MONETARY POLICY REPORT
BEFORE THE
PRESENTATION
COMMISSION OF THE OF THE
FINANCE HONORABLE SENATE
REPUBLIC
Mario Marcel
Governor
Central Bank of Chile
10 June 2019
I. Introduction
Mr President of the Senate's Finance Commission, senator Ricardo Lagos-Weber, Senators members of this
Commission, ladies, gentlemen,
I am grateful for your invitation to present the vision of the Board of the Central Bank of Chile on recent
macroeconomic developments, outlook and monetary policy implications. This vision is detailed in our June
2019 Monetary Policy Report released this morning. Its contents also provide the background for the decision
adopted by the Board in its monetary policy meeting of last Friday.
There we decided unanimously to reduce the Monetary Policy Rate (MPR) by 50 basis points, taking it to 2.5%.
Key in this decision was our evaluation that the monetary policy had to be recalibrated, because the delivered
impulse was not enough to ensure the timely convergence of inflation to the 3% target in light of the new CPI
figures and the new estimates for the activity gap and the neutral monetary policy rate.
The vision that the macroeconomic scenario could need a different monetary impulse began to be forged in the
Monetary Policy
March Report, when the measurement of inflation with the new Consumer Price Index (CPI)
showed us an increase in prices significantly smaller tan with the previous figures, postponing for about a year
its convergence to the 3% target. As you will recall from the presentation we made on that occasion, we linked
lower inflation to the possibility of greater capacity gaps as a result of the massive immigration of recent years,
and to a lower pass-through from exchange rate variations to prices.
When presenting that diagnosis, we said that the lower inflation as measured by the new CPI had implications
for monetary policy, so we halted the normalization process that we had started in late last year. In addition, in
order to fine-tune the diagnosis, we decided to advance to June the updating of the structural parameters-i.e.
trend GDP, potential GDP and the neutral monetary policy rate. Then, at our May Monetary Policy Meeting,
we discussed the option of reducing the MPR, advancing that such an adjustment would be justified in case of
a significant widening of the gaps, or a lesser dynamism of the economy, a worsening of external conditions
and/or a lower neutral MPR.
At last Friday's meeting we verified that all these conditions have been met. First, estimates of trend and
potential economic growth have increased as a result of immigration, which translates into greater capacity
gaps. Second, the neutral MPR is lower, partly because of the fall in the estimated neutral rates in the main
economies. Third, in recent months, the dynamism of the economy has been below potential growth, helping to
widen the activity gap. Finally, the external scenario has deteriorated, mainly because the balance of risks has
become more negative.
After considering these elements and the prospects for the economic scenario, the right move was to reduce the
MPR. I believe it is important to stress that this decision is based on an important analytical effort of the Bank,
backed by the search for more evidence and capacity to identify structural phenomena that affect the Chilean
economy. This is the conclusion of an announced and documented process, which required a rigorous
development before materializing in a change of the MPR, because monetary policy cannot be conducted on
the basis of intuitions or perceptions.
We have characterized this exercise as a monetary policy recalibration because it is largely derived from an
update of the structural parameters that serve to characterize the macroeconomic situation and inform the policy
rate decision. This translates into a one-time adjustment of the rate, whose exceptionality is reinforced by the
unusual combination of changes in the parameters, including the new measurement of inflation.
However, we must make it clear that this does not mean ignoring the recent performance of the economy. On
the contrary, the effective growth rate of recent months is weaker when compared with a higher trend growth.
Similarly, recalibrating the MPR does not mean that it cannot be adjusted in the future in the face of changes in
the macroeconomic environment: rather it will allow for an adequate response to said changes to be evaluated
on their own merits, without mistaking them for the factors that justified this adjustment.
Going forward, activity will grow above potential over the next two years and inflation will converge to 3%
during 2020. The beginning of the MPR normalization will depend on our conviction that inflation is in a clear
process of convergence to 3%. Especially important for this evaluation will be the way the labor market absorbs
the strong immigration flow, the response of investment and external developments. At the same time, there are
important risks around these projections.
Let me now describe this scenario and associated risks.
