MONETARY POLICY REPORT
BEFORE THE
PRESENTATION HONORABLE
OF THE
SENATE REPUBLIC
Mario Marcel
Governor
Central Bank of Chile
5 September 2018
The September 2018 Monetary Policy Report can be downloaded at http://www.bcentral.cl. The Spanish
original prevails.
Introduction
Mr. President of the Senate, senator Carlos Montes, honorable senators, ladies, gentlemen,
On behalf of the Board of the Central Bank of Chile (CBC), I am grateful for your invitation
Monetary Policy Report
to present the (IPoM). As usually in September of each year, this
coincides with the report that, according to the Organic Law of the CBC, we must submit
annually to the Senate. In compliance with this obligation, the Monetary Policy Report that
I will be summarizing in a moment contains our view of the recent macroeconomic and
financial developments in the Chilean and international economy, as well as their prospects
and implications for the conduct of monetary policy. It also includes the Bank's financial
results of the first half of 2018, the results of the management of international reserves and a
summary of the main decisions adopted by the Board this year to date.
Monetary Policy Report
The
Incoming data this year has been showing greater than expected economic growth, and
inflation consolidating its prospects of convergence to the target, in a context of positive
surprises in several areas, an upward revision of potential growth and a faster closing of the
activity gap.
Annual headline Consumer Price Index (CPI) inflation remains below 3%, although it has
sped up in recent months, reaching 2.7% in July. Core inflation, meanwhile, which excludes
the more volatile prices in the consumer basket (ie. food and energy), remains below 2%.
Both figures are in line with expectations.
Globally, the US-China trade conflict has intensified which, together with the cyclical state
of the US economy and its divergence from that of other developed economies, has led to a
global appreciation of the dollar and a fall in commodity prices. All this has affected hardest
the emerging economies that are perceived as the most vulnerable. For now, global growth
projections have had limited changes. In Chile, the exchange rate has again acted as a cushion
that has protected the local financial market.
The Board of the CBC has continued to apply a clearly expansionary monetary policy,
keeping the monetary policy interest rate (MPR) at 2.5% since May of last year. At
yesterday's monetary policy meeting we held the rate unchanged and announced that the
evolution of macroeconomic conditions makes it less necessary to maintain the current
monetary stimulus, so that if the current scenario continues, the rate should begin to fall in
the coming months. This will allow both headline and core inflation to converge to the target
during 2019.
Because the normalization process is expected to proceed gradually, it can be anticipated that
monetary policy will remain expansionary still for some time, probably making it the longest
period of continued monetary expansion since the adoption of the current monetary policy
regime. The CBC will be prepared to act countercyclically if downside risks materialize in
the external sector.
Let me now turn to the details of our baseline scenario and the related risks we see.
In the second quarter, economic activity grew 5.3% annually, giving an important upward
surprise with respect to June expectations (Figure 1). By sectors, the greatest differences were
observed in non-mining activity, particularly trade, business services and manufacturing.
Domestic demand also grew above expectations, reflecting a greater expansion of private
consumption, an increase in inventory build-up and more dynamic investment in machinery
and equipment.
This dynamism was largely maintained in July's monthly index of economic activity
(Imacec). The non-mining component of this indicator posted an annual increase of around
4%, while its mining counterpart dropped by nearly 2% annually, due to some one-off
adjustments in some operations.
About the labor market, for several quarters its recovery seemed to lag behind activity,
mainly because private salaried employment-which typically has a closer link with the
business cycle-was stagnant. This phenomenon was not entirely unexpected given that the
lags with which activity affects employment are variable, but anyway advised some caution
regarding the strength and durability of the economic recovery. In recent months we have
been reviewing this diagnosis. On the one hand, private salaried employment is increasing at
annual rates above 1%, something not seen for several quarters, and shows some dynamism
in important sectors, such as construction and trade. On the other hand, evidence has been
emerging that suggests that the effective growth of employment would be somewhat greater,
since the labor market has been able to absorb a significant influx of immigrant workers. This
figure is not yet captured by the employment surveys, which are based on population
projections that have not yet been updated according to the 2017 Census. This leads us to
evaluate that the lag we observed between employment and activity is beginning to dissipate
(Figure 2).
