José De Gregorio: Monetary policy and commodity prices in turbulent
times
Keynote address by Mr José De Gregorio, Governor of the Central Bank of Chile, at the 2008
Annual Meeting of Latin American Chief Executives of the Institute of International Finance
(IIF), hosted by Corpbanca, Santiago, 2 April 2008.
I am very grateful to Igal Magendzo for his great contribution during the preparation of these notes.
* * *
The global economy is in turmoil. In this scenario, monetary policies around the world face
strong challenges. Sailing through quiet waters has been pleasant. As we know, the stable
and prosperous performance of the world economy in recent years has partly been the result
of sound monetary policies. Now, during difficult times, monetary policy should contribute to
make the adjustment less costly and lay the foundations for a sound, persistent recovery.
Macroeconomic management in emerging market economies have improved significantly in
the past several years, owing part of this to the large increase in commodity prices, but also
to fiscal consolidation and the commitment to price stability. This has increased the resilience
of emerging economies to global economic turbulences.
In this presentation I will address three issues. First, the troublesome inflationary effects of
the high commodity prices cycle we have experienced. Then, I will argue that, in this
juncture, reinforcing the commitment to control inflation and reverse deviations from the
target is a first order task. Finally, drawing upon lessons from the recent experience I will talk
about risk management in monetary policy, and what it implies in such an uncertain
economic environment as we face today.
Commodity prices and domestic adjustment
Recent increases in the prices of commodities have been dramatic: many reached record
highs in a very short period of time. This increase has been particularly broad across
commodities and unexpectedly persistent.
Commodity price indices
(index 1967=100)
500 500 1000 1000
400 400 800 800
300 300 600 600
200 200 400 400
100 100 200 200
0 0 0 0
00 00 01 01 02 02 03 03 04 04 05 05 06 06 07 07 08 08
Total Total Total Metals Metals
Food Food Food
Copper price
(US cents/Lb.)
2006 2006 2007 2007 2008 2008 (f) (f) 2009 2009 (f) (f)
Jan. Jan. MPR MPR Mar. Mar. Jan. Jan. MPR MPR Mar. Mar.
Central Central Bank Bank of of Chile Chile 305 305 323 323 295 295 -250 -250 -- --
Deutsche Deutsche Bank Bank (7 (7 mar) mar) 332 332 325 325 274 274 306 306
Scotiabank Scotiabank (20 (20 mar) mar) 295 295 325 325 -250 -250
JPMorgan JPMorgan Chase Chase (14 (14 mar) mar) 315 315 310 310 228 228 246 246
Barclays Barclays (13 (13 mar) mar) 354 354 343 343 295 295 326 326
Merril Merril Lynch(19 Lynch(19 mar) mar) 308 308 320 320 291 291 291 291
Cochilco Cochilco (9 (9 jan) jan) 310 310 310 310 270 270 270 270
IB's IB's Mean Mean 321 321 325 325 272 272 284 284
Futures Futures (1) (1) 316 316 368 368 314 314 357 357
Actual Actual Mean Mean (2) (2) 313 313 350 350
(1) Futures consider average of the last 10 working days prior to 20 March 2008.
(2) Up to 25 March 2008.
Sources: Central Bank of Chile based on a sample of investment banks (IB), Consensus Forecast and
International Monetary Fund.