II. Macroeconomic scenario
II.1. Recent evolution of activity and inflation
In the first quarter this year, activity grew 1.6% annually, which combined a 3.6% fall in the mining sector and
a 2.2% increase in the non-mining sectors (Figure 1). The high basis for comparison of the same period in 2018
anticipated that first-quarter growth this year would underperform that of 2018, but the result was lower than
expected. This combined the negative performance of mining-affected by climatic factors, downtime at some
mines and the lower ore-and several of the more volatile sectors-linked to natural resources-of non-mining
GDP. In particular, the worse-than-expected performance of agriculture, fishing, and electricity, gas and water
stood out.
Most of the non-mining sectors whose activity is more related to demand behaved in line with expectations,
particularly construction and services. One exception was the export industry, which combined high bases for
comparison, weak demand from its target markets-mainly Latin America-and stronger competition abroad.
On the demand side, the main changes in the first quarter were the slowdown in investment in machinery and
equipment and in exports (Figure 2). This coincides with the deterioration of the external scenario in recent
quarters and an inventory buildup that has not been undone as expected. On the other hand, investment in
construction and other works and consumption evolved as expected, without major changes compared to the
previous quarters. All in a context where various indicators show an increase in job creation.
Headline inflation as measured by the CPI and core inflation (CPI excluding food and energy, CPIEFE) continue
near 2% per year. In the case of the CPI, with a level that has increased somewhat in the most recent past (Figure
Report
3). In any case, the same phenomena identified in the March are still present: greater competition in
certain markets, wider capacity gaps than previously estimated and lower pass-through of the accumulated peso
depreciation than its historical averages.
II.2. Updating the structural parameters
As I just said, in this Report we have updated the estimates of the structural parameters that are used to assess
the state of the economy, its outlook and the calibration of monetary policy. This allowed mainly to quantify
the effect of the massive immigration flow of recent years on trend and potential growth, increasing both. It
was also possible to compare the impact on the neutral MPR of a higher trend growth with that of the fall in
international interest rates.
Before I dive into the detail of the estimates, I would like to make a couple of precisions regarding the concepts
of trend and potential GDP. In the first place, it is evident that estimating the growth capacity of an economy is
very important when defining monetary policy and macroeconomic policies in general. In fact, not only the
Central Bank estimates trend growth, but also the Ministry of Finance to calculate the structural income of the
Treasury. In our case, we estimate two concepts: trend GDP and potential GDP. The first has to do with the
medium-term growth capacity of the economy, while the second refers to the level of GDP consistent with
stable inflation and, therefore, is adequate to measure the activity gap associated with short-term inflationary
pressures. Although in the long term the potential and trend growth rates converge to the same number, in the
short term there are transitory elements-such as temporary shocks to productivity and restrictions in the use
of factors-that alter the productive capacity and cause differences between the two. Hence the importance of
analyzing them separately (Figure 4).
II.3. Trend GDP
The updating of our trend growth estimate-which dated back to 2017-had the purpose of measuring the
effects of the considerable immigration flow of recent years on the country's medium- and long-term growth
capacity.
A box in the Report identifies episodes of significant immigration flows into other economies. Although each
case is, in some sense, unique, and international experiences are not easily transferable, its analysis provides
some useful background to understand the Chilean case. The first is to confirm the exceptional nature of the
Chilean experience, due to its size and speed. In addition, given the factors that motivate migration-
particularly from Venezuela-one can think that it will not be reversed any time soon. Secondly, recent
immigration is characterized by an average population that is more qualified, younger and with a greater labor
participation than the Chilean population. Third, relative to other countries, Chile poses fewer legal
impediments to enter the labor market, and unlike other migratory cases, shares the language and other cultural
aspects with a majority fraction of the immigrant population.
To update our trend growth estimate, we use the population projections for the period 1992-2050, published by
the National Statistics Institute (INE) at the end of 2018. These reflect the significant immigration flow observed
since 2015, which is expected to continue to be important in the coming years (Figure 5). This affects the
projection of the labor factor and, through it, the growth capacity of the economy. The other forecasting
assumptions do not undergo major changes with respect to the fiscal year of 2017, except for the updating of
the Quarterly National Accounts figures and an explicit modeling of the way in which capital and total factor
productivity respond to the immigration-related increase in the labor factor.