At the same time that private salaried employment has increased, the unemployment rate has
increased too, as exemplified by the figures from the National Statistics Institute (INE)
employment survey for the May-July moving quarter. This is so because during the phase of
low growth of 2015-2017 many people became self-employed, others worked fewer hours
than desired and others simply quit the labor market because they could not find what they
were looking for. In recent months, this process has been reversed, with the workforce
growing around 2.5%, more than the 1.5% of the period 2015-2017. It is important that in
the next few months the speed of job creation, especially salaried jobs, match and hopefully
surpass the workforce's growth.
Every September, the CBC revises its potential growth estimates. This concept refers to the
level of Gross Domestic Product (GDP) that is consistent with stable inflation around the
target and, therefore, it is adequate for measuring the activity gap associated with short-term
inflationary pressures. Along with this, from time to time we also make estimates of trend
growth, a concept that is related to the medium-term growth capacity of the economy. At
long terms, potential and trend growth rate converge to the same number; however, they tend
to diverge in the short term due to transitory factors that alter productive capacity, such as
temporary shocks to productivity and limitations to factor utilization.
On this occasion, our potential growth estimate has been revised upwards, which is to be
expected in a context of recovering investment, higher growth and still well-contained core
inflation. For 2018, the potential growth of non-mining GDP stands at 3.1%, which compares
with our 2.7% estimate a year ago. For 2019, the potential growth of non-mining GDP is
3.2% (2.9% a year ago). Trend growth remains within the 3% to 3.5% range estimated in
2017 and will be reviewed next year, once the updated demographic projections from the
Census are released. With this, potential and trend growth should converge sooner than
expected.
Growth accumulated up to the second quarter of the year-even considering the higher
potential growth-has narrowed the activity gap with respect to the forecast, and we estimate
that it is near zero in absolute level (Figure 3). We must bear in mind that the activity gap is
a non-observable variable, so calculating it will give an approximation that may vary over
time. Every now and then a re-estimation may yield important differences with previous
values, including different readings of its level and direction. A Box in our Report identifies
the elements that explain these adjustments and consider both the revision that is made to the
published data-until they are considered definitive-and the changes in the parameters and
estimation methods.
For this reason, we consider other antecedents to assess the state of the capacity gaps. They
all coincide that slack has been reduced but suggest that they still persist to some degree. For
example, installed capacity utilization indicators continue to show space and core inflation
has remained below 2% over the last year. On the other hand, the labor market may contain
additional degrees of slack due to migrant inflows and increased labor participation of women
and elderly workers. All considered, we evaluate that the inflationary pressures are consistent
with the convergence of inflation to the target under our working assumption for the MPR.
The behavior of economic activity in the first half and underlying factors lead to an upward
revision of the GDP estimate for 2018. In the baseline scenario of this Report, GDP will
increase between 4% and 4.5% this year, which compares with the 3.25% to 4% range we
estimated in June. This is consistent with lower 12-month growth rates in the second half,
which respond largely to a tighter comparison base. For 2019 and 2020, the forecast ranges
are similar to those considered in June. Thus, GDP will grow between 3.25% and 4.25% next
year, and between 2.75% and 3.75% in 2020 (Figure 4). The lower growth expected in 2020
stems from the economy closing the gaps somewhat faster than expected and, therefore,
growing around potential. Moreover, the impulse from abroad will contribute somewhat less
growth at that horizon.
These projections represent a somewhat less favorable external scenario than in the previous
Report, an MPR that will remain below its neutral level for several more quarters, investment
outgrowing GDP, no major macroeconomic imbalances and the economy growing around its
trend trajectory towards 2020.
Compared with June's Report, the baseline scenario adjusts the gross fixed capital formation
(GFCF) of 2018 upwards but maintains the same gradual reduction in its expansion rates
over the rest of the projection horizon. On the consumption side, we expect private
consumption to grow at a similar pace as GDP during 2018, 2019 and 2020. This assumes
that the durable component-largely its imported part-will decelerate from the first half of
the year, affected by the depreciation of the peso. The support that household spending
receives in the baseline scenario from the recovery of the labor market should help offset this
effect (Figure 5).