WTI oil price
(US$/barrel)
2007 2007 2007 2008 2008 2008 (f) (f) (f) 2009 2009 2009 (f) (f) (f)
Jan. Jan. Jan. MPR MPR MPR Mar.08 Mar.08 Mar.08 Jan. Jan. Jan. MPR MPR MPR Mar.08 Mar.08 Mar.08
Central Central Central Bank Bank Bank of of of Chile Chile Chile 93 93 93 88 88 88
DoE DoE DoE (11 (11 (11 mar) mar) mar) 87 87 87 94 94 94 82 82 82 86 86 86
Deutsche Deutsche Deutsche Bank Bank Bank (07 (07 (07 mar) mar) mar) 80 80 80 85 85 85 75 75 75 80 80 80
JP JP JP Morgan Morgan Morgan Chase Chase Chase (14 (14 (14 mar) mar) mar) 70 70 70 82 82 82 65 65 65 75 75 75
Scotiabank Scotiabank Scotiabank (14 (14 (14 mar) mar) mar) 90 90 90 95 95 95 -95 -95 -95
Lehman Lehman Lehman Brothers Brothers Brothers (29 (29 (29 feb) feb) feb) 86 86 86 78 78 78
Barclays Barclays Barclays (19 (19 (19 mar) mar) mar) 87 87 87 101 101 101 --- --- ---
Goldman Goldman Goldman Sachs Sachs Sachs (04 (04 (04 mar) mar) mar) 97 97 97 97 97 97
-Merril -Merril -Merril Lynch Lynch Lynch (19 (19 (19 mar) mar) mar) 76 76 76 102 102 102 --- --- ---
IB's IB's IB's Mean Mean Mean (1) (1) (1) 83 83 83 90 90 90 74 74 74 83 83 83
Actual Actual Actual Mean Mean Mean (2) (2) (2) 72 72 72 97 97 97 97 97 97 --- --- ---
(1) Excludes Goldman Sachs and Merrill Lynch.
(2) Up to 24 March 2008.
Sources: Central Bank of Chile based on a sample of investment banks (IB), Consensus Forecast and
International Monetary Fund.
We are in the presence of a significant relative price shock. The relative price of foodstuff
and energy has changed in a number of countries. Given the persistency of these
international relative prices changes, domestic prices are adjusting accordingly, giving the
appropriate signals for resource reallocation. Chile is an interesting case in this respect.
Relative food prices for several countries
(ratio)
1,2 1,2 1,2 1,2
1,1 1,1 1,1 1,1
1,0 1,0 1,0 1,0
0,9 0,9 0,9 0,9
0,8 0,8 0,8 0,8
0,7 0,7 0,7 0,7
00 00 01 01 02 02 03 03 04 04 05 05 06 06 07 07 08 08
USA USA Euro Euro Zone Zone Brazil Brazil
Mexico Mexico China China New New Zealand Zealand
Chile Chile
Sources: Each country's central bank and statistics bureau, Bloomberg and International Monetary
Fund.
Relative energy prices for several countries
(ratio)
1,6 1,6 1,6 1,6
1,4 1,4 1,4 1,4
1,2 1,2 1,2 1,2
1,0 1,0 1,0 1,0
0,8 0,8 0,8 0,8
01 01 02 02 03 03 04 04 05 05 06 06 07 07 08 08
USA USA Euro Euro Zone Zone Brazil Brazil
Mexico Mexico China China New New Zealand Zealand
Chile Chile
Sources: Each country's central bank and statistics bureau, Bloomberg and International Monetary
Fund.
The impressive scale of the supply shocks and their transmission to Chilean domestic prices
can be appreciated by comparing the unusual increase of some prices in 2007 with their
average increase since the year 2000. Non-perishable foods rose by nearly 15% last year,
while only around 2% per year in 2000-2006. The prices of fresh fruit and vegetables - even
considering high-price years like 2002 and 2005 - fell by an average of nearly 2% between
2000 and 2006, while in 2007 they increased by more than 30%. During last year, the price
of gasoline unexpectedly increased by almost 15%.
One characteristic of the Chilean economy is that changes in costs are regularly passed on
to consumer prices. Markets for foodstuff are globally integrated and competitive. In the case
of fuels, every week the changes in the international price are passed on to domestic
consumers. However, there is a price stabilization fund to smooth out short run fluctuations
and recently there has been a gasoline tax cut, which ameliorates the large increase in
international prices. Finally, the electric power price-setting mechanism is designed to pass
changes in upstream marginal costs to retail prices. Electric power rates, affected by a rise in
costs, posted an average increase of 23% during 2007 compared with a less than 6%
average increase between 2000 and 2006.
This context of price flexibility provides the right signals to markets. In the case of Chile, with
the increase in the prices of electricity and minerals, several investment projects are in the
pipeline, which will propel an expansion of supply.
