Rodrigo Vergara: Chile's latest Monetary Policy Report
Presentation by Mr Rodrigo Vergara, Governor of the Central Bank of Chile, of the Monetary
Policy Report before the Honorable Senate of the Republic, Santiago de Chile, 5 September
2012.
The Monetary Policy Report of September 2012 can be found at http://www.bcentral.cl.
* * *
Introduction
Mr. President of the Senate, Senator Camilo Escalona, honorable senators.
I am grateful for your invitation to the Board of the Central Bank of Chile to present our latest
Monetary Policy Report. As usual every year in September, this presentation coincides with
the annual report of the Central Bank Board to the Senate, which contains our view on recent
macroeconomic and financial developments in Chile and in the world, as well as their outlook
and implications for the conduct of monetary policy.
In the last few months, the differences between the performance of the global economy and
the Chilean economy have deepened. The situation abroad is still very complex. Forecasts
for world growth have weakened, mainly because of sharper than expected deceleration in
emerging market economies (EMEs). Tensions in international markets have eased in recent
weeks, but fundamental problems are still present. The Chilean economy, however, in
contrast with most of the rest of the world, is performing strongly. In the second quarter,
domestic output and demand grew above projections, showing that, so far, the effects of the
frail external scenario on the local economy have been mild.
The growth forecast for 2012 we are presenting in this Report, details of which I will be
sharing with you in a few moments, runs higher than what we presented before the Finance
Commission of this Senate last June. A number of factors have contributed to this growth,
including increased personal income resulting from labor market strength, an expansion of
credit to firms and households, as well as the impulse from investment in mining and
complementary projects associated to the high copper price. Consumer and business
confidence has risen or remained in optimistic levels. Another contributor was the drop in
inflation in recent months, reflecting the prices of perishable foodstuffs and fuels. The latter,
however, has tended to revert in the past few weeks.
However, the macroeconomic scenario entails significant risks and, to some extent, opposing
ones, that drive monetary policy to face a difficult dilemma. On one hand, the effects of the
frail international conditions on world growth and external financial conditions should help to
reduce the strength of the Chilean economy. In addition, there is the possibility of a further
deterioration of the external scenario, with more acute consequences on our economy. On
the other hand, the recent intensification in installed capacity utilization, as well as the
widening of the current account deficit, reflect the persistence of a degree of dynamism of
domestic demand that also entails medium term risks for inflation and the vulnerability of the
country's external accounts.
For good reasons, the Chilean economy is open commercially and financially to the world,
and, because of the nature of its exports, is strongly affected by shocks coming from abroad.
In the past we have benefited from the external situation. We have also felt the
consequences when the external situation has deteriorated. We cannot isolate ourselves
from these external impulses, and it would not be a good idea to do so. The important thing,
however, is that we have developed a policy framework that allows us to absorb and mitigate
these shocks in the best way possible. Chile needs to keep a robust macroeconomic and
financial policy scheme that helps it overcome effectively these external disturbances at the
lowest possible cost for the country.
Part of this scheme is the autonomous central bank with clear-cut objectives: low, stable
inflation, and the normal operation of internal and external payments. Our monetary policy is
oriented at attaining an explicit inflation target over a medium-term horizon, by applying an
independent monetary policy that contributes to stabilize the business cycle. Its complement
is a floating exchange rate regime. Another important element is responsible and predictable
fiscal policy making, as reflected in its governing rule. Add a sound financial system, with
proper regulation and supervision. Plus ever growing commercial and financial integration.
The fact that the deterioration of the developed economies has not hit our exports so hard is
the result of this diversification of external markets, among other factors.
Let me delve into some aspects of these pillars. In terms of regulation and supervision of the
financial system, the causes and effects of the crisis of 2008-2009 have taught great lessons
to policy makers around the world. Suffice is to mention the changes that are being effected
in the United States and the Eurozone, such as the Dodd-Frank Act and the instauration of a
European banking authority. In Chile, our financial system was not involved in the practices
that originated the crisis in the developed world, because our legislation does not allow it.
Even so, we are permanently reviewing our legislation in light of the experiences and best
practices in place today in the world.