One positive recent surprise has been the greater dynamism of investment, especially in
machinery and equipment, which outperforms GDP growth in our projections for the period
2018-2020. The greater contribution that is foreseen for mining investment stands out, in line
with the near 40% growth that it showed in the first quarter of this year. The new five-year
plan announced by Codelco is added as background. In any case, generating conditions for
the development of larger projects remains a challenge if we are to sustain high growth rates.
This is especially relevant if one considers that the observed and projected currency
depreciation in the baseline scenario will reduce spending on tradable goods, and that an
important part of this greater investment is explained by capital replacement needs. On the
construction side, activity shows more limited dynamism. With this, GFCF as a percentage
of GDP-in both nominal and real terms-will reach 21.7% this year and will border 22%
next year (Table 1).
Regarding fiscal policy, our working assumption is that in 2018 the economy will receive a
fiscal impulse consistent with the current budget. From then on, we assume that the structural
deficit will follow the path of gradual reduction defined by the authority.
Although the CBC is an independent organization and does not coordinate its monetary
policy decisions with the government, it does need to anticipate the evolution of the fiscal
position as part of the macro framework within which it makes its decisions. The operation
of a structural rule and the establishment of a path with annual goals for it helps to provide
more certainty to the formulation of monetary policy, while allowing the budget's automatic
stabilizers to operate, letting monetary policy assume the main countercyclical role.
In the projections I have just presented, we estimate that the impulse the Chilean economy
will receive from abroad will fall somewhat short of our June estimates, particularly because
of lower terms of trade. In recent weeks, copper has approached its long-term levels faster
than we thought. Therefore, our projections are down from June, to US$2.95 per pound this
year, 2.85 in 2019 and 2.8 in 2020. For its part, the oil price has moved kind of erratically,
but is still above the prices of the beginning of the year. Going forward, in our baseline
scenario a downward trajectory is still considered, in line with market price futures. With
this, the terms of trade will post a decrease of 1.2% this year, not the slight rise we expected
in June. In 2019 and 2020, they will decline further.
Regarding financial conditions, in the developed world the divergence of their monetary
policies persists, because of dissimilar evaluations of capacity gaps and the inflationary
pressures that each face. While the Fed raised the fed funds rate by 25 basis points in June
and has signaled two more increases this year and three the next-while continuing to
downsize of its balance sheet-the European Central Bank extended its asset purchasing
program and signaled that the benchmark rates will stay put for a while.
The trade dispute between the US and China has continued to escalate. So far, the tariffs
applied by the US and the reprisals have been limited, but the conflict has not subsided, and
the measures adopted are already having an impact on risk perceptions, and the markets are
more sensitive to them. As detailed in a Box in this Report, the effects that these measures
may have on the global economy are difficult to quantify, as they depend on the number of
countries that would be directly and indirectly involved, the amounts levied, the sectors
affected and the time during which the higher tariffs would be applied. However, there are
some qualitative dimensions and certain transmission channels common to the different
possible scenarios. For the economies directly involved, there would be a negative impact
due to lower external demand and greater uncertainty, which would affect local consumption
and investment decisions. The size of the impact is related to the importance of trade among
those directly involved and their ability to divert it to other economies. In China, for example,
the share of its exports to the US in terms of the growth of its overall economy has fallen by
half (Figure 6).
In any case, we must consider that certain automatic stabilizers are at play. For example, the
reduction in external demand induces a depreciation of the currency of the economy facing
higher tariffs, making its products relatively more competitive. Conversely, in the economy
imposing the tariffs, an appreciation of the currency should be observed. Except if this
appreciation compensates the increase in tariffs, the higher prices of imported goods would
temporarily push inflation up. In the case of the US, this greater pressure of imported costs
would be added to the scarce gaps that the economy already presents, which could lead to
greater current-account imbalances, higher inflation and additional pressures to speed up the
pace of monetary normalization.
Special attention deserves the effects on financial markets and asset prices, especially in
circumstances where the Fed continues to progress in normalizing its monetary policy. The
uncertainty associated with the trade conflict contributes to reducing risk appetite, making
capital flow out of emerging economies. So far, this adjustment has been selective and major
effects have materialized in only a few vulnerable economies. For an economy with good
fundamentals, such as Chile, one possible risk comes from a synchronized adjustment of
emerging economies' asset prices, as it happened in the late 1990s or during the Global
Financial Crisis. A scenario of greater uncertainty, tight financial conditions and an
appreciated dollar is particularly negative for the prices of commodities, especially copper.