Electricity
(US$ MM; index Dec-98=100)
1200 1200 240 240
1000 1000 200 200
800 800 160 160
600 600 120 120
400 400 80 80
200 200 40 40
0 0 0 0
96 96 98 98 00 00 02 02 04 04 06 06 III III 07 07 III III 08 08 (1) (1)
Energy Energy Energy investment investment investment (2) (2) (2) CPI CPI Electricity Electricity
(1) Figures as of February.
(2) Includes investment in buildings, engineering, equipments and others.
Sources: Corporation for Technological Development of Capital Goods (CBC) and National Statistics
Bureau (INE).
BIS Review 39/20086
Copper
(US$ MM; US cents/Lb.)
900 900 450 450
600 600 300 300
300 300 150 150
0 0 0 0
96 96 98 98 00 00 02 02 04 04 06 06 III III 07 07 III III 08 08 (1) (1)
Mining Mining investment investment (2) (2) Copper price
(1) Figures as of February.
(2) Includes investment in buildings, engineering, equipments and others.
Sources: Corporation for Technological Development of Capital Goods (CBC) and Bloomberg.
For countries that are net exporters of commodities, the impressive price hikes results in a
positive terms-of-trade shock. In Chile, terms of trade have increased by almost 70% in the
last three years, mostly due to the sharp increase in copper prices. Not surprisingly, this
shock has resulted in an appreciation of the real exchange rate. However, the
macroeconomic policy framework, as well as particular characteristics of the Chilean mining
sector, has mitigated the effects of terms of trade gains on domestic demand, inflation and
the exchange rate. Half the income from copper (after tax) goes to foreigners and almost
none of it remains in Chilean territory. The other half is from a state-owned enterprise and
taxes from private companies. There is a fiscal rule for government spending that stipulates
that all income above certain long-term price has to be saved. Government surplus has been
7% on average the last three years, and foreign assets reached about 13% of GDP in 2007.
Moreover, all windfalls from the high copper price have been saved in sovereign funds
deposited abroad.
International changes in terms of trade
(cumulated growth between 2003 and 2007, percent)
Venezuela
Russia
Chile
Peru
Norway
Australia
Colombia
Mexico
Argentina
Canada
South Africa
New Zealand
Thailand
Brazil
Poland
United Kingdom
China
Malaysia
Switzerland
Turkey
Israel
Hungary
Sweden
United States
Singapore
South Korea
Japan
Philippines
-40 -20 0 20 40 60 80 100
Source: Institute of International Finance, International Monetary Fund.
The downside of commodity price increases is inflation. The rise in the prices of specific
goods leads to an increase in measured inflation. The effects of these external shocks on
inflation will depend on a number of factors. First, on the weight each commodity has in total
CPI. In general, in poorer countries commodities in general (foodstuff and energy in
particular) have more weight, while in richer countries, services are more important. Also
important is the level of price protection (tariffs, price bands and other mechanisms to isolate
internal prices from international fluctuations), price controls or subsidies. In Chile, the shock
to food prices has been further aggravated by weather problems.
Food price indices (*)
(annual change in US dollars, percent)
CRB Grains
CRB
.Czech Rep
Chile
Brazil
CRB Food
China
Poland
Turkey
Colombia
Philippines
Russia
Israel
Hungary
New Zealand
Euro Zone
Peru
Australia
Thailand
Canada
Singapur
Romania
Taiwan
Malaysia
Japan
Hong Kong
Indonesia
Mexico
South Africa
United
Argentina
USA
Korea
0 10 20 30 40 50 60 7 0
(*) Figures as of January or February, as available.
Sources: Each country's central bank, Bloomberg, Commodity Research Bureau (CRB), each country's
statistics bureau and International Monetary Fund
During 2007, inflation in Chile rose to numbers way above the inflation target of 3% and the
tolerance ceiling of 4%, largely due to the commodity price hikes. Measured in US dollars,
Chile is one of the countries where foodstuff increased the most. Nevertheless, about 30% of
the price rise obeyed to country-specific climatic factors that translated into a dramatic fall in
crop yields. In addition, the oil price increase, from US$70 to US$110 and beyond, affected
not only the prices of gasoline and diesel, but also power rates. Again, an idiosyncratic
problem compounded with the international shock. In Chile, 50% of electricity is generated in
hydroelectric plants. Given the low rainfall of 2007, it was necessary to intensify diesel-based
generation, which significantly raised marginal upstream costs and ultimately consumers'
electric bill (households, industrial producers, etc.).