Despite the importance of the labor force increase, its impact on trend growth is not immediate or transmitted
one for one. The economy must undergo a process of adjustment while the sharp increase in the supply of labor
is completely absorbed, so that new workers are placed in positions that match their skills. The international
experience is not conclusive regarding the duration of this transition, because, as I mentioned, the characteristics
of the migratory processes have been very different. In any case, it can be expected that as the immigration flow
is accommodated, a gradual increase in capital accumulation and productivity will be observed.
Thus, we estimate that the trend growth of the Chilean economy is between 3.25% and 3.75% for the period
2019-2028 (Table 1). This estimate compares with the 3.0% to 3.5% range that we considered before. It is
important to note that the use of a range reflects the uncertainty regarding several of the factors that have been
mentioned. In particular, this projection considers that the total factor productivity of the non-mining sector will
grow 1% in the next ten years. However, there is uncertainty in light of this variable's volatility of recent years.
II.4. Potential GDP
The updating of trend GDP is important for determining the potential GDP of the economy. Regarding the
latter, we estimate that in the period 2019-2021 it will be around 3.4% (around 3.2% was the previous estimate),
somewhat below its trend growth (Table 2). In this judgment, the initial fall in productivity is combined with
the increase in the labor force and the expected lags in the adequacy of the capital stock in response to this
phenomenon.
The updating of potential growth, together with the performance of the economy in the first quarter, drive the
activity gap level (-0.7 percentage points) to be wider than previously considered (Figure 6). It is important to
note that, with respect to last December, the estimated level of the activity gap is greater in the beginning-the
first quarter of 2019-, but also throughout the projection horizon. Although first-quarter activity figures play
a role in the former, in the latter the fundamental factor is the potential growth update. The baseline scenario
assumes that the gap will gradually close along the projection horizon, although at a slower pace than previously
expected due to the magnitude of the adaptation process that the economy will have to go through in the face
of the migratory shock.
II.5. The neutral MPR
About the neutral policy rate, I think a couple of conceptual clarifications are in order. The neutral MPR is
defined as the rate that is consistent with a GDP in its equilibrium (trend) level and an inflation rate in the 3%
target. All this, once the effects of transitory shocks in the economy have dissipated. For this reason, the neutral
MPR is inherently associated with the long term, while the effective MPR gradually converges, in the absence
of further disturbances moving the economy away from its trend level. Hence, the neutral MPR to which we
refer is understood as a trend neutral rate. For operational effects, monetary policy is considered expansionary
whenever the actual MPR is below the neutral MPR, and contractionary the other way around, i.e., the actual
MPR is higher than the neutral MPR. This is why keeping an updated estimate of this measure of neutral interest
rate is relevant for both monetary policy implementation and communication of future orientation.
In the past few years we have seen several developments in the macroeconomic scenario that could have
affected the level of the neutral MPR. Among them, we can mention the fall of external interest rates and the
higher growth of both trend and potential GDP driven by the massive immigration of recent years I just
mentioned. Moreover, the Bank has developed and expanded the use of new methodologies to estimate the
neutral rate, following the practice of other central banks and the need to reconcile the different changes
presented by the economy.
Our set of estimates yields neutral interest rates of the order of 1% in real terms. Taking into account the range
of values and the uncertainty surrounding this calculation, we consider that the neutral MPR lies within the 3.75
to 4.25% range, that is, 25 basis points below the range we expected until March, partly reflecting the drop in
interest rates around the globe (Figure 7).
III. Baseline projection scenario
The convergence of inflation to the 3% target is subject to a baseline projection scenario that features the
following characteristics.
III.1. Activity and demand
On one hand, as I mentioned, it considers that the activity gap will close throughout the projection horizon, a
period in which the economy will accumulate growth above its potential. This is consistent with GDP growing
in 2019 between 2.75% and 3.5%. This range is below the range we expected in March, mainly reflecting the
effects of the negative surprise of activity in the first quarter. Actually, this projection assumes that the economy
will resume higher rates of annual expansion in the second half of this year. For 2020 and 2021, higher growth
rates are foreseen, between 3% and 4% in both years (Table 3).
On the expenditure side, compared with March, the biggest adjustments are seen in gross fixed capital formation
(GFCF), a component that, instead of growing 6.2% this year as projected, will grow only 4.5%. This revision
owes to a great extent to the poor first-quarter performance of the machinery and equipment component. This
weakness has continued, according to partial second-quarter data. It must be noted that this occurs in the context
of high inventory buildup towards the end of 2018 and the increased uncertainty surrounding the external
scenario.