Fears about the effects of the trade war have been heightened by the further moderation of
China's economic activity figures. The Chinese authorities again intensified fiscal and
monetary stimuli, reversing some of the measures adopted during 2017 to limit indebtedness
and promote more balanced growth. About the monetary stance, its Central Bank has led
interest rates downward and granted liquidity to the banking market by cutting reserve
requirements twice during 2018. In turn, it has allowed the currency to depreciate-close to
10% since March-without major interventions, partially offsetting the higher tariffs on
Chinese goods. At the fiscal level, they have relaxed the limits of indebtedness of local
governments, allowing them to issue debt at lower interest rates and eliminating restrictions
on public-private partnerships with the aim of stimulating investment in infrastructure. Tax
reductions have also been applied to companies and households for an amount of roughly
1.3% of GDP and the easing of environmental constraints, which already resulted in a
rebound in industrial production during the first quarter.
How much room do the Chinese authorities have to further stimulate demand? One doubt
refers to their level of indebtedness, which is three times their GDP, too high for an emerging
economy, and originated in a poorly regulated segment of the financial industry. The same
is true of their fiscal side, with a deficit that is high and would grow more if local governments
were included. Finally, in a currency scheme that is still relatively rigid, expectations of a
greater depreciation of the currency could trigger capital outflows, which in the past have
caused significant losses of international reserves. Although some of these risks look less
pressing than they did a couple of years ago, additional doses of stimulus applied to an
economy that has accumulated imbalances, in a more uncertain context and with more
stringent financial conditions, amplify the risks in medium-term horizons.
The effects of such a scenario could be brought home in Chile through several channels. An
escalation of the conflict would certainly threaten our trading partners' growth, particularly
China, by increasing medium-term risks, beyond the particular effects it may have on specific
exporting sectors of our economy-depending on whether its products are complements or
substitutes of the taxed products. It could also deteriorate financial conditions significantly
in the emerging world. In addition, it could pull the price of copper below its long-term level.
This external framework would worsen the terms of trade, depreciate the peso and lower
prospects for growth, especially due to a downward adjustment in investment. The effects on
inflation are not entirely evident. A depreciation would generate short-term upward
pressures, while lower growth would widen the gap, generating disinflationary pressures in
the medium term, a horizon that is more relevant to the calibration of the monetary impulse.
The appropriate monetary policy response to this scenario depends largely on the magnitude
and relative persistence of these shocks and their impact on inflation expectations. In any
case, the Chilean economy has an economic policy framework that allows it to absorb
external shocks and reduce their negative effects, particularly a flexible exchange rate and a
monetary policy regime that, being based on a two-year inflation target, can act
countercyclically.
In the current external picture, those economies perceived as having weaker macroeconomic
fundamentals may undergo abrupt changes in the financial conditions they face. The recent
experience of Argentina and Turkey are good examples of this. In particular, the currencies
of these countries have lost more than a third of their value in the last month and a half. Both
economies share high inflation, monetary policy making with less credible targets, in a still
highly dollarized economy and a fragile external position, resulting from a high
currentaccount deficit and limited reserves. One Argentina-specific vulnerability is its high fiscal
deficit at 6% of GDP in 2017, which is difficult to contain with a public debt denominated in
dollars that exceeds 30% of GDP and whose service becomes complex in the current
circumstances. Turkey, for its part, became highly dependent on external financing to sustain
growth above its potential for several years. By 2019, the overall Turkish economy's needs
are estimated to approach 30% of GDP.
In Chile, the biggest reaction has come from the nominal exchange rate, while long-term
interest rates have not been affected. At the statistical close of this Report (28 August), the
peso/dollar parity was somewhat above CLP660, 5.5% higher than at the close of the
previous Report. In the days that followed the peso has depreciated further vis-à-vis the
dollar. However, in multilateral terms the depreciation has been milder, even with an
appreciation against other emerging and commodity exporters' currencies, reflecting the
greater relative strength of the Chilean economy. The real depreciation of the peso has been
lower (near 1% since the previous Report). As a working assumption, the baseline scenario
of this Report continues to assume that, in the course of the policy horizon, the real exchange
rate will go back to its averages of the last fifteen to twenty years (Figure 7).