Incidence in annual CPI inflation (*)
(percentage points)
10 10 10 10
8 8 8 8
6 6 6 6
4 4 4 4
2 2 2 2
0 0 0 0
-2 -2 -2 -2
01 01 02 02 03 03 04 04 05 05 06 06 07 07 08 08
Fuels Fuels Fuels (3,97%) (3,97%) (3,97%) Fresh Fresh Fresh fruits fruits fruits and and and vegetables vegetables vegetables (3,77%) (3,77%) (3,77%)
Food Food Food ex. ex. ex. fresh fresh fresh fruits fruits fruits and and and vegetables vegetables vegetables (23,5%) (23,5%) (23,5%) Other Other Other (68,76%) (68,76%) (68,76%)
(*) Between parenthesis CPI basket weights.
Sources: Central Bank of Chile and National Statistics Bureau.
The upward trend of international prices of foodstuff has not replicated the intensity of 2007
and the weather-related problems of last year were left behind with the change of season.
Nevertheless, Chile faces this year a new climatic shock that is already affecting the prices of
perishable goods and electricity, associated to the "La Niña" phenomenon.
The challenge of monetary policy is to allow the adjustment in relative prices avoiding
undesired second-round effects. For this purpose, we have adopted a flexible inflation target
framework. The inflation objective is to keep inflation most of the time close to 3% with a
tolerance range of plus/minus one percentage point. We implement this framework adapting
monetary policy to having an inflation forecast near 3% in about two years. This time horizon
gives enough flexibility to allow for the full effects of monetary policy to take place and for
transitory inflationary shock to vanish without the need for monetary policy action. It also
incorporates the output costs of disinflation.
On the need to reinforce the commitment with price stability
Both theory and empirical evidence indicate that inflation damages economic growth. As a
result, the best contribution that monetary policy can make to a country's long-term growth is
to keep inflation low and stable. Price stability reduces uncertainty and generates an
environment that promotes investment, productivity growth, and financial development.
Likewise, these factors stimulate growth and favor risk diversification. Moreover, price
stability prevents the arbitrary and often regressive redistribution of resources between
debtors and creditors, and between the owners of labor and capital. It also limits the Central
Bank's collection of a disruptive and regressive tax: inflation. In short, low and stable inflation
improves welfare of the overall population. Although many other policies are also essential to
a solid economic performance, a low-inflation environment is a necessary and essential
condition for maximizing the contribution of other public policies.
To reduce inflation, most central banks raise short-term interest rates affecting the whole
yield curve. This depresses aggregate demand for GDP and appreciates the local currency,
reducing inflationary pressures. Inflation reduction is costly. There are those who ask to
reduce inflation, depreciate the currency and grow more, all at the same time. This cannot be
achieved solely with one instrument. There are short-term tradeoffs. The more persistent
these tradeoffs, the costlier to bring inflation back under control. Expectations play a crucial
role. If agents expect inflation to go down towards a target, they will price their goods
accordingly and inflation persistence will be lower. If, in contrast, agents expect inflation to
persist in high levels, they will price goods higher, making inflation more persistent and more
difficult for the central bank to bring it down. As stated in Bernanke (2007): "a one-off change
in energy prices can translate into persistent inflation only if it leads to higher expected
inflation and a consequent "wage-price spiral". With inflation expectations well anchored, a
one-time increase in energy prices should not lead to a permanent increase in inflation, but
only to a change in relative prices." Credibility of the target in an inflation-targeting regime is
therefore a key asset.
If we were to give up on the inflation commitment, the future adjustment of interest rates to
rein in inflation would have to be much larger, with adverse consequences on economic
activity and relative prices, in particular the exchange rate. Indeed, we have witnessed many
experiences where a persistent rise in inflation has required strong monetary policy actions,
the most notable case being the great inflation of the USA in the 1970s and early 80s. The
control of inflation in Chile has also come with a decline in inflationary persistence.
