation expectations. The impact of inflation expectations is even more important for the VAR system depicting the asset prices and exchange rate channel of monetary policy in the Philippines. With the inclusion of the inflation expectations variable, the “puzzling” results earlier arrived at were eliminated. There is now, as expected, a negative response in the real exchange rate and asset prices to a rise in the policy rate or the ERRP.

38 While the inclusion of a credit variable did not significantly change the response of real output and prices on shocks in the ERRP--a short-lived price puzzle in fact is still observed for innovations in the ERRP--the credit channel appears to have suppressed the response of the output gap to innovations in the 91Tbill rate. The output gap shows a marginally smaller decline persisting over a shorter period and moving almost asymptotically much later on. In addition, the credit channel has increased the duration and magnitude of the decline in prices in response to a higher 91Tbill rate before dissipating compared to the basic interest rate channel VAR system.

49

The important finding in the study is that it is necessary to include inflation expectations in any assessment or estimation of the relative importance and magnitude of the transmission effects in all channels, if we are to represent as close as possible the process by which monetary policy changes impact the real economy. An assessment on the expected impact of policy rate changes and movements in the market interest rates on the real economy could truly replicate the monetary policy transmission mechanism in the Philippines if monetary authorities factor in how inflation expectations are evolving and how they will change with any policy decision. In retrospect, during the period June to August 2008 the BSP decided to raise policy rates by a cumulative 100 basis points mainly in order to anchor inflation expectations, despite an inflation outlook that was seen as broadly remaining within the upper bound of the target ranges for 2009 and 2010. The tightening policy moves at that time were broadly successful in minimizing the adverse impact of the higher inflation expectations on demand and on confidence (see chart below). The economy continued to post positive growth in Q3 and Q4 2008, and higher inflation expectations began to subside towards the end of 2008. Had the BSP failed to tighten, basing its decisions on the inflation outlook alone without considering how inflation expectations were evolving, second-round effects of the higher commodity and fuel prices in Q3 and Q4 2008 may have aggravated the impact of the worsening global financial crisis on the domestic economy during the same period. The impact of a policy adjustment in the economy should also not be limited to its impact via the basic interest rate route, which we have identified here using the Taylor-rule framework. As seen in the earlier VAR results, the credit channel can “block” or lessen some of the adverse impact of monetary tightening on the domestic output, in the same way that it can create a lagged response of economic growth to an accommodative monetary policy stance. This may be due to the fact that credit growth is found to have a lagged response to changes in the business cycle, inasmuch as high transactions costs and information asymmetry as well as a supplier-driven Philippine banking system all contribute to some rigidities in loan growth. It is thus important that in its decisions, monetary authorities assess the impact of a monetary policy shock via all relevant transmission channels in the real economy. Chart: Inflation Ex pectations in the Philippines, 1997-2009

0

1

2

3

4

5

6

7

8

9

10

Asia Pacific Consensus Forecasts One-Year Ahead Inflation Forecasts for the Philippines

50

References Ahmed, N., Shah, H., et. al., 2005. Transmission Mechanism of Monetary Policy

in Pakistan, Working Papers No. 9, State Bank of Pakistan. Balke, N.S. and Emery, Kenneth M., 1994. Understanding the Price Puzzle.

Economic Review, Federal Reserve Bank of Dallas, pp. 15-26. Castelnuevo, E. and Surico, Paolo, 2006. The price puzzle: fact or artifact?

Working Paper Ni. 288, Bank of England.

Castelnuevo, E. and Surico, Paolo, 2005. The Price Puzzle and Indeterminancy. Working Paper, University of Padua and Bank of England.

Dakila, F.G., Jr. and Claveria, Raquel A., 2006. The Impact of BSP Policy

Interest Rates on Market Interest Rates. BS Review. Dakila, F.G., Jr. and Paraso, Ma. Digna G., 2004. Transmission Mechanism of

Monetary Policy in the Philippines. Bangko Sentral (BS) Review.

Giordani, P., 2001. An Alternative Explanation of the Price Puzzle, Working Paper, Stockholm School of Economics.

Gochoco-Bautista, M. S., 2005. An Assessment of the Usefulness of Money for Policy in the Philippines. University of the Philippines School of Economics (UPSE) Discussion Paper No. 0508.

Hanson, M. S., 2000. The “price puzzle” reconsidered, Journal of Monetary Economics (51) 2004, 1385-1413.

