Rodrigo Vergara: Chile - economic outlook
Speech by Mr Rodrigo Vergara, Governor of the Central Bank of Chile, at seminars held
during the Annual Meeting of the Inter American Development Bank, Montevideo, Uruguay,
12 March 2012.
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I thank Luis Oscar Herrera, Enrique Orellana and Tatiana Vargas for helpful comments.
I would like to thank you for inviting me to present our views on Chile's economic situation at
this Conference. These last years have been particularly challenging for policymakers
worldwide. Periodically we must make decisions in an uncertain environment, weighing the
costs and risks of alternative scenarios. For this reason, we welcome opportunities for
meetings and discussions such as this, as they allow us to communicate our views in greater
detail, as well as to hear other opinions. A better understanding of our decisions strengthens
the effectiveness of our policies.
More than four years have elapsed since the onset of the financial crisis that triggered the
Great Recession. Nonetheless, we are still handling its legacy, experiencing periodic
episodes of financial stress that will likely continue for some time. The situation in the
Eurozone is complex, due to the interaction among fiscal, financial and macroeconomic
vulnerabilities. From a historical viewpoint, growth perspectives for developed countries are
weak. The outlook for emerging economies is noticeably better, although we are witnessing a
slowdown whose pace is difficult to assess, particularly for China. Additionally, we are
confronting new risks, in the face of international tensions related to Iran's nuclear situation
and its impact on the oil market.
These sources of uncertainty are beyond our control. Therefore, our role as policymakers in
emerging countries is to preserve flexibility and space for policies that will enable us to
respond to and buffer the financial and real effects that those risks pose on our economies.
Over the last years we have gained credibility, flexibility and space to implement a
macroeconomic and financial policy framework that will help us smooth out the economic
cycle. This framework rests on four pillars. First, monetary policy management is based on a
flexible inflation-targeting regime, conducted by an autonomous central bank and supported
by a floating exchange rate system. Second, a fiscal policy that is accountable and
predictable thanks to a structural balance rule. The significant amount of savings
accumulated during the run-up of copper prices was a crucial factor in bolstering the
resilience of the Chilean economy and in providing a countercyclical fiscal boost. Third, a
high degree of commercial and financial integration with the rest of the world. Finally, a
sound financial system, with globally integrated, well capitalized, and adequately-regulated
banks. These elements allowed us to be less affected by the Great Recession than by
previous episodes.
In Chile, the effects of the world slowdown of the second half of 2011 and the financial
turbulences coming from Europe have so far been limited. In terms of output, third quarter
data showed a marked slowdown that continued into the beginning of the fourth quarter, but
which has tended to dissipate according to incoming information. The most recent data show
that this deceleration has continued, albeit at a slower pace than forecast. Likewise, as
regards financial conditions, after a shift towards a tighter situation at the end of last year,
more recently we have returned to a more normal situation. In particular, the monetary
market frictions that occurred in late 2011 were quickly overcome after the Central Bank
adopted transitory measures to provide greater liquidity.
To go into more detail regarding Chile's current economic situation, allow me to provide
some background on the challenges we face in light of last year's economic developments in
our country.
The Chilean economy in 2011
In early 2011, several emerging economies, among them Chile, experienced an increase in
inflationary pressures due to an episode of rises in international prices of commodities,
particularly oil and some foodstuffs. Additionally, in Chile domestic demand, output and
employment recovered quickly, helping close output and labor market gaps. Likewise, in the
face of rising prices of oil and foodstuffs, the private sector's inflation expectations
rebounded, reflecting a greater risk of inflation. Core inflation measures remained at
reasonable levels, below the minimum level of the target range. In this setting, the Central
Bank Board decided to speed up the normalization of monetary policy during the first half of
the year. Thus, between January and June of 2011, MPR (monetary policy interest rate) was
raised 200 base points. The level reached at the time - 5.25% - was within ranges
historically considered neutral. Further rises were not dismissed. However, events triggered
during the second half of the year changed the bias of monetary policy.
In the Eurozone, the situation that at first was confined to peripheral economies, began to
take its toll on systemically more important economies. This coupled with the political
difficulties for the United States to reach an agreement on how to consolidate its fiscal
position. Thus, international tensions escalated, with sharp increases in volatility, risk
premiums and liquidity premiums, together with significant drops in stock markets.
