A Forecasting and Monetary Policy

Analysis Framework for the

Philippines

Shanaka J. Peiris
The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF
or IMF policy

Outline
I.

Background and Current Context: Global crisis and

appropriate design of monetary policy framework

II.

FPAS (Forecasting and Policy Analysis System) for

Philippines (see Laxton, Rose, and Scott, 2009)

Understanding monetary policy transmission
mechanism and impact of exogenous shocks

Forecasting inflation conditional on global factors
and distribution of shocks

III.

Optimal monetary policy rules and appropriate policy

stance

Motivation
 Philippines inflation targeting regime has so far
yielded low and stable inflation
 The BSP has kept policy rates at a historical low
partly as a response to the global crisis
 In this new world, there is a need to revisit
monetary frameworks to take account of global
shocks (and uncertainty) and macro-financial
transmission mechanisms.
 What does this mean for the Philippines?

Headline CPI Trend and Target: 2003-2010

(Year-on-year percent change)
20%
Headline Inflation

15%

Inflation Target Upper

Threshold
Inflation Target Lower
Threshold
Core Inflation

10%

5%

0%
2002 2003 2004 2005 2006 2007 2008 2009 2010

Preview of FPAS model results

 The monetary policy framework should take
account of both domestic and global factors as well
as macro-financial linkages (see Carabenciov et al.,
2008 for more detail).
 A FPAS model-based approach could provide a
good forecast of future inflation.
 Alternative monetary policy rules can help reduce
macroeconomic volatility given the size and type of
shocks faced by the economy.
 Optimal policy rules can help guide the
appropriate monetary stance.

An FPAS Model for the Philippines



What is the FPAS model (see Berg, Karam, and Laxton, 2006)?

A stripped down version of a dynamic stochastic general equilibrium
(DSGE) model with rational expectations;

A structural model as each of its equations has an economic
interpretation;

New Keynesian emphasis on nominal and real rigidities and a role
of aggregate demand in output determination.

The model consists of a set of equations :

IS Curve

Phillips Curve

Interest Parity

Monetary Policy Reaction Function

Estimation Methods


Quarterly data 1996-2010. Seasonally adjusted data on

GDPgap (hp filtered), headline inflation (QoQ annualized),
and monetary and financial conditions.

Advantages of Bayesian estimation

fits the complete, solved DSGE model

allows the consideration of priors

explicitly addresses model misspecification by including
shocks and measurement error

efficient in small samples

Provides a natural comparison of models based on fit

Estimation Results (IS curve)

The economy is susceptible to volatility

Direct interest rate channel is relatively
weak, though more effective through credit
and a financial accelerator mechanism
Exchange rate channel is weak

Parameter Prior

lag
ld
RRgap
Zgap
RW ygap
FBgap
BL

Posterior
0.65
0.1
0.1
0.05
0.15
0.2
0.1

0.68
0.11
0.04
0.02
0.14
0.21
0.12

Global demand conditions is important

Counter-cyclical fiscal policy has a role to
play

Estimation Results (Phillips curve)

tc = ld t 4 t +1 + (1 ld ) t 4 t 1 + ygap ygapt 1 + zgap ( z t z t 1 ) + 0 ( to o ) + t
Inflation expectations is well anchored but
with a significant inertial component

Parameter Prior

The sacrifice ratio is in line with other

countries over 1996-2010

ld
ygap
zgap
o
olag

Exchange rate pass through is relatively low

taking into account other factors
Global oil prices feed into higher inflation
with a short lag

Posterior
0.5
0.4
0.05
0.05
0.05

0.61
0.45
0.01
0.02
0.03

Estimation Results
z t = z z t +1 + (1 z ) z t 1 [ RR t RR tRW * ] / 4 + tz
Parameter Prior
Posterior
Higher values makes monetary policy a
more effective tool, though exchange rate
z
0.4
0.75
pass-through is low.

RSt = RSlag RSt 1 + (1 RSlag ) * (RRt* + 4t + 4 t +4 t*+4 + ygap ygapt + zgap zgapt ) + tRS

There is a high degree of interest

rate smoothing
Policy response to inflation and real
activity is in line with other EMs
The weight on the exchange rate is
somewhat higher than expected

Parameter

Prior

RSlag

ygap
zgap

Posterior
0.75
1.1
0.5
0.1

0.91
2.2
0.51
0.35

Impulse Responses: Monetary policy shock

LK_GDP_GAP

LK_PIE

0
0.2

0.05

0.4
0.1
0.6
0.15

0.2

0.8

10

20

30

40

10

LK_RS

30

40

30

40

LK_Z_GAP

1.5

0.5

0.5

1.5

0.5

2.5

1
1.5

20

3
10

20

30

40

3.5

10

20

Impulse Responses: Global demand shock

LK_GDP_GAP

LK_PIE

LK_RS

0.2

0.8

0.8

0.15

0.6

0.6

0.1

0.4

0.4

0.05

0.2

0.2

10

20

30

40

LK_Z_GAP

0.5

10

20

20

30

40

10

RW_GDP_GAP

10

30

40

30

40

0.6

0.4

0.4

0.3

0.2

0.2

0.1

0.2

10

20

30

20

30

40

30

40

RW_PIE

40

10

20

RW_RS
0.8
0.6
0.4
0.2
0

10

20

Optimal Monetary Policy

 Loss Function:

 The optimal monetary policy function minimizes the

volatilities of key variables.
 Optimal weights in monetary policy function:
Estimated Optimal

RSlag

ygap
zgap

0.91
2.2
0.51
0.35

0.81
3.5
0.45
0.28

FPAS model based inflation forecast



We can forecast inflation and other real economy factors

(e.g., output gap) conditional on the WEO forecast for the
U.S. economy, global oil prices, and estimated distributions
for stochastic shocks in the Philippines.

The forecast assumes the inflation target, potential output,

and equilibrium real interest and exchange rates are
unchanged. Alternative policy rules could also be considered
(e.g., Taylor rule vs. no change policy).

The FPAS model based provides a relatively good out-ofsample forecast (compared to a BVAR after 2 lags).

Summary


We have developed a monetary policy analysis model, along the

lines of those in use in a number of central banks

The FPAS model provides good forecast of the Philippine

economy and could be used to guide monetary policy

It could also be used for risk-assessments of the baseline

inflation forecast and counter-factual scenarios

Future work:

refine the model to account for shocks to potential output

explore the implications of food prices on core inflation

Model capital flows possibly in a full DSGE setting