Central Bank of Chile's Twenty-Second Annual Conference:
"Changing Inflation Dynamics, Evolving Monetary Policy"
Opening remarks by Mario Marcel, Governor of the Central Bank of Chile
October 25, 2018 - Santiago, Chile
Welcome remarks
Good morning everybody and welcome to the Twenty-Second Annual Conference of the
Central Bank of Chile. It is a pleasure to host this event that every year gives us the opportunity to
reflect and discuss about issues that have direct implications on our work as central bankers and
stimulate the related academic agenda. I am looking forward to active discussions today and
tomorrow on this year's conference theme: changing inflation dynamics and its implications for
monetary policy. This conference is being followed online via live streaming on our website.
Inflation dynamics and monetary policy in recent years
The last ten years have been an extraordinary time for macroeconomics. The deepest financial
crisis since the Great Depression was followed by an unprecedented bold, coordinated,
unorthodox and persistent response by central banks in advanced countries. In all, a decade in
which the world economy stood a long way from normal and, as it depended so much on
emergency support, it was not easy to detect how much the economy was changing underneath.
So it is perhaps not that surprising that once the same central banks began to envisage a
gradual, cautious and well communicated approach to monetary policy normalization, some
challenges appeared on the road. True, some of them had to do with political change and policy
uncertainty to the heart of the developed world, but on top of that, major empirical and
theoretical puzzles are challenging central tenets of monetary policy.
In particular, inflation appears not to be responding to monetary policy as expected in
advanced economies. Despite record- low interest rates over many years and massive liquidity
injections by central banks through asset purchase programs, inflation has not picked up as
expected. Explaining the apparent unresponsiveness of inflation has become a theoretical and
empirical challenge that has drawn great attention from academia and policymakers in the last
couple of years.
Inflation dynamics and the way they interact with other economic variables are, of course,
crucially important to central banks that have price stability as their core mandate. Most of them
currently deliver on this mandate under a forward inflation targeting framework, whereby the
stance of monetary policy seeks to achieve convergence of forecasted inflation to the target over a
medium-term horizon. This prevents central banks from having to respond to short-term price
volatility, but if inflation does not respond to monetary impulses as predicted by models,
policymaking may become a much more complex game. If price responses get delayed in a highly
accommodative environment, financial imbalances may build up, fiscal discipline may be eroded
and inflation risks may get underpriced by markets, exposing themselves to reversals with data
surprises in the future.
It is in this context where the topic of this year's conference falls right into the core business of
central banks: understanding inflation dynamics, and how they influence monetary policymaking.
Indeed, throughout the post crisis period we have observed a puzzling behavior of inflation in
many developed countries, as standard Phillips curve approaches have done a rather poor job
predicting price pressures. During this period, the unemployment rate has reached historically low
levels, but inflation has remained low.
Economists have referred to a "twin puzzle" in inflation dynamics and several explanations
with different policy implications have been put forward. Some have pointed to the existence of
"hysteresis" as causing a drop in potential output and, consequently, smaller gaps in the economy
after the crisis. Others argue that the weakening of the relationship between activity and inflation
responds to structural changes, like globalization forces pulling wages down, or technological
innovation prompting changes in industrial organization. Another alternative, a sort of "catch 22"
for central bankers, is that the flattening of the Phillips curve may be the consequence of the
success of central banks in targeting inflation.
Measurement issues should not be ruled out either. Measuring a common movement of prices
throughout the economy has never been a straightforward task, but this may be getting harder as
standardized goods take a smaller and smaller share of household consumption compared to
services and to goods that are subject to fast change. Some have argued that output gaps and
prices retain their historical association if the right measure of "output gap" is compared to prices
that are responsive to it. But then, what is a "correct measure" of the output gap, given that this is
a not directly observable variable? In recent months, the Fed has been underscoring that some key
structural variables for monetary policy, like the output gap itself, the neutral interest rate and
natural unemployment are estimated with considerable uncertainty and may have shifted in
recent years. We will hear about measurement challenges and structural parameters across this
conference.
Inflation dynamics in emerging countries
As we hold these discussions in an emerging country, it is also important to note some
differences with the advanced world concerning price dynamics and monetary policy. For one,
average inflation in emerging economies has been traditionally higher and more volatile than in
advanced countries. This keeps our countries generally far from the risk of deflation, but has also
contributed to the buildup of indexation mechanisms and more volatile inflation expectations,
which may make inflation targeting more difficult. Also, in many emerging countries, the domestic
economy is relatively small compared to foreign trade, and pass-through from the exchange rate
to prices is a much more relevant determinant of short term inflation. The larger size of the
informal sector also tends to weaken the relationship between wages and prices. So the relative
weight of past inflation, the exchange rate, wage inflation, market expectations and output gaps in
inflation dynamics may differ significantly from advanced economies.
Chile has pioneered monetary policy innovation in the emerging world. After four decades of
double-digit inflation, our Central Bank was given independent status and a mandate of price
stability nearly 30 years ago and exercised it swiftly, with the support of a first version of inflation
targets in the early 1990s. The monetary policy framework further evolved after the Asian Crisis to
a fully-fledged forward inflation targeting regime with a floating exchange rate in 1999. This was
soon complemented by a major upgrading of monetary policy communications and a structural
fiscal policy rule.