Another significant aspect has to do with our foreign exchange policy. In recent weeks the
peso has appreciated against the dollar, prompting some sectors to demand intervention by
the Central Bank. I think that some clarification is in order. In the first place, I reaffirm the
validity of a flexible exchange rate for the Chilean economy. Our economic history is full of
examples in this area. So far, the scheme that has yielded the best results for economies
similar to the Chilean is a floating exchange rate regime. When policy makers sought to
artificially control the value of our currency, imbalances were generated that ended up being
very costly for the country. The adoption of exchange rate flexibility in 1999 has allowed us to
wade subsequent complex moments. The worst was the world recession of 2009, when the
floating exchange rate policy allowed accommodating the sharp changes in the external
scenario, both via the depreciation of the peso and an active monetary policy to stabilize
demand. In turn, the creation of instruments designed to shield the economy from short-run
fluctuations in this variable, permits to bound its effects on hedged agents. Certainly more
can be achieved in this sense, but there have been important advances.
Still, the Central Bank has always reserved the right to intervene the forex market. We have
done it four times since 1999. However, this type of measures, which are used only
exceptionally, must be based on solid grounds. In the past, these interventions have been
justified by the Central Bank's international liquidity position and by obvious and persistent
deviations of the real exchange rate from its medium- to long-term fundamentals.
In the present circumstances, it is not evident that these criteria apply. In the first place, it is
important to note that the current level of the real exchange rate, while low compared to
some months ago and also with respect to the average of the last fifteen to twenty years, is
within the range believed to reflect its underlying fundamentals. It is certainly in the lower part
of the range, but still consistent with its long-term fundamentals (figure i).
As I said, the elements behind the peso appreciation are manifold. On one hand there is the
favorable level of our terms of trade. Despite the downturn of the developed world and the
deceleration in China, commodity prices have remained high, especially for copper. This has
driven today's terms of trade, despite a drop this year, to be fairly high by historic standards.
In fact, other commodity exporting economies, such as Australia, New Zealand or Canada,
have seen appreciations in their currencies that are comparable with that of the Chilean peso
(figure ii).
On the other hand, there is our strong economy, partly related to the effects of the higher
copper price on the public sector's structural income and expenditure, as well as with the
greater impulse coming from mining projects and related investments. While the developed
world is weak and the main emerging economies are decelerating beyond projections, Chile
is growing more than expected. The differentials between developed countries' and Chilean
interest rates reflect this dissimilar stage in the cycle.
It must be noted that the appreciation of the local currency with respect to the dollar is not an
exclusive feature of the Chilean economy. This phenomenon is shared by all the exporters
that are our competitors in the world markets. This, because it originates primarily in the
weak dollar, which in turn originates in the strong monetary expansion carried out by the
United States. However, as I said before, this is the result not only of the expansionary
monetary policy, but also of weak domestic demand and external imbalances in the U.S. The
case of Europe is comparable, and that is why the euro has also depreciated against other
currencies, not only the peso. In order for growth of developed countries to improve and the
overall world economy to pick up, the domestic demand of countries in a strong cyclical
position needs to be redirected to imports, while at the same time those countries with weak
domestic demand increase their exports.
The second factor advocated to intervene the forex market is the need to hoard international
reserves. This, for protection against a further worsening of the external scenario. Over the
past several years, the Central Bank has increased its level of reserves significantly. The
interventions of 2008 and 2011 increased the reserves by nearly 18 billion dollars, to twice
the level of December 2007. Thus, at July this year, our reserves amounted to close to 15%
of GDP.
Certainly, there are benefits associated with hoarding international reserves. An economy
with a higher level of international reserves reduces the probability of sudden changes in its
external credit conditions, moderates its effects and provides room for policy makers to take
offsetting measures. By the same token, it is important that the level and management of
international reserves are such that they can be readily available whenever it is deemed
necessary. Still, the gains obtained in the margin are lower the greater the amount
accumulated. The reserves accumulation carried out by the Bank in the past few years, as
well as management thereof - details are provided in an Appendix - should suffice to
confront extreme episodes. Chile also has sovereign wealth funds that could help alleviate
the financing needs in case of increased external tensions as well. The foreign funds of
institutional investors can also act as stabilizing agents in this sense.
On the other hand, we must always bear in mind that any intervention has associated costs.
