Rodrigo Vergara: The global economic scenario and monetary policy
management
Speech by Mr Rodrigo Vergara, Governor of the Central Bank of Chile, at the 2012 Latin
American Forum of the Institute of International Finance (IIF), Montevideo, Uruguay,
17 March 1012.
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I thank Luis Oscar Herrera, Enrique Orellana and Tatiana Vargas for helpful comments.
Thank you for inviting me to speak at the 2012 meeting of the IIF Latin American Economic
Forum. This is my first time here as governor of the Central Bank of Chile. I have been asked
to share with you some thoughts on the impact on our region of the crisis that is affecting the
developed world, especially of how we can confront it using policy instruments, and the
challenges that lie ahead of us.
These last years have been very challenging in terms of the evolution of macroeconomic
conditions in our region and worldwide. After the crises in Argentina and Brazil of the late
1990s and early 2000s, for the most part Latin American economies experienced a period of
sustained growth, lower unemployment and a drop or relative stability of inflation rates.
Nonetheless, towards the end of the past decade this state was abruptly interrupted by the
international financial crisis. The worst came with the fall of Lehman Brothers in September
of 2008. The abrupt and significant collapse of global demand caused serious problems in all
our economies. Terms of trade plummeted and soon we were facing a completely different
picture.
Economic policy reaction came promptly. In Chile, and other Latin American countries, we
implemented a combination of fiscal and monetary policies to stimulate the economy. More
important was the fact that probably for the first time, a crisis of the magnitude that affected
- and still affects - developed countries, did not cause Latin American economies to enter
into a balance of payments crisis or a profound recession. Suffice it to remember what
happened in the early 1980s, when our own weaknesses and the shortcomings of economic
policies, coupled with a significant rise in interest rates worldwide, dragged us into a deep
recession. This is of utmost importance as it shows that we have matured in economic policy
framework and that we face the challenge not only of maintaining but also of improving it.
After some quarters, the world economy began to recover gradually. This process took place
at two speeds. Emerging economies recovered at a fast pace, while developed countries
experienced a slower rebound. The causes and consequences of the Great Recession
continue to affect economic performance of the developed world. This is so because the
fundamental problem, high indebtedness of households, companies and governments, is still
present. The fact that the higher the level of debt the more costly the solutions and greater
the side-effects, poses a problem.
We have been seeing this clearly during recent quarters. You may recall that just a year ago
the main problem faced by emerging economies was how to deal with inflationary pressures,
given the narrowing of domestic capacity gaps and the rise in prices of commodities in
international markets. This happened at the same time as the two-speed recovery process I
just mentioned was accompanied by an interest rate differential that redirected capital flows
towards emerging markets, exerting strong pressures to appreciate our currencies. Our
concern then was the pace at which we would lower impulse to our economies, taking care
that it did not intensify pressures on the exchange rate and cause new imbalances.
Only six months later our major concern had changed dramatically. The intensification of
financial tensions in the developed economies drastically changed our perception of the
future of the global economy. Financial markets drastically picked up this change of mood
and very quickly we saw, among other developments, drops in stock prices, hikes in risk
premiums, and reductions in the prices of commodities. The tough discussions held in the
United States on fiscal issues, together with the weakness of its economic data towards
mid-year, fueled these negative perceptions.
Overall, emerging economies dramatically changed their perceptions and communication as
to the future of monetary policy. Between August and October, probably on the peak
moments of the last financial turbulences in the developed world, many central banks
stopped the process of interest rate raises, and many also changed the direction of changes
in their monetary policies to more expansive ones. In Chile, after raising MPR by 200 basis
points during the first half of 2011 and stating that there were still some increases to be
made, in August we moved towards a neutral stance. In October, considering the envisaged
consequences of the deterioration of the international scenario, we announced that we would
increase monetary impulse if we foresaw that this situation could have a negative impact on
our economy. Thus, in January of this year we lowered the MPR by 25 basis points. Now we
have announced that new monetary policy actions will depend both on our assessment of the
effects of the international scenario on the domestic economy as well as on the evolution of
the domestic economy itself.
Allow me to present you our vision of what is going on in the world and how it will affect us.
Particularly, to do so from a monetary policy perspective.
