José De Gregorio: Monetary policy and pass-through to interest rates
Speech by Mr José De Gregorio, Governor of the Central Bank of Chile, before the
Honorable Chamber of Representative's Economic, Promotion and Development
Commission, Santiago, 16 March 2009.
The Spanish original prevails.
* * *
Mr. President. I wish to thank you and the Economic, Promotion and Development
Commission of the Honorable Chamber of Representatives for inviting me to speak about
how our monetary policy decisions affect the country's financial and lending conditions.
The global economy is enduring terribly uncertain times, which have implications on our
country's prospects for growth and inflation. Thus, we share your preoccupation for
evaluating how monetary policy actions - one of the main stabilizing tools we have available
as a country - ultimately affect the cost of borrowing faced by households and firms.
Monetary policy, in the context of an inflation target and a floating exchange rate like the one
operating in Chile since 1999, is an important mechanism for smoothing out the business
cycle. Periods of weak output and demand performance, which reduce the medium-term
inflation outlook, lend themselves to countercyclical monetary policy actions that cushion the
negative effects on consumption, investment and employment. This is what the Central Bank
of Chile is presently doing, acting resolutely to moderate the effects that the global crisis -
the worst we have seen in decades - is having in Chile.
The transmission of monetary policy
The Central Bank of Chile's monetary policy operates largely through its effects on the cost
of lending, as it influences the cost of bank financing. The Bank's main instrument is the
monetary policy interest rate, or MPR. It is worth noting that the level which the Board
chooses every month for the MPR represents an objective for the cost of overnight lending
between banks. In other words, the Central Bank operates in the interbank market, seeing
that the interest rate at which banks lend to and borrow from each other overnight
approaches the MPR. Therefore, it is important to understand how this interest rate, which
operates in a very specific and well defined market (among banks and for a term of one day
only), affects the spending and investing decisions made by households and firms even over
several years.
The explanation for this phenomenon is that, in normal circumstances, what matters is not
only today's level of the MPR, but the whole future path expected by the market for such
interest rate. This is what ultimately affects the entire yield structure. In other words, for a
five-year loan, for instance, it is more important for the potential borrower to have an idea of
how the MPR will be behaving in the next five years that to know its current level.
The above has first-order implications on the conduct, implementation and communication of
monetary policy. In fact, while obviously important, the decisions that we adopt as the Central
Bank Board at the monetary policy meetings are not the only element shaping the credit
conditions within the economy. Also of first order is the market's perception of how the
monetary policy will be managed in future months and years. This leads us to be extremely
cautious in our communication, in order for the decisions we make to be perceived with the
adequate persistence.
The monetary policy that the Board has been implementing in the past few months clearly
illustrates this phenomenon. Despite the fact that the MPR was held constant at 8.25% in the
last months of the past year, thanks to the way we communicate our decisions and to the
incorporation of an explicit bias the MPR level expected by the market six months ahead
dropped significantly, pulling down the deposit rate at longer terms. Subsequent reductions
to the MPR that have been applied this year have gone beyond market expectations,
reducing financing costs (figure 1).
To succeed in communicating properly, transparently and credibly is then key for monetary
policy decisions to cause the impact that is needed. This is what makes monetary policy
effective, and it is why the Central Bank has maintained a systematic policy of
communication and transparency, through the presentations we make as Board members,
with our Monetary Policy Reports, and with the transparency mechanisms we have for our
policy decisions. In the latter area we actually have made major innovations since our
Monetary Policy Meeting last Thursday. We now upload to our public website the
background information based on publicly available data before holding the meetings where
we decide on monetary policy.
Today's scenario: uncertainty and risks
Monetary policy is one of many factors influencing the cost of borrowing faced by households
and firms. Another factor that has gained significant importance is the perception of risk and
volatility that has swept over every financial market. This increased with the worsening of the
global financial crisis last September. In general, and despite efforts made by economic
policy makers in the main economies around the world, we are still dwelling in an extremely
uncertain scenario. This has a number of implications that ultimately affect the conditions and
costs of credit to firms and households not only in Chile but everywhere.
To begin with, external lending standards for domestic banks have become more stringent.
We see it in that, although our banks have been able to access foreign credit sources, these
have been at shorter maturities and with larger spreads over external reference interest
rates. This is a reflection of the difficulties that continue to haunt the main global financial
institutions and their reluctance to embark in new businesses. This has not altered the
liquidity available in the local money market, which has remained stable, aside from some
transitory turbulence in early October that was addressed by the Central Bank through the
implementation of new modalities in the provision of liquidity.
Secondly, the meltdown of world output and trade is increasing credit risk globally. In turn,
firms and households with a better financial situation tend naturally to postpone their
spending and borrowing decisions, awaiting the normalization of the financial environment,
thus shrinking the demand for credit. All of this results in increased average financing cost
and tougher lending standards for those agents actually engaging in borrowing operations.
We can see that the various risk and volatility indicators are substantially above their
preSeptember figures (figure 2). As we wrote in our latest Monetary Policy Report,1 the extra
financial burden for the clients of Chilean banks has tended to reflect precisely the higher
levels of global uncertainty and their impact on the Chilean economy.