First, it can blur the objective of the Central Bank: inflation or exchange rate target. In our
case, we have dealt with this problem by carrying out transparent, sterilized interventions,
with a publicly known timetable that does not conflict with the formulation of monetary policy.
In addition, our communication has been straightforward in stating that the objective of our
monetary policy is price stability.
Second, an intervention entails a significant financial cost for the Central Bank and the
country. International reserves are invested in highly liquid assets abroad, whose yield is
lower than the interest paid on the debt securities in pesos that are used to sterilize the
purchase. In the current scenario, in which external-domestic interest rate differentials are
significant and expected to remain so for some time, the financial cost of holding reserves is
substantial and negatively affects the Bank's balance sheet continually. In an Appendix to
this Report, we forecast that the negative net worth of the Bank will go from 2% to 3.8% of
GDP between 2011 and 2013. Such deterioration is explained by the composition of our
assets and liabilities. In the current circumstances, expanding our reserves would further
worsen our financial position. Although the Bank's negative net worth has not been an
impediment for monetary policy conduct, taking actions that increase such negative value is
a cost to be paid by all Chilean citizens.
Having said all this about the convenience or not of a forex intervention, undoubtedly the
best way for our exporting sector to boost competitiveness in the world markets is through
constant improvement of processes, both by investing in technology and developing their
human capital. Likewise, it is important to be constantly on the lookout for new markets of
destination and product innovation, to ensure better conditions for their businesses. In any
case, there are also internal issues that must be resolved to back our producers'
competitiveness, including any measures that disentangle administrative processes when
creating and maintaining a firm and especially, establishing a policy that aims at developing a
balanced energy matrix that can reduce energy costs. As we have said before, the cost of
electric power in Chile, which is an important input of productive activity, is higher than the
OECD member countries' average.
Let me now describe the macroeconomic scenario contained in our Monetary Policy Report.
Macroeconomic scenario
As I said earlier, in the past several months the differences between the performance of the
global and the domestic economy have deepened. The external scenario remains complex,
and the growth outlook has weakened somewhat with respect to June's forecasts. In
contrast, Chile grew more than foreseen in the second quarter, intensifying the utilization of
installed capacity. Headline inflation has been lower than expected and is currently at the
lower part of the tolerance range, as are core measures. Within core inflation, the difference
between the behavior of goods inflation and services inflation stands out. The latter, more
closely related to the state of the output gaps, is still near 5% annually, reflecting that
medium-term inflation risks are still present. In this context, the Board has held the monetary
policy interest rate (MPR) constant at 5%.
Internationally, the biggest news has concentrated in the performance of the emerging world,
shaping a scenario where deceleration exceeds forecasts. The reduced strength of Brazil,
China and India stands out. Several elements are behind this slowdown, including the effects
on their exports of the global deceleration, especially from Europe, and the stringent policies
applied in the past. This has driven the notorious drop in these countries' manufacturing
growth rates.
In Latin America the outlook is still quite heterogeneous. As I just said, the sharp deceleration
of Brazil is worth noting. Given its size, it explains a large part of the downward revision of
growth figures for the region this year and next. However, going forward a recovery is
foreseen, considering that the expansionary measures adopted by its policy makers have
begun to bear fruit. Colombia and Argentina have also shown signs of deceleration, But
Colombia growing more than Argentina. Peru, meanwhile, is still growing strongly. In Mexico,
growth during the first half of the year exceeded expectations, but in the near future the
effects of the frail external sector will be seen more clearly.
The developed economies continue to show weak growth. The developed economies
continue to post weak growth. In the United States, the overall evaluation is still of a slow
recovery. The United Kingdom is in recession, affected by anemic external and internal
demand, the latter influenced by tight credit conditions and policies aimed at fiscal
consolidation. In the Eurozone, the GDP shrank in the second quarter, after being flat in the
early part of the year. The performance of the zone continued to be marked by big
differences between peripheral economies (with sharp falls) and central European
economies (with modest increases), reflecting financial and fiscal vulnerabilities. However,
the weakness of some incoming indicators from Germany is cause for concern, particularly
domestic consumption compounded by the weak performance of its exports and
manufactures.