Commodity prices halted the upward trend they had followed in the first half, and although
they remained high for a while, they started to fall afterwards. Especially important for us was
the drop in the copper price. In addition, in Chile it was confirmed that the pass-through from
international to local prices had been limited, and signs began to appear that domestic
demand was decelerating. This, combined with monetary policy actions helped to reduce
inflation expectations.
This series of events substantially changed the economic scenario faced by the Chilean
economy. Thus, in August we eliminated the upward bias in our monetary policy releases. In
October we said that if international economic events worsened, growth and inflation in Chile
could be affected, as could the direction of monetary policy. The MPR was not changed
during the second half of 2011.
Our December Monetary Policy Report highlighted the wide range of existing risks, which
originated mostly in the directions that the Eurozone situation could take. The possibility of a
debt event occurring in a systemic sized economy or of a disruptive breakdown of the euro
were among the worst risk scenarios envisaged although we also considered the possibility
of the Eurozone authorities agreeing on a set of measures and reforms that would restore
market confidence. Considering the deleveraging process that households and governments
of developed countries would need to go through, these economies would continue to grow
at low rates for a long time, regardless of the way that the Eurozone situation was settled. All
in all, the international baseline scenario was more negative than previously considered, and
would impact Chile's growth and inflation rates. The working hypothesis of that Report was
that there would be MPR cuts in the short term, coinciding with the results of several
expectations surveys. The MPR was finally lowered at the monetary policy meeting of
January 2012.
Current dilemmas
Tensions in financial markets stemming from the Eurozone crisis have recently eased. The
European Central Bank's (ECB) measures to supply long-term financing to banks, the
political agreements to define an institutional framework aimed at maintaining fiscal discipline
in the medium term, and the announcement of a new rescue package for Greece, have all
contributed to this. In the last few days there was wide adhesion from the private sector to
the Greek debt swap, which warded off the possibility of a disorderly default, at least for now.
Nonetheless, the situation remains complex. The ECB's recent actions open a window of
time to allow implementation of fiscal adjustments in Europe, strengthening of banks and
adoption of structural measures to boost growth. Implementing these programs, however,
involves facing serious difficulties. Political, social and economic costs are paid in the
short-run and may generate tensions, whereas benefits are to be seen only in the medium
term. Therefore, we cannot rule out a rebound of financial tensions. All in all it seems as if, at
least in the short run, the imminent threat of contagion to economies systemically most
relevant has diminished. This is reflected in risk, volatility and liquidity indicators that have
dropped from the maximum levels of late 2011, while stock market and other asset prices
have recovered so far in 2012. Outstanding among the latter are commodities.
News in the United States is more encouraging, although recovery is still envisaged to be
slow, and the labor market continues to show significant imbalances. However, the US
evolution compensates the decline in the Eurozone. Data of emerging economies show that
activity has decelerated. In several cases, it is difficult to distinguish how much is driven by
international forces, how much by natural domestic slowdown or by specific events. An
outstanding event has been the announcement by the Chinese authorities of a lower growth
goal for this year.
In Chile, the effects of the international crisis have been limited and lower than was foreseen a
few months ago. Several effects that were noticeable toward the end of last year have been
reversed to a great extent or have become less intense. Terms of trade have improved over
the last months, due to rises in the copper price. Conditions for external financing have also
improved, as a result of increased confidence in international markets. Local financial markets
- one of the transmission channels of external crises towards the domestic economy - show
that stock indexes, risk premiums and exchange rates have gone back to levels similar to
those that existed before the intensification of international financial tensions. Other indicators
such as amounts and terms of external banking sector financing have stopped the decline that
occurred toward the end of last year. The Chilean peso has appreciated nearly 7% so far this
year. The real exchange rate is close to its average level of the past 15 to 20 years. The
movements of the exchange parity have matched the evolution of the US dollar in
international markets, in the face of calmer markets and a greater appetite for risk. This has
occurred with the price of copper at 3.8 dollars a pound, its highest level of the last five
months. Its trend has been similar to that of other markets of commodities.
