Sharp headline inflation greeted the Philippines in July

Blame it on higher food prices.

Headline inflation rose sharply in July due to higher food prices, while supply-side constraints are adding to import demand, raising the sensitivity of the exchange rate to headline inflation in the Philippines.

According to a research note from HSBC Global Research, it expects August price pressures to remain elevated.

This will cause the BSP to hike both the policy and the SDA rate by 25bp at the September meeting.

Further actions in Q4 are dependent on the September inflation data and the timing of the Fed's interest rate hikes.

Here’s more from HSBC Global Research:

We have long predicted that the BSP will be sailing through rough waters in Q3 2014. Key reasons to stay vigilant this quarter are:

The Philippines is having a) an on-going typhoon season, which tends to exacerbate supply-side constraints b) an unfavourable base effect in July and August that makes y-o-y headline inflation rise sharply on higher month-on-month inflation, and c) and weaker seasonal remittance inflows.

The still lingering supply-shocks from Typhoon Haiyan further exacerbate Q3 seasonal blues.

What's most worrying is that even with a favourable base effect in Q4 2014 the BSP's narrower 2015 inflation target of 2-4% will likely be breached.

Slowing remittances is also untimely, likely resulting in the USD-PHP trading higher in the coming months.

The weakness of the peso will raise the sensitivity of the exchange rate to headline inflation, as negative supply shocks add to import demand (Inflation and the exchange rate, 30 July 2014).

The sharp rise in food inflation will result in the BSP taking more aggressive action at the upcoming 11 September meeting.

Before the last meeting of Q3 2014, August inflation data will be released on 5 September, which we believe will stay elevated. After11 September, the BSP has two remaining meetings in Q4 2014.

We believe the BSP will hike both the policy rate and the SDA rate by 25bp at the September meeting.

Prior to the central bank cutting only the SDA rate by 150bp and limiting access in H1 2013, the SDA and the reverse repurchase rate moved in tandem.

The reason why markets were disappointed that the BSP only raised reverse repurchase at the last meeting is its limited ability to mop up excess liquidity.

Therefore, to seriously temper inflationary pressures and mop up excess liquidity, the BSP will have to hike the SDA rate.

We believe that, at the least, it will raise the rate by 25bp in September, taking the SDA rate to 2.5%.

After the high July headline inflation figure release, Governor Tetangco texted to the press, "The July inflation outturn is within the BSP's forecast range...This confirms our assessment that the economy could see more near-term increases in select food prices, partly due to weather-related supply concerns...

Even as we have already taken a series of policy actions to address liquidity growth and its attendant financial stability risks and to temper inflation expectations, we will not hesitate to use any of our tools to help guide market to keep inflation within the target range over the policy horizon."

The FOMC has a meeting on 18 September and the BSP will likely wait for hints about the timing of the Fed's rate hike before it aggressively raises the SDA beyond the 2.5% rate.

The central bank will also wait for any potential respite coming from September inflation reading, given that the base effect should be favourable and increasing rice imports should ease some food supply constraints (rice is 9% of the CPI basket).

Therefore, we only forecast an SDA rate hike at the September meeting, as the central bank will likely try to hold out on more aggressive easing until it absolutely must, due to its aversion to incurring higher interest expenses.