Some calm has come to the external financial markets, originating, among other causes, in
the announcements that steps will be taken towards a banking union and the statements by
the governor of the European Central Bank regarding the possibility of shortly implementing
a sovereign bond purchase plan, upon previous political agreement on a fiscal austerity
program. Besides, no significant sovereign debt payments from peripheral economies have
fallen due in the past several weeks. However, the region faces a tough path, because of
considerable difficulties to carry out these actions. For example, how a banking union for the
Eurozone could be materialized is unclear and, for the time being, there is no unanimous
support from member countries. In addition, there is the negative outlook placed for
Germany's and other central Eurozone economies' ratings. Plus, in the coming months,
several events will occur that may revive market tensions. For September there is, among
other developments, the evaluation of the tripartite group on the degree of compliance with
agreed adjustments in Greece and the possibility of a new program, aside from the voting at
the German constitutional tribunal on the legality of the ESM. For October, there is a strict
calendar of debt maturities in Spain, which entails refinancing obligations in international
markets.
The impulse from abroad on the Chilean economy will be somewhat milder than was
foreseen a few months back. On one hand, in the baseline scenario our trading partners will
grow 3.5% in 2012 and 3.8% in 2013, one tenth of a point less than forecast in June. This, as
aforesaid, because of the downward revisions to emerging economies' growth. On the other
hand, the terms of trade will be less favorable than projected then. The price of oil and fuels
will be higher than assumed in June, because of supply-side problems and increasing
geopolitical risks in the Middle East. On top of this is - also because of supply-side problems
- the increase in food prices in the world markets, especially for grains. The copper price
projection does not change from June. Finally, despite the observed calm, the baseline
scenario considers new episodes of stress in global financial markets, similar of those of the
past year. This, because of the events foreseen for the coming months and the difficulties of
advancing towards a more long-lasting solution to the problems in the Eurozone (table 1).
In Chile, the greatest news is stronger-than-expected growth in output and demand in the
second quarter of the year. Output owes its dynamism to sectors linked to domestic demand,
such as construction, trade and services. The better result of the manufacturing industry is
also worth noting, which, although growing less than aggregate GDP, still exceeded
expectations, also driven by the lines associated with demand, especially investment and
specific export-oriented activities. On the expenditures side, inventory accumulation
intensified with respect to previous months. (figure iii). This seems to respond to an attempt
to rebuild inventory levels after the reduction of late 2011 and that, at the time, was linked to
the expected negative effects of the external scenario on final sales. Also worth noting was
the renewed strength of consumption and gross fixed capital formation. Consumption
continues to rely on the evolution of the labor market and fairly stable financial conditions.
Regarding investment, the contribution of construction and infrastructure works stands out,
relating mainly to mining and energy projects, but also to a strengthened real-estate sector,
which reflects on the performance of commercial loans.
The behavior of output, especially of sectors other than natural resources, and domestic
demand intensified the utilization of installed capacity. Although y-o-y growth in employment
and nominal wages has dropped, the labor market remains tight (figure iv). However, the
increased domestic demand pressure, especially from investment, together with lower
copper prices compared with 2011, have led to a widening of the current account deficit. In
the moving year ending the second quarter of 2012 this deficit rose to 2.7% of GDP, from
1.3% at the close of 2011.
In the past few months, y-o-y inflation has continued on a downward path, influenced by fuel
prices. Core inflation, which excludes foodstuffs and energy (CPIEFE) has stabilized near
2.5%. The difference between core inflation for goods and core inflation for services has
prevailed. The latter, more closely related to the state of output gaps, has hovered around
5%, a reflection of existing medium-term risks on inflation. On the other hand, the
downsloping path of headline inflation is largely explained by the goods component (figure v).
The baseline scenario assumes that this year the Chilean economy will grow between 4.75%
and 5.25%. The correction is explained mainly by actual data for the first half of the year and
because the effects of the external situation on the Chilean economy will be milder than was
forecast in June. However, the baseline scenario assumes that, during the second half of
2012 the GDP will post lower growth rates than in the first half, gradually leading to a normal
usage of installed capacity. The Board continues to estimate trend GDP growth at around
5%. For 2013, the Board foresees GDP growing between 4% and 5%. In the baseline
scenario, the current account deficit for this year is estimated at 3.2% of GDP. In 2013 it
should widen to 4.4% as a reflection of strong domestic demand and, to a lesser extent, of a
lower copper price. The fact that the widening of the current account deficit responds mainly
to stronger expected domestic demand is confirmed in expectations that the current account
measured at trend prices will also post a larger deficit in 2013 than in 2012, going from 4.6%
of GDP to 5.2%. I will return to this subject in a while (table 2).