Therefore, a credible commitment to price stability brings along output stability. Output
stability, in turn, is an important factor to foster economic growth and the consequent social
progress that comes with it (Ramey and Ramey, 1995, and Fatas, 2002). This is also what
has happened with the well known Great Moderation experienced in industrialized countries,
where a credible monetary policy framework committed to stabilize inflation is one of the
explanatory factors (Galí and Gambetti, 2007).
As a consequence of the above, a central issue for inflation targeters is finding reliable
measures of inflation expectations. The most common practice is to rely on surveys to
specialists and on financial prices. Both have problems. Surveys not always are good
measure of market expectations, especially for longer terms which are those that most
interest central banks. For example, in the case of Chile, the expected inflation 24 months
ahead reported by market analysts in the monthly survey conducted by the Central Bank has
very little variation, which is hard to believe given the magnitude of shocks. On the other
hand, inflation compensations derived from financial market prices have premiums that are
hard to measure and most likely time varying. In fact, inflation compensation measures have
recently shown increases. This has been observed also in several other countries. We
believe this to be driven, to a large extent, by changes in different risk premiums in the
context of high uncertainty, liquidity problems and portfolio adjustments. Indeed, the
inflationary compensation from year 5 to year 10 has increased together with the forecast
error of inflation. In light of the flaws presented by the indicators, the best strategy today is to
consider a broad set of indicators. For the future, it becomes an important task to encourage
research to improve our understanding of measures of expectations.
Inflation expectations surveys
(weekly average, percent)
5,0 5,0 5,0 5,0
4,5 4,5 4,5 4,5
4,0 4,0 4,0 4,0
3,5 3,5 3,5 3,5
3,0 3,0 3,0 3,0
2,5 2,5 2,5 2,5
2,0 2,0 2,0 2,0
Jan.06 Jan.06 May.06 May.06 Sep.06 Sep.06 Jan.07 Jan.07 May.07 May.07 Sep.07 Sep.07 Jan.08 Jan.08
Money Money desks desks 1 1 yr. yr. ahead ahead Money Money desks desks 2 2 yrs. yrs. ahead ahead
EES EES 12 12 months months ahead ahead (*) (*) EES EES 24 24 months months ahead ahead
(*) Economic Expectations Survey (EES).
Source: Central Bank of Chile.
Forward inflation compensation from swap rate average
(moving weekly average, percent)
4,5 4,5 4,5 4,5 4,5 4,5
4,0 4,0 4,0 4,0 4,0 4,0
3,5 3,5 3,5 3,5 3,5 3,5
3,0 3,0 3,0 3,0 3,0 3,0
2,5 2,5 2,5 2,5 2,5 2,5
2,0 2,0 2,0 2,0 2,0 2,0
1,5 1,5 1,5 1,5 1,5 1,5
Jan.05 Jan.05 Jan.05 Jul.05 Jul.05 Jul.05 Jan.06 Jan.06 Jan.06 Jul.06 Jul.06 Jul.06 Jan.07 Jan.07 Jan.07 Jul.07 Jul.07 Jul.07 Jan.08 Jan.08 Jan.08
IC IC 1 1 in in 1 1 IC IC 5 5 in in 5 5 IC IC 3 3 in in 2 2
Source: Central Bank of Chile.
Inflation compensations and analyst's forecast error variability
(percentage points)
4,5 4,5 4,5 4,5
4,0 4,0 4,0 4,0
3,5 3,5 3,5 3,5
3,0 3,0 3,0 3,0
2,5 2,5 2,5 2,5
2,0 2,0 2,0 2,0
1,5 1,5 1,5 1,5
1,0 1,0 1,0 1,0
06 06 Jul. Jul. 07 07 Jul. Jul. 08 08
Bloomberg Bloomberg analyst's analyst's forecast forecast error error variability variability
IC IC 1 1 in in 1 1
IC IC 3 3 in in 2 2
IC IC 5 5 in in 5 5
Sources: Central Bank of Chile and Bloomberg.