Kapinos, Pavel, 2003. Resolving the Price Puzzle: Theory and Evidence. Working Paper, Illinois State University.

Martinez, L. Sanchez O., and Werner, A., 2000. Monetary Policy and the transmission mechanism in Mexico, Paper submitted for the Seminar on Stabilisation and Monetary Policy, Bank of Mexico.

Taylor, J. B., 1999. A historical analysis of monetary policy rules. In: Taylor, J.B.

(Ed.), Monetary Policy Rules. University of Chicago Press, Chicago, pp. 319-341.

51

Private Sector Economists’ Inflation Forecasts

4.7

4.8

4.94.8

4.8

4.8

4.6

4.9

4.8

4.9

4.7

4.0

4.2

4.4

4.6

4.8

5.0

5.2

5.4

Q4 2008 Q1 2009 Q2 2009 Q3 2009 Q4 2009

2012

2010

2011

MEAN INFLATION FORECASTS BY PRIVATE ECONOMISTS/ANAL YSTSIn percent

Private Sector Forecasts for Inflation Annual Percent Change

2011 2012Q1 Q2 Full year Full year Full year

ATR Kim Eng. 3.6 4.2 4.5 5.0 5.5Banco de Oro 3.1 3.5 3.5 3.25 3.0Economist.com 4.3 4.5 4.6 4.5 4.6HSBC 4.1 4.9 5.1 5.6 -IDEA 5.5 7.3 6.8 5.3 5.3ING Bank 4.6 5.1 4.8 4.2 -Metrobank - - 4.8 - -PEP/Bank of America-Meryll Lynch 4.5 4.9 4.9 5.3 -Royal Bank of Scotland 4.5 5.0 5.4 5.5 5.0RCBC 4.4-4.8 4.4-5.4 4.7-5.6 4.1-5.5 4.5-6.0Standard Chartered 4.0 3.5 3.3 3.3 4.0

Median Forecast 4.4 4.9 4.8 4.9 5.0Mean Forecast 4.3 4.8 4.8 4.7 4.7High 5.5 7.3 6.8 5.6 5.5Low 3.1 3.5 3.3 3.3 3.0Number of observations 10 10 11 10 7

Memo Item:Government Target 4.5±1.0 4.0±1.0

2010

33.0

29.4

26.7

0.0

10.0

20.0

30.0

40.0

<1 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 10.1-11 11.1-12 >12

2010 2011 2012

Probability Distribution For Analysts' Inflation Fo recasts* 2009 -2011

*Probability distributions were averages of those pr ovided by 9 respondents. (Source: BSP Survey)

.

Based on the results of the BSP’s survey for December 2009, inflation is expected to be within the target ranges for both 2010 and 2011. The mean inflation forecast for 2010 was unchanged at last quarter’s (September 2008) projection of 4.8 percent.39 For 2011, the average inflation forecast is 4.7 percent. Analysts expect the rally in global commodity prices to exert inflationary pressures. Also, unfavorable base effects from low inflation numbers in the previous year would register higher inflation readings in 2010. Meanwhile, some analysts noted that the strong peso as well as moderate demand conditions will dampen inflationary pressures. Based on the probability distribution provided by 9 respondents, there is a 33.0 percent chance that average inflation for 2010 could be within 4.1-5.0 percent, well within the 4.5 ± 1.0 percentage target for the year. The Asia Pacific consensus forecasts (for October, November, and December) for Philippine inflation showed within-target but slightly higher inflation expectations for 2010.

39 For Q1 and Q2 2010, inflation is expected at 4.3 percent and 4.8 percent, respectively.

The BSP’s survey of private economists expects inflation to remain within the target ranges for 2010 and 2011.

VI. INFLATION OUTLOOK

52

Results of the BES for Q4 2009 indicate that the proportion of respondents that anticipate inflation to move up in Q4 2009 increased. Results of the CES for Q4 2009 show marginally higher inflation expectations for the next 12 months: from 8.6 percent in the previous survey to 8.7 percent.

Relative to the previous survey, a bigger majority of respondents in Q4 (from a diffusion index of 4.4 percent to 28.2 percent) expect inflation to move up in Q4 2009 as well as in the next quarter (from 15.7 percent to 25.1 percent). This expectation could be attributed to the increase in the prices of basic commodities caused by the damages to crops and infrastructure during the recent typhoons as well as the anticipated increase in oil prices with the lifting of government price controls. In the Q4 2009 survey, consumers expect fruits and vegetables inflation to increase as well as that of rice. Meanwhile, lower inflation is expected for fish, light, fuel, transportation, and house rent. In terms of the diffusion index, however, a smaller majority of respondents expect increases in the prices of goods and services over the next 12 months: from 49.5 percent in Q3 2009 to 48.5 percent in Q4 2009.