In any case, the other part of investment-construction and other works-has remained dynamic and forward
going forward signs are still positive. On one hand, related stock market data point to a favorable development.
On the other, the large-scale investment projects that are currently in progress-especially in mining-do not
register delays and have been unfolding according to plan. Along the same lines, the various surveys of
investment projects have not seen any downward and continue to foresee larger amounts for 2019-2020,
compared with the amounts invested in the period 2017-2018 (Figure 8).
Turning to concessions, the authorities have announced a significant increase in them as from 2020, in particular
in hospitals, roads and airports. Add to this the announced approval of a set of complementary works that will
Association of Engineering Consulting Firms
be executed in 2019 and 2020. The information of the (AIC) for
the first quarter of 2019 shows that detail engineering-which covers projects scheduled for one or two years
ahead-shows high annual growth rates. In terms of housing investment, although it began the year with a zero
contribution to construction GDP, sales remain high and the outlook reflected in the May Business Perceptions
Report is positive. In any case, the Monthly Entrepreneurs Confidence Index (IMCE) for the construction sector
posted a decline most recently but is still higher tan its all-time average.
In the medium term, various elements suggest that investment will regain strength. For the time being, the lower
basis for comparison that the adjustment will leave in its 2019 growth will help to raise the 2020 record, the
year for which the baseline scenario estimates a 5.1% growth in GFCF. The capital-to-GDP ratio has remained
low in recent years (under 22% in real terms), with productive investment-excluding mining and housing-
that practically grew zero in the 2016-2018 period. Plus, that the strong immigration of recent years reduced
the capital/labor ratio. Absorbing this greater workforce requires adjusting the capital stock, so that, absent a
more significant change in the vision about productivity, and/or the various costs associated with the formalities
of investment projects, it should resume its former dynamism.
The domestic conditions to finance this greater investment are favorable: local interest rates have remained low
(Figure 9), something that will be reinforced with the decision of the last Monetary Policy Meeting. In the same
way, external financing conditions have remained favorable and, in fact, the interest rates of US Treasury bonds
are also low. All this occurs in a context of no imbalances in the local financial system, no elements hindering
the flow of financing, and a bounded fiscal deficit.
All in all, the first-quarter evolution of investment puts a note of caution in case the slowdown proves more
persistent, especially because of the higher uncertainty abroad. For now, this has reduced asset prices and, with
it, the incentives to invest. There is also the currency depreciation that could reduce the acquisition of imported
capital goods imports. The behavior of inventories also poses a risk on the dynamics of investment. Already by
the end of 2018 there had been an inventory buildup that at the time was believed would turn into investment,
but that did not happen and, on the contrary, in the first quarter accumulated further. This, in a context in which,
according to the IMCE, the percentage of respondents in wholesale trade who judge their inventories as
unwanted has risen, and in which the interviewees for the Business Perceptions Report in companies that trade
in machinery and equipment report sales below expectations, particularly in the northernmost regions.
Consumption, meanwhile, has behaved as expected and the baseline scenario estimates that, after growing 3.1%
in 2019, will grow an average of 3.5% in the next two years. Accordingly, the projection for this expenditure
component remains virtually unchanged from the March Report estimates. The higher growth rates foreseen for
2020 and 2021 are consistent with the economy speeding up growth.
The labor market has given more positive signals regarding employment, as can be seen from in the INE figures,
the administrative records and the information obtained for the Business Perceptions Report. Imports of
consumer goods have remained high (with the exception of automobiles) and the expectations of the trade sector
remain optimistic, as indicated by the IMCE. All of this in a context in which financial conditions remain
favorable, due to both the persistence of low interest rates and good credit lending conditions.
It is important to warn against the temptation of trying to extract information on the behavior of private
consumption from indicators of retail activity. Although this practice can provide some information, there are
differences between both variables that confuse the reading. First, consumption is a component of demand,
while retail is a part of GDP, so they differ in their measurement, magnitude and components. Second, retail
sales indicators are one of the sources on which household consumption is calculated in the National Accounts.