As the Chilean peso, emerging market currencies have generally appreciated, and since the
beginning of the year have been accompanied by a return of capital inflows to these
economies. The continuation of this phenomenon brings back some issues, as the
abundance of capital may be difficult to accommodate in a small economy like Chile. Such
episodes are not new to us and bring with them discussions as to the convenience of
exchange market intervention, which some Latin American economies have undertaken in
recent weeks.
We are convinced that a floating exchange rate regime is the most appropriate one for Chile,
as it facilitates macroeconomic and external accounts adjustments. Nonetheless, there are
circumstances that may lead to Central Bank intervention in the exchange market, either to
sustain an adequate level of foreign reserve assets, or to respond to overreactions in the
exchange rate that are not aligned with medium-and long-term fundamentals. Associated to
this type of intervention, there are costs. A first one is that it may create confusion as to the
monetary authorities ́ objective: inflation or the exchange rate. In our case, we have dealt
with this by means of transparent mechanisms whereby we anticipate the amounts and
terms of interventions, and by maintaining exchange rate flexibility. A specific exchange rate
level has never been a Central Bank objective; at most these interventions are conducted to
prevent excess volatility or temporary diversions from its long-term equilibrium. It has always
been made clear that the Central Bank of Chile pursues a price stability target. A second cost
is of a financial nature. Foreign reserves are invested in highly liquid and secure instruments
of developed countries, whose interest rates are lower than those of the domestic
instruments used to finance their acquisition. This originates a significant cost that
deteriorates the Central Bank's capital. The benefit of having these reserves is the enhanced
security in case of an abrupt cut of external financing. These benefits are hard to quantify,
but it is reasonable to expect that they will diminish as the availability of reserves increases,
as has been occurring in Chile since 2008.
On the real side, the deceleration of output and demand has been slower than expected,
reflecting the fact that the external scenario has had a lower than projected impact. Although
there are differences among sectors, economic activity in general shows a behavior
consistent with convergence towards its long term trend. Some sectors have performed
poorly and have shown more cautious inventory management, while others such as Trade
and Construction have performed solidly.
There are several signs that activity and demand will decelerate in the coming months. On
one hand, there is the behavior of imports of capital and consumer goods. Worth noting is
the drop in car imports that has taken place during the last months, consistent with the
cautious behavior I mentioned a few moments ago. On the other hand, domestic credit
conditions have also become somewhat tighter these last months, specially for consumer
loans. These elements and the fact that MPR is within a range considered neutral, makes us
believe that the deceleration of domestic demand will become more evident in the coming
months. Nonetheless, this process will occur at a rate lower than what we expected a few
months ago.
A significant part of the impulse of private consumption relies on the strength of the labor
market. The unemployment level is at its lowest level of the last 15 years, in spite of a
deceleration in job creation. Outstanding is the quality of newly created jobs, with a greater
share of wage earners. This type of employment, due to its stability, is more prone to
generate consumption of durable goods and increases households' borrowing capacity, thus
feeding back into a rise in consumption. As expected, a low unemployment rate with few
output gaps is consistent with greater wage pressures. Real wages have increased between
2 and 3% during several months, while growth of nominal wages has been close to 7%.
Indicators of consumer confidence have maintained a positive trend in the last months,
although they remain in a pessimistic zone.
Investment in 2010 and 2011 was boosted by the acquisition of machinery and equipment.
This has recently been changing, with a greater dynamism in Construction and Public Works.
The increased importance of Construction is related to residential construction and
infrastructure, the latter linked to Mining and Energy projects. Residential construction is
consistent with the high level of lending for housing and with interest rates that are still low
when compared to historical levels. Overall, the strength in gross fixed capital formation is
consistent with the evolution of business perspectives. Although these expectations
experienced a setback in 2011, they were never in the pessimistic range. They have
rebounded during 2012, across different economic sectors.
I do not want to skip mentioning the new National Accounts data that we will be releasing
shortly, as result of the recently published 2008 Reference Compilation. Besides the update
of the reference year from 2003 to 2008, the new national accounts volume measures will be
compiled using chained moving bases, instead of the traditional fixed base measures. Thus,
these statistics are set in a level that can be compared with that of other OECD member
countries.