53

BSP Inflation Forecasts BSP's latest baseline forecasts indicate inflation would settle slightly above the middle of the inflation target range for 2010 and at the lower half of the inflation target range for 2011.

Inflation is expected to track a target-consistent path over the policy horizon, with the latest baseline inflation forecasts for both 2010 and 2011 only slightly higher than the forecast in the previous Inflation Report. Based on potential near-term price movements, the current inflation outlook shows a hump-shaped path that could settle slightly above the middle of the 3.5 – 5.5 percent target range for 2010 and at the lower half of the 3.0 – 5.0 percent target range for 2011. Factors which may cause an upward shift in the inflation path relate to the strength of world economic recovery, US dollar developments and their impact on global commodity prices, the investment and operational environment in the oil and agriculture sectors, weather conditions, power rate adjustments, and the timing of exit from accommodative macroeconomic policies. Meanwhile, the downside risks to the inflation outlook include a weak global economic recovery and a sustained appreciation of the peso due to the depreciation of other currencies and the strong inflows of foreign exchange. Demand Conditions Latest information indicates stabilization in economic activity, albeit at a lower level, relative to the previous report. Household consumption and the government's stimulative spending remained at the helm of economic expansion while capital formation and exports continued to be weighed down. Other demand indicators showed signs of moderate recovery: sales of vehicles spiked, capacity utilization in manufacturing continued its uptrend and business sentiment improved. Meanwhile, land and rental values were lower relative to Q2 2009, office vacancy rates increased, while residential vacancy rates declined in Q3 2009. Meanwhile, consumer confidence fell in Q4 2009.

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Prospects for global and domestic food supply remain broadly favorable, despite upside risks to prices. Latest projections indicate higher world oil consumption for 2010. Output gap narrows but remains positive.

Supply Conditions Agriculture, fishery and forestry (AFF) declined in Q4 2009, reflecting the impact of a series of tropical storms that damaged production of most crops, livestock and poultry as well as fishery. Meanwhile, emerging projections for Q1 2010 point to an increase in palay production due to expectations of replanting, seed availability, and fertilizer subsidy. Corn production is expected to decline due to unfavorable weather conditions and lower profitability in corn farming. In the international market, the FAO expects less upside risks to global prices of wheat in the months ahead given adequate stocks and prospects of higher plantings this year. Meanwhile, IMF projects commodity prices in 2010 to be historically high, but below the record 2008 levels, with rising demand from emerging and developing economies likely to remain the key driver of the price uptrend. In the oil market, the EIA estimates higher world oil demand for 2010 due to optimism that global economic recovery will continue. Meanwhile, a gradual rise in both OPEC and non-OPEC supply are projected for 2010 on higher projected output and expectations of recovery in global oil consumption. Output gap contracts although still positive. 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 the latest GDP data, preliminary estimates yielded an output gap of 0.3 percent in Q3 2009, down from 2.4 percent in the previous quarter. The narrower though positive output gap suggests that demand-side pressures have moderated.

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Latest surveys indicate well-anchored inflation expectations for 2010.

Inflation Expectations Consistent with previous surveys, the Asia Pacific consensus forecast and the BSP’s survey of private sector economists for December 2009 showed within target inflation forecast for 2010. Results of the Q4 2009 Consumer Expectations Survey (CES) showed that a smaller majority of respondents expect increases in the prices of goods and services over the next 12 months while the Q4 2009 Business Expectations Survey (BES) indicated that more respondents expect inflation to increase in the current quarter as well as in the next quarter. Likewise, secondary market yields on government securities as of 4 January 2010 generally increased across most tenors, consistent with the results of the expectations surveys. Key assumptions used to generate the BSP’s inflation forecasts The BSP's baseline forecasts generated from the BSP’s single equation model (SEM) and the multi-equation model (MEM), are based on the following assumptions:

(a) endogenously-determined real GDP growth in the BSP multi-equation model;

(b) a budget deficit of 3.5 percent of GDP for 2010 and 2.0 percent for 2011;

(c) headline overnight RRP rate at 4.0 percent from February 2010 to December 2011;

(d) 91-day T-bill rate which is consistent with the DBCC-approved macroeconomic assumptions;

(e) Dubai crude oil price assumption which is consistent with the futures price of oil in the international market;

(f) annual increase in nominal wage of 6.1-6.5 percent in 2010 and 2011; and

(g) endogenously-determined exchange rate in the BSP’s multi-equation model through the purchasing power parity and interest rate parity relationships.