As for domestic credit, local financial conditions are still good, in line with the ongoing
expansionary stance of monetary policy. Accordingly, the interest rates of many segments
stayed low and credit growth remained limited. However, it is worth mentioning that
commercial rates increased again, in a context where qualitative indicators report increased
demand and more accommodating supply (Figure 8).
For the moment, the higher risk perception has translated into a limited revision to global
growth prospects, with decelerating growth rates in 2019 and 2020. By blocs, the outlook for
developed countries does not differ from that in the June Monetary Policy Report. Instead,
in the emerging countries the downward adjustment in Latin America stands out, especially
Argentina and Brazil. Add the expected slowdown in China (Table 2).
As I said at the beginning, the annual variation of the Consumer Price Index excluding Food
and Energy (CPIEFE)-our measure of core inflation that deletes the prices of food and
energy from the CPI-has remained below 2%, with annual inflation still negative for goods
and persistently around 3% for services. The CPI has approached 3%, mainly driven by the
behavior of the more volatile prices (Figure 9).
The peso depreciation has an effect on the revision of the short-term inflation outlook. By
the end of this year, the annual variation of the CPIEFE is forecast to be at 2.7% (2.3% in
June) and that of the CPI, at 3.1% (2.8% in June). Once both indicators converge to 3%
during 2019, they will remain in the neighborhood until the end of the projection horizon
(Figure 10). It is very likely that in September the annual CPI inflation rate will be
temporarily above 3%, because of the low basis for comparison left by the unusual behavior
of some foodstuffs in 2017.
Regarding monetary policy, we think that the evolution of macroeconomic conditions makes
it less necessary to maintain the current monetary stimulus. Therefore, our working
assumption for the MPR is that it will begin to increase in the coming months and by 2020 it
will stand near its neutral level-ie. between 4% and 4.5%. This assumption is not essentially
different from the forecast a few months ago, as it implies gradual increases in the policy rate
associated with the recovery of the domestic economy. However, the fact that the figures
confirm that the economy is expanding with relative strength for several quarters already,
makes the start of the normalization process more imminent.
As always, this trajectory does not mean a commitment, as it is conditional on the
materialization of the baseline scenario outlined here. New information modifying the
projected inflation trajectory will entail changes in monetary policy implementation.
I wish to emphasize how important the work of monetary policy in recent years has been. As
from 2013, we are facing a scenario of less favorable external conditions and where our
economy has lost dynamism. A significant depreciation of the peso put pressure on inflation
pushing it above 4%. The inflation-targeting scheme that guides our monetary policy and the
credibility that the CBC has gained allowed us to think prospectively and apply a highly
expansionary monetary policy to mitigate the lost dynamism of domestic and foreign demand
and thus ensure that inflation would converge to 3 % within two years. Today, almost five
years into the process, the evolution of macroeconomic conditions indicates that, finally, the
economy no longer needs such an expansionary monetary stance, which is very good news,
no doubt.
As usual, there are internal and external elements that could modify these projections. From
the point of view of its impact on local activity, the balance of risks in the external scenario
remains biased downward. The main risk continues to be an abrupt deterioration of financial
conditions facing emerging economies, especially because markets seem to be more reactive
to negative news. In this area, what happens in the US is still relevant, in terms of both the
evolution of inflation and its outlook and the unfolding of the trade conflict. This situation
has revived the fears about China, especially the risks implicit in the imbalances it maintains
in several of its markets. In Europe, among other issues, the uncertainty surrounding Brexit
is cause for concern.
In the context of normalizing global financial conditions, investors have drawn a line between
the emerging economies they perceive as more vulnerable and those with more solid
fundamentals. Chile meets the current situation with good macroeconomic indicators in terms
of growth, inflation and the balance of its fiscal and external accounts. Moreover, our floating
exchange rate makes it possible to cushion external shocks, and the monetary policy
framework permits us to act countercyclically. This is feasible due to the low exposure to
interest rate and exchange rate risks by the main economic agents.