As I stated recently, various indicators point out that activity and domestic demand will
decelerate in the coming months. Nevertheless, we believe that it will do so at a slower pace
than we expected a few months ago. In our December Monetary Policy Report we projected
a baseline scenario where growth ranged between 3.75 and 4.75%. Some of the risk factors
that in December we envisaged could reduce growth during this year - accounting for the
downward bias that we announced then - have had a better evolution than forecast at the
time. Examples are the recent evolution of demand, which coupled with the signs of a tight
labor market suggest that output gaps are fairly limited. Another example are the terms of
trade, which take place in an environment where the likelihood of more catastrophic external
scenarios seems to have diminished. In March, private expectations point to a growth in GDP
close to 4.5% this year, having been in the range of 4% at the end of 2011.
At the same time that some risks have diminished, others appear. An important matter for us
is the widening of the current account deficit, explained by the dynamics of spending. In spite
of the high level of our terms of trade, and following current account surpluses in 2009 and
2010, we estimate that in 2011 we had a small current account deficit and in 2012 it could
expand further. This matter needs to be analyzed in depth.
On the other hand, a lower deceleration of domestic demand, in the context of narrow output
gaps, could give rise to inflation pressures. During the last months core inflation measures
converged towards 3% at a speed higher than forecast. Although this evolution may well be
a lagged adjustment of core inflation, after it remained persistently at low levels during
several months, its path must be carefully monitored, more so in the light of a narrowing of
capacity gaps and a tightening of the labor market. Overall, in recent weeks, market
expectations have raised the projections of short-term inflation.
In addition, in the short term, inflation is affected by supply shocks that can have significant
effects. Developments in the international oil market do not help the outlook for domestic
inflation. Recent geopolitical tensions in the Middle East, which, among other consequences,
led to an embargo on Iranian exports, and a harsh winter in the Northern Hemisphere have
made the actual and expected oil price to escalate. The Brent price has risen more than 15%
during the current year, while projections taken from futures contracts have also risen and
point to an average price for oil of near US$120 per barrel during 2012. The persistence of a
high price always raises worldwide concern because of its implications on inflation and
growth. Concerns regarding inflation deal with the direct impact of fuel and energy inflation,
and also with the secondary effects that they cause, which could be accentuated in an
environment with a narrow output gap.
Final thoughts
Before I end my presentation, I would like to share some thoughts on monetary policy.
As mentioned at the beginning of this presentation, our task as economic policymakers is
made more difficult in a more uncertain environment. We make our best decisions based on
whatever information is available at the moment. Currently, decision making relies on certain
elements that point to opposite directions. On one hand, the international scenario is very
complex, even though when compared to a few months back, the tensions seem somewhat
smaller. Nonetheless, depending on the outcome of events, there could be contractive
effects on emerging economies. Scenarios such as this back slacker monetary policies. On
the other hand, the domestic scenario poses challenges in the opposite direction, inasmuch
as the behavior of domestic demand may bring inflationary risks. Today, prudent monetary
policy management has to be prepared for all kinds of scenarios and to adapt the amount of
stimulus applied according to needs established on a case by case basis. In fact, in our latest
Monetary Policy Meeting we decided to maintain the Monetary Policy Rate at 5% for a
second month in a row. The greater caution in policy decisions that these events pose has
been reflected in the fact that private expectations currently incorporate a higher probability
of MPR to remain at 5% until the end of the year.
With the Board we have conditioned future changes in MPR to the implications that domestic
and external macroeconomic conditions may have on inflation perspectives. The Board has
also reaffirmed its commitment to conduct monetary policy in a flexible fashion, so that
projected inflation remains at 3% within the policy horizon. Without a doubt, the best
contribution that central bankers can make to prosperity in our countries is to conduct
monetary policy aimed at maintaining low and stable inflation. This is perfectly clear for us at
the Central Bank of Chile. As emerging economies we are long-time victims of inflation and
are well aware of its devastating effects on our more vulnerable population. The objective is
clear, but the difficulties we face are in its implementation, with the caution demanded by the
complex macroeconomic environment.
Thank you.