As for inflation, the baseline scenario foresees that CPI inflation will end the year below
June's projections, reaching 2.5%. It will then return gradually to 3% by the second half of
2013, to stay in the neighborhood until the end of the projection horizon, this time the third
quarter of 2014. The CPIEFE will converge to 3% later than foreseen in June (figure vi). This
trajectory assumes that wages will be adjusted according to productivity and the inflation
target. A methodological assumption is that the RER will remain around its recent figures
during the forecast horizon. Finally, the baseline scenario uses as a working assumption that
the MPR will remain stable over the short term.
The baseline scenario reflects the developments that the Board believes to be the most likely
to occur with the information at hand at the statistical closing of the Report. However, there
are risk scenarios that, if materialized, might change - significantly, in some cases - the
macroeconomic outlook and, therefore, the course of monetary policy. On this occasion, after
evaluating the alternative scenarios, the Board estimates that the risk balance for output and
inflation is unbiased.
Abroad, the risks described during the past several quarters have not changed significantly.
The situation of the Eurozone is complex. The materialization of the announcements will not
be easy and the passing of time will bring more problems to the economies of peripheral
Europe, so a severe aggravation of the financial crisis in the Eurozone or even more extreme
scenarios with systemic implications cannot be ruled out. Add to this the discussion in the
United States to prevent fiscal adjustments from being triggered in 2013. If attempts to reach
agreements are unsuccessful, this economy's GDP growth could fall significantly and
tensions could increase in financial markets.
In the emerging world, the biggest risk is a deepening of signs of economic slowdown. On
aggregate, the world growth forecast does not divert from the average of the past 15 to
20 years, but this has been sustained by the expansion of the larger emerging economies.
Particularly preoccupying is the performance of China, due to its weight in the world
economy and its relevance in the evolution of the prices of copper. Should it post a sharper
deceleration, global growth would weaken further, with intensified effects on commodity
exporting economies like Chile, which are still growing at high rates. Another possibility is for
supply-side factors to intensify recent increases in the prices of some commodities,
especially fuels and grains.
Locally, medium-term inflationary risks are still present. The recent trajectory of the world
prices of fuels and some foodstuffs could rapidly pass through to inflation, all the more so
considering the current state of output gaps. In addition, if domestic output and demand
remain as dynamic even or more so, they can further intensify the usage of installed capacity
pressuring inflation away from the target. At the same time, this could also could result in a
widening of the current account deficit that could create vulnerability factors in the economy
in a complex global environment. Actually, if this phenomenon occurs within a context of
sudden drops in the copper price or costlier external financing, difficult adjustments could be
necessary.
The current macroeconomic scenario poses significant risks, demanding policy
responses in different directions. On one hand, although so far its effects have been mild,
the external situation is severe. Chile is a small economy, commercially and financially open,
so it will not be immune to global developments. The probability of extreme events has not
diminished, and their materialization could have very severe consequences on output around
the world, including Chile. On the other hand, the strength of domestic demand and output,
together with recent increases in some commodity prices, means that medium-term
inflationary risks remain present. The MPR is within a range of values that are considered
neutral, providing flexibility to wait for the concrete effects of such scenarios on the Chilean
economy to become visible. The Board monitors closely the evolution of the external and
internal macroeconomic scenario and its implications on inflation, and reiterates its
commitment to conduct monetary policy so that projected inflation stands at 3% over the
policy horizon.
Allow me some final remarks.
Final remarks
Our latest presentations to the Senate have been marked by periods of high volatility or
relative calm in international financial markets. But at yearend 2011 and last June we brought
our Monetary Policy Report to you in the midst of heavy external turbulence, with market
expectations that did not rule out the occurrence of worst-case scenarios in the near future.
Today, as in last March, we are presenting our Report in a calmer environment, but where
the risks are still there.
Our baseline scenario assumes that stress episodes will be repeated in the world markets.