This framework has basically remained in place for the last 18 years and its effectiveness has
improved as markets, agents and institutions have adapted to it. Over time, markets have
developed adequate FX hedging mechanisms, inflation expectations have become more anchored
at the monetary policy target level, the Central Bank has overcome fear of floating, financial
markets have deepened and the labor market has gained some flexibility. As an open economy,
we are not immune to external shocks but the ability to cushion them through the exchange rate
and countercyclical policy response has improved significantly.
At the time of the 2007 Global Financial Crisis, this framework helped us to avoid large costs
and contain financial problems despite our strong ties with the global economy. In the aftermath
of the Global Financial Crisis, the local currency depreciated around 45 percent in seven months,
while the monetary policy rate was reduced from a relatively high level of 8.25 percent in
December 2008 to a 0.5 percent in July 2009, where it stayed for about a year. Together with
lowering the interest rate, the Central Bank implemented a program of liquidity provision that
significantly reduced the market interest rates to a level much closer to the monetary policy rate.
The active monetary policy response, together with an expansionary fiscal policy, facilitated a
speedy adjustment. After only one year of negative annual growth in 2009, the economy was able
to sustain growth rates above 4 percent in the years that followed. The inflation rate fell well
below the target range for about a year, but inflation expectations remained anchored at the 3
percent target in the two-year horizon.
Undoubtedly, this is the strongest countercyclical macroeconomic policy response we have
ever articulated, proportional to the magnitude of the shock, but our monetary policy framework
has also been useful to face subsequent challenges at home and abroad, like the end of the
commodity price boom in 2013-2014, delivering lower price and output volatility. In each of these
episodes, anchored inflation expectations, automatic fiscal stabilizers, foreign exchange hedging,
and a sound financial sector have contributed to provide monetary policy with sufficient room for
maneuver. But it is crucial to remark that these factors are not exogenous to macroeconomic
policy. They were nurtured by a consistent macro policy framework built and maintained in the
last two decades.
The challenge for central banks
The Chilean experience illustrates that for forward inflation targeting to work, central banks
need to develop the right set of tools-data sources, models and judgment-to formulate and
communicate a policy path that is coherent with such convergence. As the local and world
economy evolve, the relevance of all these tools needs to be kept constantly in check.
Over time, economies are subject to major changes, especially in the case of emerging
economies, and this may alter well-established relationships. The current focus in the relevance of
the Phillips curve and price dynamics is a good example of this. But the extent to which structural
changes involve a permanent change in the responsiveness of prices to output gaps or one-off
changes delaying inflationary responses for some time is equally relevant, especially for
policymaking. This also applies to structural changes that are especially relevant for emerging
countries, like demographic transition or the lengthening of international value chains.
The quantity and quality of data available to make monetary policy decisions may also change
substantially over time. The traditional dominance of regular economic surveys is increasingly
challenged by growing administrative datasets and big data. In this regard one should never forget
that data is only an instrument to capture true economic behavior. From a policymaking
perspective, data collection, processing and statistical methods are a way to produce evidence for
better decision making. A central bank that operates in a forward-looking environment, dealing
with a large number of unobservable concepts, has an ultimate responsibility to use all the
relevant information at hand. Monetary policy making is not a bureaucratic procedure, but an
intense exercise of judgment. Of course, we must be able to share such information and judgment
with the public to make our decisions easier to understand.
As for judgment, a major challenge for central banks is to connect incoming information with
medium-term prospects. While central bank boards generally meet at regular intervals, they need
to assess when accumulated information is sufficient to indicate a change in the medium-term
scenario, possibly demanding a change in the trajectory of monetary policy. In the case of
emerging countries, FX pass-through poses a major challenge, as currency parities may exert
substantial pressure on inflation in the short run, gaining a lot of public attention, but they may
not prevail in longer spells. The source of currency volatility and the exposure of economic agents
to FX risk are key factors that, in our experience, may help assess the medium-term impact of
exchange rate movements and condition the need for a monetary policy response.
A similar challenge to the exercise of judgment by central banks is to distinguish between
"normal" times and stressed scenarios. While in normal times, economies can adjust gradually and
tolerance for deviations for a charted path may be higher, a stressed environments is
characterized by a very low tolerance to risk, shorter time horizons and powerful feedback loops
with financial markets. The recent experience of fast-shifting conditions for some emerging
economies that were caught in the ebbing tide of capital movements is in stark contrast with the
slow-motion of monetary policy in advanced countries, which is also a source of theoretical
puzzles and information challenges.
Acknowledgements
To guide our discussions on these issues over the next two days, we can rely on a distinguished
group of economists that have joined us to present and discuss issues concerning inflation
dynamics and monetary policy. I would especially like to thank Gonzalo Castex, Jordi Galí, Diego
Saravia, and Joaquín Fuenzalida for putting together the program, and Carolina Besa, Paloma
Navarro, and María José Reyes for helping with the organization. I wish you all a fruitful discussion
and a pleasant stay in Santiago.
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