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Risks to the Inflation Outlook The latest fan chart shows inflation would pick up over the next two quarters then ease gradually towards end-2011, with a higher probability of inflation turning out above the central projection than below it. Factors which might push up inflation further include a stronger-than-expected world economic recovery; a sustained weakening of the US dollar which could contribute to surges in global commodity prices; constraints to oil and agricultural production including adverse weather conditions; electricity rate increases; and a delayed unwinding of stimulus programs.

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. The central projection of the latest fan chart suggests inflation would pick up over the first half of 2010 then ease gradually as 2011 draws to a close. Based on data as of the second week of January 2010, annual average inflation would hover at around the middle of the 4.5 percent + 1.0 percentage point target range for 2010 and at the lower half of the 4.0 percent + 1.0 percentage point target range for 2011. The latest fan chart also shows that there are uncertainties further out—as depicted by the widening bands of the fan chart over time—and there are risks to the inflation outlook in both directions. On the upside, inflation risks relate to the strength of world economic recovery, US dollar developments and their impact on global commodity prices, the investment and operational environment in the oil and agriculture sectors, weather conditions, power rate adjustments, and the timing of exit from accommodative macroeconomic policies. In its October 2009 World Economic Outlook (WEO) report, the IMF noted that the turnaround in market sentiment on signs of economic recovery could translate to higher-than-anticipated growth in consumption and investment. In this case, prices could rise more rapidly than initially forecasted.

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Commodity demand tends to be sensitive to world economic activity and has been an important driver of prices. Indeed, the latest overall reading by international energy and food agencies is for commodity prices to increase moderately in the near term due in large part to rising demand from emerging and developing economies. Sharp commodity price hikes are expected to be held back by sluggish economic recovery, adequate commodity stocks, higher oil supply and excess crude oil production capacity, but they cannot be ruled out entirely due to a number of supply-side constraints and increased vulnerability of global commodity prices to foreign exchange developments.

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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 Q3 2009.

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In food markets, the FAO noted that the balance of supply and demand is uneven across commodities, with some markets facing tighter conditions than others. For global rice production, the FAO is forecasting a 1.9 percent decline for 2009/10 due to adverse weather conditions in India and natural calamities in other Asian countries. Along with higher importation by the Philippines, a further deterioration of the global rice supply outlook could support a pickup in rice prices. The growing interdependence of the food and oil sectors has also raised commodity price volatility. For wheat, the FAO cautioned that “a period of volatile and even rising prices cannot be ruled out” given the wheat sector’s strengthening linkages with other markets. For coarse grains, the FAO expects the risk of a sustained increase in prices to be limited given less buoyant demand from the feed and fuel sectors, but nonetheless recognizes that further developments in the energy and soybean markets “will continue to be influential.” The direction of commodity prices would also depend partly on developments in the US dollar market, with a sustained depreciation of the dollar possibly boosting the incentive to hold commodity assets. The FAO noted in its December 2009 Food Outlook report that among other factors, the weakening of the US dollar pushed up global prices of wheat and coarse grains towards end-2009. The OPEC likewise pointed to the US dollar depreciation as one of the reasons for the run-up in crude oil prices in November 2009.

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The IMF noted other upside risks to world oil prices, namely, the deterioration of investment incentives in some producer countries and the geological and technological constraints in new and existing oil fields. It is also possible that the response of OPEC production to the upturn in demand would be more gradual than expected. For food, FAO has warned that lagging investment in agriculture, as observed today, was among the structural factors which drove the surge in food prices in 2008. Adverse weather conditions could put greater upward pressure on inflation. The recent typhoons which hit the Philippines have eroded rice and corn output and added to market tightness in the domestic poultry sector. Moreover, according to PAGASA, the El Niño phenomenon continues to strengthen as reflected by the oceanic and atmospheric conditions in the equatorial Pacific. This is expected to persist at least into early 2010 and likely to reach its peak during the January-February 2010 season.40 Should electricity rate hikes due to pending NPC petitions to recover fuel, independent power producers (IPP) and foreign exchange rate costs materialize, these could also support a further uptick in inflation moving forward. The timing of withdrawal of substantial stimulus policies also poses a risk to the inflation outlook. On one hand, a delayed implementation of exit strategies from accommodative fiscal and monetary policies could generate higher-than-targeted growth in prices.

