Caution as inflation expectations emerge

Expectations over inflation are still evolving ahead of the inflation report for March, the first month of the war. With data, the expectations would have something to anchor themselves on.

We see market expectations forming over the implications of the rapid onset of high inflation. Inflation surged from 2.4 percent in February to 4.1 percent in March, with the energy and rice components of the consumer price index (CPI) leading the charge. As I have written over the past month, inflation is the biggest concern that is being generated by the Iran-US/Israel war and preparation is key.

However, there is a difference in how investors and policymakers prepare for inflation. Inflation has real economic effects, like a reduction in purchasing power and consumption. This is why national governments and central banks such as the Bangko Sentral ng Pilipinas (BSP) use fiscal and monetary policy to manage inflation, as well as the exchange rate and economic growth.

On the other hand, investors prepare for inflation by anticipating policy changes that can have an impact on returns on investment. This is the effect of inflation on the asset side of the economy. A BSP interest rate hike or a government placement of treasury securities can alter the yield curve, i.e., interest rates across different maturities of government debt, or make it more expensive for companies to issue debt to finance operations or capital expenditures.

Because of the spike in inflation, market expectations of a BSP rate hike have risen. The BSP has been cutting rates since July 2024 after hiking them to manage both the high inflation and a rapid depreciation of the peso two years prior when the Ukraine-Russia war began. With this new war, it is reasonable to expect that the BSP, and other central banks, will hike rates anew — just like before.

However, market expectations are facing multiple outcomes, as economists like to call multiple equilibria or paths. In other words, anything can still happen.

Game theory predicts a longer conflict given the best strategy of Iran (to keep the Strait of Hormuz closed to use as leverage) runs counter to the best strategy of the US (compress the timeline of the conflict to preserve advantage). Game theory does predict the best option is a negotiated settlement rather than an outright regime change.

The ceasefire that was announced and the potential second round of negotiations have provided evidence that the conflict could end sooner than predicted. Again, anything can happen.

This is why policymakers are monitoring the situation very closely. After all, policy decisions such as removing the excise tax or reducing the VAT and, of course, hiking interest rates can be costly to the economy.

The removal of taxes means loss of tax revenues, which means you will have to earn it back in the future. With the recent large rollbacks, a quick normalization could neutralize the energy crisis measures, which may be hard to walk back after the storm has passed.

Hiking rates at this stage, when many companies are still clawing their way back from the pandemic, can add unwanted pressure to the financial system. The BSP has already relaxed the rules for banks on recognizing stressed loans due to the energy crisis.

Unlike in the 2022 energy crisis, companies were still benefiting from historically low interest rates. Today, balance sheets and profits are not in the same state or shape as they were back pre-Covid.

Having said that, persistently high inflation can entrench itself and transmit to long-term inflation.

Market expectations of entrenched inflation can also be self-fulfilling. The BSP would like to avoid transitory inflation from becoming long-term inflation, which in such an event may make hikes necessary.

Similarly, tax cuts may be necessary to improve purchasing power and support growth. But such decisions must be weighed carefully against the evidence and probabilities of this ongoing conflict and its real economic effects.

Given the existing uncertainty, there is much room for overreaction and overcorrection of investment actions. The best that investors can do at this stage is to diversify, monitor, adjust expectations regularly, and focus on sizing your bets.