Why is that? Simply because the situation in developed economies with their complex
macroeconomic, financial and fiscal problems is far from being resolved. There is a long road
ahead. The classical economic policy conundrum is time consistency, as the costs are paid
upfront for promised benefits for the future. Plus, in the case of the Eurozone, a difficult
collective action problem, due to difficulties in spreading the cost among those involved.
Thus, policy decisions are pushed back while the problems needing resolution only
aggravate over time.
We may add that the bigger emerging economies, including China, Brazil and India, are
showing signs of a sharper than expected deceleration. Their weight in world trade, and
particularly with Chile, makes us worry about their evolution. Although the copper price has
been fairly stable, a further deceleration of the Chinese economy could have significant
effects on the rest of the world and drive us to a complex situation, especially if it triggers a
reduction in our terms of trade.
Let us stop for a moment to examine the current account of the balance of payments. In our
Report's baseline scenario we forecast that in 2012 and 2013 the current account will post a
deficit of around 3 to 4% of GDP. These balances contrast with what has been the behavior
of the current account in recent years. It is striking because it happens at a time that, despite
the complex external scenario, the terms of trade facing our country are favorable.
The persistence and expansion of high current account deficits may generate factors of
vulnerability for the Chilean economy when facing an external shock. Although an economy's
current account deficit is not a sufficient condition to anticipate a crisis of some sort, it does
help increase its probability of occurrence. For example, due to the importance that this
variable may have in sovereign risk, external credit conditions and, ultimately, on access to
the sources that sustain such deficit.
In the past, a significant part of the crises that the country endured have had to do with
persistently, high current account deficits. Accordingly, the Board cannot overestimate the
importance of closely monitoring the factors underlying our current deficit, in order to prevent
the incubation of imbalances affecting the future performance of our economy.
However, a big difference with the past is that today our economy has made progress in
devising mechanisms to deal with external shocks and imbalances. Thus, as I said before,
we need to maintain and permanently improve the macroeconomic pillars that have made
our economy stable and resilient. On our part, with constant observation of the factors that
may jeopardize our financial stability and the normal functioning of our payment system, in
order to adapt our regulations for better regulation and supervision. Also, with our
commitment to maintain our flexible exchange rate policy, which we believe is the best way
to deal opportunely with any sudden changes in external conditions and rely on monetary
policy to alleviate its effects on the Chilean economy.
Finally, through a credible monetary policy aimed at controlling inflation. Inflation is a source
of social stress, that hits with special force the most needy: those unable to negotiate wage
adjustments to sharp changes in the price level.
As we have insisted time and again in recent months, monetary policy has to juggle with two
opposing forces. Pulling in one direction, there is a weak external scenario that will not add
momentum to our economy. In the other, there is strong domestic output and demand, with
tight output gaps and labor market. It is the task of the Central Bank to conduct monetary
policy avoiding the incubation of pressures pushing inflation away from the target.
Facing this environment of high risks and volatility, the Board has kept a prudent attitude.
Acting hastily would only reduce its capacity for action. As unreasonable as supposing that
we will be spared the problems of the world, is thinking that we are being severely affected
by them. Time will shed more light on the true effects of developments abroad on Chile's
external position and the evolution of domestic balances. For now, it is important that we take
the opportunities we have to preserve and enhance the soundness of our economy, but
bearing in mind that there are risks and that they are significant.
Thank you.
Figure 1
Real exchange rate (*)
(index, 1986=100)
120 120
110 110
100 100
90 90
80 80
70 70
88 90 92 94 96 98 00 02 04 06 08 10 12
RER 1997-2011 average 1992-2011 average
(*) August figure includes information up to 30 August 2012.
Source: Central Bank of Chile.
Figure 2
Nominal exchange rate
(index, December 2010=100)
110 110
105 105
100 100
95 95
90 90
85 85
Dec. 10 Jun.11 Dec.11 Jun.12
Chile Australia N. Zealand Canada
Figure 3
Contribution to annual GDP growth
(real annual change, percentage points)
20 20
15 15
10 10
5 5
0 0
-5 -5
-10 -10
-15 -15
08 III 09 III 10 III 11 III 12
Net exports (*) Private consumption
Government consumption Inventory change
GFCF GDP
(*) Exports minus imports of goods and services.
Source: Central Bank of Chile.
Figure 4
Labor market
(annual change, percent)
15 10
13 8
1