40 Philippine Atmospheric, Geophysical, and Astronomical Services Administration, El Niño Advisory No. 5, December 2009, available at http://www.pagasa.dost.gov.ph.

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Downside risks to the inflation outlook include a weak global economic recovery and a sustained appreciation of the peso due to the depreciation of other currencies and the strong inflows of foreign exchange.

On the other hand, a premature withdrawal of stimulus policies runs the risk of breaking the momentum for the full recovery of advanced economies and the sustained growth of emerging and developing economies. This and the possibility of elevated oil prices which could restrain demand, and higher delinquencies and unemployment which could tighten financial conditions anew were among the factors considered by the IMF in assessing the risks to world economic growth as remaining broadly on the downside.41 Under such low growth scenario, inflation could settle below the central projection. While a continued depreciation of the US dollar poses an upside risk to inflation through higher world commodity prices, it could, on the other hand, help stabilize the value of the peso an in the process, help contain price pressures from imported commodities. Large foreign exchange inflows from overseas Filipinos’ remittances and foreign investments could also add pressures for the peso to appreciate.

41 International Monetary Fund, World Economic Outlook, October 2009, available at: http://www.imf.org

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VII. IMPLICATIONS FOR THE MONETARY POLICY STANCE

Inflation is expected to track a target-consistent path over the policy horizon. Given a manageable inflation environment, authorities could afford to maintain adequate monetary stimulus so as not to disrupt the economic recovery. Meanwhile, there is a need to be cautious as supply-side price pressures persist.

Emerging baseline forecasts indicate that inflation would settle slightly above the middle of the 4.5 percent + 1.0 percentage point target range for 2010 and at the lower half of the 4.0 percent + 1.0 percentage point target range for 2011. Meanwhile, price pressures are expected to remain manageable over the near term given modest improvement in domestic demand conditions, likelihood of a moderate global recovery, adequate inventory levels and presence of spare capacity in advanced economies. Global inflationary pressures are also expected to be reduced as some major central banks have started to signal a gradual exit from their extraordinary stimulus measures implemented earlier. Limited demand-based pressures, as evident from the absence of broad-based calls for wage adjustments and well-contained inflation expectations could also help keep price pressures in check over the near term. Recent developments suggest that risk of a prolonged adverse impact from the global financial crisis is markedly reduced and economic activity has started to recover in Q4 2009. However, there are still no signs of a strong pick-up in domestic demand. For one, capital formation continued to decline while most of the improvements in growth drivers could be due to inventory restocking and stimulus spending which are temporary in nature. At the same time, the pace of the global recovery remains subject to high uncertainty as soon as stimulus measures are withdrawn. The fragility of the global recovery warrants the need for authorities to maintain a supportive monetary policy until recovery is in more stable ground. Current policy settings remain appropriate as economic recovery is expected to proceed at a gradual pace. Clearer prospects of modest recovery in the global economy in 2010 indicate possible resurgence in commodity prices in the near term. Oil market risk assessment continues to suggest oil price pressures over the policy horizon, since the factors behind tight global supply have remained largely intact. Likewise, tight supply in key agricultural products like rice, meat, and sugar by the end of 2009 could continue to put pressure on domestic food prices going forward. Supply could also be

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The prevailing assessment of price and output conditions over the policy horizon continue to suggest that current policy settings are appropriate, but also suggest continued readiness to undertake prompt policy action before inflation pressures begin to manifest.

affected as the El Niño phenomenon is expected to strengthen in Q1 2010. Pending adjustments in domestic power charges would also add to price pressures. In sum, continuing supply-side pressures have figured prominently in the upside risks to the inflation outlook. Thus, monetary authorities will remain focused on the likelihood of second-round effects and risks to inflation expectations. With the expected improvement in the domestic economy alongside the recovery in the global economy by 2010, the BSP will continue to review its support measures in line with its commitment to the inflation objective. The decision to recalibrate the support measures of the BSP will depend on the underlying conditions in the economy, particularly the inflation outlook and the speed of economic recovery in the domestic and global economies. [On 28 January 2010, the Monetary Board maintained the RRP and RP rates at 4.0 and 6.0 percent, respectively. The Monetary Board also decided to align the peso rediscount rate with the overnight RRP rate effective 1 February 2010.]

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