I must stress that these phenomena are occurring today in every economy in the world,
sometimes with catastrophic implications on their levels of output and the solvency of their
financial institutions. Because we prepared as a country for a long while to confront severe
deteriorations of the international economic environment, Chile and our financial market have
suffered limited effects, with no sudden stops but, on the contrary, with increases in credit
supply and without a generalized process of insolvency. These same precautions have
permitted macroeconomic policies - both fiscal and monetary - to be clearly countercyclical,
helping to cushion the effects of the world crisis on our economy.
The transmission of MPR reductions to lending interest rates
One important element in the diagnosis of how this countercyclical effort is actually working
is the evaluation we perform on a permanent basis to the way our decisions are affecting the
borrowing conditions facing households and firms. This issue is not new, and was the subject
of analysis several years back when the Central Bank's monetary policy was on a sustained
expansionary path.2 The evidence we gathered then can be summed up in that the Central
Bank's monetary policy decisions are reflected in the banks' financial cost very quickly, but in
the overall cost of credit only after a few months. This response pattern was similar to that in
other economies. Lately, we have reviewed that information,3 and we have found that, even
in moments of great uncertainty as we experienced in recent months, reductions to the MPR
are translating into reduced borrowing costs for both businesses and consumers.
One good example is the trend of the interest rate on commercial loans at 30 to 89 days,
which can be linked to the funding of working capital. This rate was very high in October last
year, but this year so far it has fallen substantially. We estimate that if we had not cut the
MPR by a combined 350 basis points (bp) between January and February, this rate would be
some 250 bp above where it is today. A similar situation can be seen in the case of
consumer loans. The cost of mortgage financing, meanwhile, has been less sensitive to the
changes in the MPR precisely because those are long-term borrowing decisions. However,
without the drop in long-term rates - which has partly originated in the monetary easing -
mortgage rates would have stayed largely above their current levels (figure 3). We estimate,
then, that the monetary policy decisions recently adopted have begun to pass through to the
credit conditions faced by households and firms. This pass-through should continue in the
near future, especially after the reduction in the MPR that the Board determined last week.
We will keep monitoring these effects permanently, because for us it is essential that the
MPR propagates to market rates smoothly. We certainly expect the latest MPR reduction last
Thursday to result in additional decreases in the banking system's lending rates.
This type of exercises also permits to evaluate the impact of the higher degrees of
uncertainty, volatility and risk we have been observing since last September. If we do the
exercise of asking ourselves where would the lending rate be in a hypothetical scenario
without the global financial crisis, we find that it would be between 50 bp and 350 bp below
its present level, with the larger effect on the interest rates on commercial and consumer
loans. In the specific case of mortgage loans, the increase in the interest rate occurred
between September and December 2008 can be largely linked to the implications of the
external conditions on the local perception of risk (figure 4). All the above is a clear
illustration of how the severe uncertainty and high risks that were unleashed last September
are affecting the domestic economy.
Non-bank financing sources
Notwithstanding the key role played by domestic banks in funding households and firms,
especially smaller ones, for the bigger companies there are other equally important credit
sources. Thus, around 45% of total corporate borrowing is non-bank, with external debt and
domestic bonds at the top of the list. Therefore, it is important to understand the behavior of
the interest rates on these credits before offering a global outlook of financial conditions.
The Central Bank of Chile has no direct effect on external financial conditions. Like banks,
Chilean firms have seen their borrowing conditions tighten under the changed state of affairs.
Still, our banks and firms continue to enjoy normal access to world financial markets, owing
to a great extent to our policy framework that ensures the solvency of our economy and to
our sound financial system.
As for the local bonds market, January stood out for its large corporate bond issuances.
Meanwhile, the interest rate demanded from corporate bonds in the secondary market has
been falling through all of this year, and is currently approaching its levels of last September.
This drop owes exclusively to the decline in the interest rates on Central Bank documents,
because the spread between public and corporate securities has increased significantly
since September, reflecting the same global risk factors already mentioned (figure 5).
Conclusions
The global financial crisis has hit hard credit markets around the world. In some unfortunate
cases, economies that faced this debacle from a fragile initial position, with high
indebtedness or with fast credit growth, have faced drastic adjustments in local asset prices,
output, and employment, with dire consequences on their living standards. Thanks to the fact
that we prepared for years as a country to confront deteriorations of the external
environment, our monetary policy has been able to adopt a clear countercyclical stance to
lessen the effect on our economy of the global financial meltdown.
We have seen that the aggressive reductions in the MPR implemented by the Board since
January have begun to reflect on the borrowing conditions faced by households and firms. It
is reasonable to expect this to continue in the coming weeks, especially after the MPR cut of
last week. However, a full normalization of credit demand and supply will depend on the
appeasing of the global financial environment, on more clarity about the definitive structure of
the global financial system, and on economic growth prospects settling down in the larger
economies of the world.