The current international scenario
The onset of 2012 has surprised us with a considerably calmer state of affairs than we
expected a few months ago. The Eurozone situation is far from being solved. There are
many challenges ahead, among them increasing productivity in many peripheral economies.
Nonetheless, significant progress has been made. The European Central Bank (ECB) has
provided long-term liquidity to the financial sector, European leaders have placed conditions
on this financing, governments have agreed on adjustment plans that seem to go in the right
direction, and it seems as time has been bought to address the more structural problems that
are still present in the Eurozone. Financial markets have understood this, and risk indicators
and monetary conditions have improved.
Consensus forecasts on world growth point to a performance of the global economy below
that of 2011. Nonetheless, the degree of downward correction has diminished noticeably in
the latest data. Does this mean that circumstances in developed countries have reached a
point beyond which we must not expect other significant setbacks? This is not so in my
opinion.
Allow me to give you some background. As mentioned, the solution to the Eurozone's
problems is still far ahead. Its economy is in recession and the necessary adjustments are
expensive and highly unpopular among the population. Some economies have very high
unemployment and a very fragile fiscal situation. If anything, measures adopted up to now
have put a firewall to isolate systemically relevant economies from greater disaster. Also,
financial conditions have improved these last weeks, mainly due to the ECB's LTRO
initiative. With it, the concern over the region's banking sector financing needs has been
dealt with.
However, serious fiscal and financial problems and macroeconomic imbalances continue to
exist in the Eurozone. In response to high unemployment and low growth, banks' portfolios
deteriorated. On the other hand, the European Banking Authority (EBA) has demanded a
capital increase of the system's major banks. Finally, US dollar financing pressure persists in
some major banks. This has resulted in more stringent credit conditions, which may continue
and have a profound impact particularly on small and medium-sized businesses and,
eventually, on some countries' foreign trade.
The situation of the Eurozone is complex and we cannot rule out as a possible risk scenario
a disorderly default of peripheral economies, due to the challenging debt maturity profile they
face. This high risk scenario is, however, less likely that at the end of last year.
The US economic data of the last months have been a pleasant surprise. The labor market
and households' expenditure seem to have behaved better than forecast. Although, the
difficulties that persist in the labor market and the fiscal adjustments that are needed explain
the continuing doubts as to how true and sustainable the recovery we are currently
witnessing is. In spite of the more positive indicators, the Fed authorities extended from 2013
to 2014 the period in which it expects to keep interest rate at minimum levels. Certainly, the
problem of fiscal indebtedness continues.
In emerging countries the data are diverse. Over the course of the second half of 2011 we
witnessed a generalized deterioration of consumer and business expectations. Neither case
can be compared to what happened between late 2008 and the beginning of 2009.
Generally, the data show a deceleration of activity. Nonetheless, it is difficult to identify how
much of this decline is due to a lower external stimulus, how much is accounted for by a
natural slowdown in each economy, and what part is explained by particular events.
All these elements add up to a situation in which, although the external scenario is not
worsening, the belief that risks have disappeared is far off. It is possible to think that the
likelihood of extreme scenarios is low, but, in my opinion, it is still there.
More challenges for monetary policy
As already mentioned, the change in how the global panorama was perceived led many
emerging economies to change their views on their future economic policies. This made
them halt their processes of lowering expansiveness and/or made them resume impulse.
However, the new change of mood brought about by the greater calm of the beginning of the
year, coupled with geopolitical factors, has again put us in a dilemma.
On one hand, probably as a result of the recent memory of the late 2008 and early 2009
global confidence crisis, most economic authorities quickly set up a close monitoring system
and prepared a batch of instruments to implement a quick offsetting of the adverse effects of
a global crisis. However, time has shown that the effects of the crisis of the Eurozone area
have been fairly limited so far.
Financial markets have suffered the biggest impacts, but trade, output and employment have
not been greatly affected. In Chile, activity and domestic demand, specially consumption,
have not worsened significantly. This does not mean that our vision of the effects that the
crisis in the developed world will have on our economy or the rest of the world has changed.
However, it is a fact that activity at the beginning of the year is at a higher level than we
envisaged a few months ago.
On the other hand, this has been compounded by an increase in the oil price. Political
tensions in the Middle East have again put pressure on this price, thus affecting domestic
prices.