On financial matters, one issue drawing attention in this conjuncture is the external debt. The
Box in this Report, entitled "Financial Volatility and External Debt", provides an in-depth
analysis of this issue, particularly with regard to corporate debt. This analysis concludes that
the risks of refinancing and exchange rate volatility for companies are limited, either because
of the type of creditor (matrices of foreign investors), loan maturities or the absence of
significant currency mismatches. Additionally, it should be kept in mind that an important
part of the group of companies that report to the Financial Market Commission have
investments abroad that are financed with debt taken in Chile. Therefore, analyzing Chile's
external debt as a proportion of GDP can be distorting, because part of the added value is
produced outside the country. Using of financial indicators such as assets and net worth is
more recommended for a financially more integrated economy such as Chile and a modern
productive sector (Figure 11).
And, the flexible exchange rate plays a role in cushioning external shocks in Chile, unlike
other emerging countries, precisely because both the corporate and the financial sectors have
adequate hedging-and are monitored by their respective regulators on a permanent basis. In
fact, since the adoption of exchange rate flexibility in 1999, the Chilean economy has lived
through several periods of significant peso depreciation, like in 2008, 2013 and 2015, without
causing any problems of mismatching in the corporate sector with dollar-denominated debt.
In this way, our inflation-targeting monetary policy framework, floating exchange rate and
deep financial markets are the key pillars of our country's macroeconomic design. In any
case, the bias and probabilities of external risk scenarios reinforce the need for a small and
open economy such as Chile to maintain deep-rooted macroeconomic foundations,
particularly a path of fiscal consolidation, sustainable debt levels and adequate capitalization
of the country's banking system.
At home, we estimate that the risks to activity are unbiased. The economy has brought
positive surprises in good measure because the possibility of a more dynamic behavior of
investment identified in previous reports has materialized, short only of a more significant
response from large-scale projects and the real estate sector. For its part, although the labor
market could take a little longer than expected to recover, the latest data tend to provide
greater robustness to the employment, wage bill and consumption projections.
As for inflation, we estimate that the risks are unbiased. Although the risks in the international
scenario and their negative implications have increased, the economy has shown more
dynamism than expected and the short-term outlook for headline inflation has been corrected
upwards. In this context, we consider that the current level of monetary stimulus is less
necessary and may begin to withdraw it in the coming months. Thus, we reaffirm our
commitment to conduct monetary policy with flexibility, so that projected inflation stands at
3% over the two-year horizon.
Institutional advances and challenges
As I pointed out at the beginning, this presentation to the full Senate has a special connotation.
Indeed, the Constitutional Organic Act mandates the CBC Board to present at this time of
the year an evaluation of the progress of the policies and programs of the current year, a
report of those proposed for the following calendar year, the overall economic projections
that sustain them, and a recount of the factors that can affect its balance sheet. In other words,
it is not just about presenting the Monetary Policy Report, but a more complete account about
the evolution of our institution.
However, today I wish to go beyond the usual institutional account. I would like in particular
to recount the content and progress of the Bank's Strategic Plan that I anticipated on this
same venue last year, as well as share some additional steps that we intend to take on the
issue of institutional transparency.
Our Strategic Plan 2018-2022 was prepared during the better part of last year and is currently
in full implementation. Although this type of exercise was not new to our institution, this
time it relied on an extensive process of external consultations, gathering of relevant
information and internal deliberation unprecedented in the CBC, which is very innovative
for the central banking community in general. This exercise was completed at the end of 2017
with the approval of the Plan. Below I summarize its main contents and advances.
This Strategic Plan 2018-2022 updated the basic definitions of the CBC's institutional
mission and vision. The latter in particular is defined as "being a reliable institution because
of its technical nature and excellence in achieving the mandated objectives." This expresses
the need for the CBC to be prepared to respond to the opportunities and challenges that are
presented to it at the macroeconomic and institutional level, in the understanding that in
today's world and society the citizens' and markets' confidence have to be earned day by
day, beyond our past achievements.
Based on these definitions, the plan identifies five areas of priority:

Maintain intellectual leadership in the areas related to the institutional
mandates of the CBC;

Strengthen the understanding and dialogue of the organization with its
environment;
 Strengthen its corporate governance to balance out risk tolerance and the
efficiency of its business processes;

Improve ability to understand and incorporate technological changes into its
tasks; and

Consolidate the CBC as an employer of excellence, capable of attracting and
engaging the best talent.
Accordingly, twenty-one lines of action were defined that will be developed over this
fiveyear period, all of them d