MANILA - The Philippine central bank announced Thursday it hiked the key policy rate by 75 basis points, the biggest increase in 20 years, since it shifted to an inflation-targeting approach in 2002.

The off-cycle monetary policy adjustment, implemented ahead of the Bangko Sentral ng Pilipinas' monetary policy-setting meeting on Aug. 18, raised the benchmark overnight borrowing rate to 3.25 percent from 2.5 percent to tame rising inflation.

Interest rate, used by banks to price loans, was last seen at the 3.25 percent level in March 2020.

The BSP has earlier raised interest rates by a back-to-back bps hike in May and June. The interest rate was kept at 2 percent for the entire 2021 to support the recovery of the pandemic-hit economy.

WHY RAISE THE INTEREST RATE?

The central bank can either cut, increase or maintain the key policy rate, primarily to address the rising inflation numbers.

Inflation rate in June 2022 reached 6.1 percent, the highest since November 2018. From January to June, average inflation is currently at 4.4 percent.

The current data is above the government inflation target of 2 to 4 percent range.

Since the start of the year, headline inflation was steadily moving up from 3 percent in January and February, 4 percent in March, 4.9 percent in April and 5.4 percent in May.

This year, the government said inflation could average between 4.5 percent to 5.5 percent.

Inflation rate is still expected to go up in the succeeding months. Some economist have said it could even hit up to 7.2 percent in the second half of the year.

The big time interest rate hike could also support the weakening peso, an analyst have said.

The Philippine peso has recently weakened to an 18-year low. It breached past P56 to $1 in July from P50 in the beginning of 2022.

Peso is expected to settle at P51 to 53 for this year, based on earlier government estimates.

How does an increase in interest rate actually work?

When the interest rate is higher, bank loans become more expensive. Higher interests in loans could discourage people to apply for loans, including housing, car loans or even credit card use.

Because people are not borrowing as much, there is less money in circulation. Lower demand leads to lower inflation.

High interest rate may also affect businesses as they might considering suspending expansion plans or lay off workers to reduce cost.

To some extent, this could also help stabilize the peso.

A higher interest rate makes peso denominated assets more attractive because of the higher rate of return. This could lead to strengthening of the peso because of a higher demand for it.

A stronger peso also affects prices of imported products, especially oil, which has a direct impact on inflation.

The central bank's move signalled that uncertainties called for the tightening of monetary policy.

Finance Chief Benjamin Diokno on Thursday assured the public that the country's "robust" economy could absorb the recent jumbo rate hike by the BSP.

But the BSP noted that the rising world crude oil price and global supply chain woes are likely to continue affecting the prices of goods thus the need for the government to implement non-monetary interventions to mitigate the persistent supply-side pressures on commodity prices.

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