Overall, it is important to note that this analysis has focused on the cost of credit for
operations already materialized. The other central dimension of the financial system
operation is clients' access to credit. Lately loans have slowed down. It is difficult to figure out
how much of this to blame on lower demand and how much on the financial institutions'
reluctance to lend. In any case, we believe it is important that financial institutions, provided
good risk management, continue to lend to firms and households. We agree with the
Superintendent of Banks and share the principle that through tough times the banks must
stand by their clients and cooperate in the solution of their financial problems.
I would like to inform you that, as part of our process of increasing transparency, particularly
regarding public dissemination of information about interest rates charged on credit
operations, we have decided to extend the available data on credit conditions by maturity,
indexation, and type of loan. Thus, starting today our website has increased the level of
detail of interest rate information made available to the public.4 Part of said information was
used in producing the results reported in this presentation.
Just as we did a year ago, when we discussed the exchange rate conjuncture at the
Honorable Chamber of Representatives, I want to state that we act with the conviction that
we are making the best decisions to provide stability to our economy and widen its growth
opportunities. We permanently and carefully monitor the situation and we incorporate it
consistently in our monetary policy decisions.
To finish, I thank again the Economic, Promotion and Development Commission of the
Honorable Chamber of Representatives and its President, representative Mr. Antonio Leal
for letting me present our visions here. The serious management of monetary policy and its
formulation on a solid technical basis is essential to ensure economic stability in such volatile
and blurred global conditions as we are now going through. I appreciate this opportunity to
come and expose our vision of the relationship between market interest rates and the
conduct of our monetary policy.
Thank you.
References
Becerra, S., L. Ceballos, F. Córdova, and M. Pedersen (2009), "Evolución Reciente de las
Tasas de Interés de Colocación," manuscript, Research Division, Central Bank of Chile,
March.
Berstein, S. and R. Fuentes (2003), "De la Tasa de Política a la Tasa de Colocación
Bancaria: La Industria Bancaria Chilena," Economía Chilena, Vol.6, N°1, April.
Central Bank of Chile (2009), Monetary Policy Report, January.
Matus, J., D. Oda, and N. Silva (2009), "Caracterización de las Colocaciones Bancarias en
Chile." Studies in Economic Statistics N°73, Central Bank of Chile, March.
Figure 1
Monetary Policy Interest Rate, Deposit Rate, and Forward Curve
(percent)
12
12
10
10
8
8
6
6
4
4
2
2
0
0
Jan.08 May.08 Sep.08 Jan.09
180-day prime deposit rate MPR 6 month forward rate
Source: Central Bank of Chile
Figure 2
Lending Rate Spread over MPR and Other Financial Indicators
(index, average Jan. 2002-Jul. 2007=1)
4.0 40
3.5 35
3.0 30
2.5 25
2.0 20
1.5 15
1.0 10
0.5 5
0.0 0
02 03 04 05 06 07 08 09
Lending spread over MPR VIX (1)
Libor - OIS (2)
(1) The VIX index measures implied volatility in the U.S. stock market
(2) Libor-OIS spread measures the difference between dollar financing cost for banks around the
world and a measure of the expectation of the monetary policy rate in the U.S.
Sources: Central Bank of Chile; Bloomberg.
Figure 3
Lending interest rates without reduction in the MPR
(percent)
Consumer loan rates at 3 years or more Commercial loan rates at 30-89 days Mortgage interest rates
40 40 20 20 5.5 5.5
36 36 17 17 5.0 5.0
32 32 14 14
4.5 4.5
28 28 11 11
4.0 4.0
24 24
8 8 3.5 3.5
20 20
5 5
3.0 3.0
Jan. 08 May 08 Oct. 08 Feb. 09 Jan. 08 May 08 Sep. 08 Jan. 09
Jan. 08 May 08 Sep. 08 Jan. 09
Effective Estimated Simulated without MPR reduction
Source: Central Bank of Chile.
Figure 4
Lending interest rates without increase in risks after September
(percent)
Consumer loan rates at 3 years or more Commercial loan rates at 30-89 days Mortgage interest rates
40 40 20 20 5.5 5.5
36 36
17 17 5.0 5.0
32 32
14 14 4.5 4.5
28 28
11 11
4.0 4.0
24 24
8 8
3.5 3.5
20 20
5 5
3.0 3.0
Jan. 08 May 08 Sep. 08 Jan. 09
Jan. 08 May 08 Sep. 08 Jan. 09
Jan. 08 May 08 Sep. 08 Jan. 09
Effective Estimated Simulated rate without increase in risk after September
Source: Central Bank of Chile.
Figure 5
Corporate Bond and Long-Term Interest Rates
(percent)
6 6
5
5
4
4
3
3
2
2
1
1 0
Jan.08 May 08 Sep.08 Jan.09
EE.UU. (1) Chile (2) Chile corporate (3)
(1) Nominal 10-year interest rates in the U.S.
(2) Interest rate on Central Bank's BCU-5.
(3) Interest on domestic 5-year corporate bond.
Sources: Central Bank of Chile and LVA indices.