The effects of a higher oil price can be interpreted at least twofold, with opposing implications
for monetary policy. On one hand, in a situation of tight output gaps - as is the case of many
emerging economies, Chile among them - an increase in the price of energy may
exacerbate domestic inflationary pressure, making the dynamics of inflation more complex
and demanding great care when assessing the evolution of the inflation trend. On the other
hand, in the face of existing risk scenarios, an increase in the oil price also has a negative
effect on world activity. If we take into account the fragile state of households, businesses
and governments in the developed world, a higher price of energy may further weaken their
position and lead to a more lasting and deeper economic fragility.
A third factor that has added difficulty to monetary policy management is a renewed concern
over capital flows towards the emerging world. The change in investors' mood has made
them look for other markets in which to invest, and has led to a widespread appreciation of
emerging countries' currencies. As usual, this has rekindled a debate that was present in our
discussions a year back, as to the convenience of implementing measures to avoid
currencies from appreciating. Last year several emerging economies, among them Chile,
intervened their exchange markets using different mechanisms. This year some emerging
economies have continued to do so.
Clearly, the discussion as to the convenience or not of performing such actions remains
unresolved. The first thing to bear in mind is that in small open economies, all efforts to
persistently keep the exchange rate at levels beyond margins aligned with the fundamentals,
particularly at overvalued levels, are not sustainable and may eventually generate higher
inflation.
We are convinced that a floating exchange rate regime is the most appropriate one for the
Chilean economy, as it facilitates macroeconomic and external accounts adjustments.
Nonetheless, certain circumstances may lead the Central Bank to intervene in the forex
market, either to maintain an adequate international reserve position or to respond to
overreactions of the exchange parity beyond its long-term fundamentals. However, there are
costs associated to this type of intervention. A first cost is that it may create confusion as to
the objective of the monetary authorities: inflation or the exchange rate. In our case, we have
dealt with this through transparent mechanisms whereby we anticipate the amounts and
terms of interventions, and by maintaining a flexible exchange rate. In addition it has always
been clear that the exchange rate is not an objective and the main goal of the Central Bank
is price stability. 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 domestic instruments used to finance their acquisition. Conversely, the benefits
of having these reserves are the enhanced security they provide in case of an abrupt cut of
external financing. These benefits are hard to measure, but it is reasonable to expect that
they will decline as the availability of reserves increases, as has been occurring in Chile
since 2008.
Allow me to express some final thoughts.
Final thoughts
News during these last weeks have led us to a scenario in which the effects of the
deteriorating external situation that we forecast some time back are not evident and in which
inflationary pressures stemming from a higher cost of energy have resurfaced. Hence, if a
few months ago it was clear that the most likely scenario for monetary policy in emerging
economies was a further loosening, today it is much less clear so. Compounded to it is the
renewed influx of capital flows towards emerging economies and the resulting appreciation of
our currencies. Against this backdrop, managing monetary policy has become more
complex.
Today, our assessment continues to be that the crisis in the developed world will sooner or
later affect the performance of our economies. It is possible that the impact will be less than
what we thought some time ago, but to assume that nothing will happen does not seem
sensible. Nonetheless, the difficulties involved in measuring the actual impact makes me
very cautious in measuring the impulse required by each economy to offset the effects of the
external scenario.
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. As I said a moment ago, activity we see today is at a level above what we
forecast a few months back. 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 current situation in developed economies is very complex, and teaches valuable
lessons. On one hand, as to how imbalances that are not addressed on time end up creating
enormous costs for the population. For those of us in charge of economic policy in our
countries, it is absolutely essential that we strive to address these imbalances if they exist,
and at the same time that we do not create them through our decisions. Over-stimulating the
economy when output gaps are narrow and inflationary pressures have risen could lead to
imbalances. I trust that they are not as sizeable as those of the developed world, but in any
case solving them is always costly. On the other hand, it has taught us the relevance of
maintaining and improving a good macroeconomic framework. In Chile, 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 has been 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. Our countries have suffered
decades as a result of mistaken economic policies. The Great Recession showed that our
current state of preparation to confront and mitigate the impact of an adverse scenario is
much better than in the past, and that it is the path that we must continue. Undoubtedly,
there are still many things to improve. Attaining a level of development such that prosperity
reaches the whole population is still far away, but at least we are on the right track.
Thank you.