Macroeconomic risk management
The main risk stemming from the world economy is the deceleration of the US economy. We
still do not know, and there are unusually big uncertainties, about the depth and duration of
the US slowdown. However, this slowdown should not be a surprise, and is an expected
consequence of a correction in US current account imbalances. The adjustment to those
imbalances, sooner or later had to result in economic slowdown and a correction of
exchange rates (see, e.g., De Gregorio, 2007, and Obstfeld and Rogoff, 2007). Indeed, as I
argued some time ago, a current account reversal should occur sooner or later and a
depreciation of the dollar should help. The Central Bank of Chile included among the risks
Inflation
described in the Report, the correction of global imbalances since January 2004.
The adjustment was triggered and seriously aggravated by the subprime crisis.
Usually central banks define a baseline scenario to orient monetary policy. We make public
this scenario in three Monetary Policy Reports that are presented to the Senate. Deviations
from the baseline scenario result in adjustments of the path of monetary policy. Risk
management becomes central when deviations are not small, and the probability of
occurrence of large and disruptive deviations becomes significant. In that case, strong
actions may be needed, which may result in large deviations from the policies envisioned in
the base projection.
In this context, we can interpret current policy actions in the US as exactly doing risk
management. As explained in Mishkin (2008): "given that financial market disruption can
pose significant risks to the macroeconomy, risk management is crucial in formulating the
appropriate response of monetary policy... the design of monetary policy ought to reflect the
public's preferences, especially with respect to avoiding particularly adverse economic
outcomes." Furthermore, he adds that "the most likely outcome - referred to as the modal
forecast - for the economy may be fairly benign, but there may be a significant risk of more
severe adverse outcomes. In such circumstances, the central bank may prefer to take out
insurance." In other words, the Fed is preventing large and disruptive consequences of the
current credit crisis in the economy.
In emerging market economies the main risk is inflation, that is, the propagation of
inflationary shocks to high and persistent inflation. Indeed, past experience shows that when
inflation goes up there is an increase in indexation practices, which make inflationary shocks
more persistent or more difficult to fight. In addition, the persistence of relatively high inflation
is likely to diminish the degree to which expectations are anchored. On the one hand,
inflation expectations may increase, making it costlier to bring it back down. On the other
hand, medium and long term inflation expectations are likely to become more sensitive to
shocks, introducing undesired volatility to the economy with the associated costs of said
volatility. All this can derive on an inflation spiral, fueled by higher prices, higher indexation
practices, accelerating wages and increases in inflation expectations. These processes can
be very persistent and extremely costly to the economy. In some cases they may even result
in sudden uncontrolled inflation acceleration with catastrophic consequences. Nevertheless
we have learnt the lesson, and we know today the importance of price stability and
appropriate risk management.
References
Bernanke, B. (2007), "Inflation Expectations and Inflation Forecasting," speech delivered at
the Monetary Economics Workshop of the NBER Summer Institute, Cambridge,
Massachusetts, July 10.
De Gregorio, J. (2007), "Comments," in Clarida, R. (ed.) G7 Current Account Imbalance,
Sustainability and Adjustment, NBER and Chicago University Press, also as Documento de
Política Económica No. 115, Banco Central de Chile.
Fatas, A. (2002), "The Effects of Business Cycle on Growth", en N. Loayza y R. Soto (eds.),
Economic Growth: Sources, Trends and Cycles, Banco Central de Chile.
Galí, J. y L. Gambetti (2007), "On the Sources of the Great Moderation", mimeo, UPF.
Mishkin, F. (2008), "Monetary Policy Flexibility, Risk Management, and Financial
Disruptions," speech delivered at the Federal Reserve Bank of New York, January 11.
Obstfeld, M. and K. Rogoff (2007), "The Unsustainable Current Account Revisited," in
G7 Current Account Imbalance, Sustainability and
Clarida, R. (ed.) Adjustment, NBER and
Chicago University Press.
Ramey, G. y V. Ramey, (1995), "Cross-Country Evidence on the Link between Volatility and
American Economic
Growth", Review, Vol. 85, No. 5, pp. 1138-1151.