However, formal retail trade represents only 15% of private consumption. Third, the consumption of goods
must be added up to the consumption of all services (domestic and foreign acquired), which are almost half of
household consumption and are not captured in retail sales indicators. Finally, when it comes to making the
GDP retail figures compatible with consumption, we must keep in mind that this retail includes not only retail
(related to household consumption) but also wholesale (related to companies). All this recommends using retail
data with caution, given the important differences between this sector's activity and private consumption.
III.2. International scenario
Internationally, in the baseline scenario, the impulse that the Chilean economy will receive from abroad in the
next two years will be lower than in the two previous years and the one we expected in March. The correction
with respect to March responds to the negative developments in the external scenario in recent weeks,
particularly as the escalation of the trade conflict has led to greater risk aversion, causing, among other effects,
a global appreciation of the dollar and a reduction in most commodity prices, including copper. The latter is
especially relevant due to its effect on the terms of trade (ToT). Thus, for the period 2019-2021 we assume that
the ToT will accumulate an increase of 0.6%, which compares with the increase of 1% expected in March
(Figure 10). This projection considers a copper price whose annual averages will be closer to 280 cents per
pound between 2019 and 2021, and not around 290 cents per pound, as we estimated in March.
As for global growth, the baseline scenario adjusts slightly the expected expansion of our trading partners during
this year, to 3.2% (3.3% in March). In this correction, a much lower performance of Latin America becomes
important. We still estimate that China will grow around 6% and the US somewhat above 2% (table 4).
Although our trading partners' growth is adjusted only slightly, there has been a marked deterioration in world
trade growth, which is captured in the less favorable evolution that is expected for Chilean exports (Figure 11).
In the baseline scenario, we project that these will lose dynamism, particularly in 2019, due to the difficulties
encountered by some exporting sectors. Also because of the lower copper output, which will impact metal
shipments. Within imports, the downward adjustment of consumer goods stands out, in response to the
performance of car sales in the local market, but also to the decrease in the purchase of machinery and equipment
(specifically trucks), which is estimated to continue beyond the first quarter. This is reflected in the current
account, which will have deficits of somewhat under 3% of GDP in the projection horizon.
III.3. Working assumptions
The baseline projection scenario is made using a set of information and analysis that determine how inflation
will converge to the target. This includes the expected behavior of the activity gap-which factors in potential
and actual growth-, the copper price, the oil price, the dollar in the world, etcetera.
The baseline scenario also includes working assumptions for variables such as the real exchange rate, the
behavior of fiscal policy and the MPR. In particular, with respect to the real exchange rate, we foresee that
during the next two years it will fluctuate around its averages of the last 15 and 20 years. In the fiscal area, it is
assumed that in 2019 the economy will receive a boost consistent with the approved budget. From then onwards,
it is assumed that the structural deficit will follow the path of gradual descent defined by the authority. No
modifications are introduced as a result of the recent announcements to streamline public investments given
that, according to authorities' statements, these will be made within the limits imposed by the structural balance
target. This is notwithstanding a more intense operation of automatic stabilizers as a result of divergences in
the behavior of cyclical revenues.
About the MPR, the working assumption is that in the coming quarters it will stay flat and will begin a gradual
normalization process during next year. Nonetheless, this is one of several alternative MPR paths compatible
with achieving the target, so it must not be construed as a forecast or commitment with respect to the decisions
that the Board will be making as more information is gleaned about the twists and turns of the economy.
Taking all of this into account, the baseline scenario sees CPI inflation hovering around 3% during 2020, and
the CPIEFE arriving to 3% by the turn of 2021. For the end of this year CPI inflation is foreseen slightly below
3% (Figure 12).
III.4. Risk balance
As always, the baseline scenario I just presented reflects those events most likely to occur with the information
at hand at the close of this Report. There are risks, however, that if come true, would alter not only the
macroeconomic outlook, but also the course of monetary policy.
On the external front, the balance of risks continues to be clearly biased downwards, increasing the probability
of occurrence of negative events. The escalation of the trade dispute between China and the US has become the
main risk and has begun to transcend other areas of these economies' relationship. Moreover, US tariff decisions
have been extended to other countries and with motivations not strictly commercial. All this has aggravated
fears of a sharper slowdown in trade, a deterioration in the confidence of companies and households globally
and a loss of dynamism in global activity. And there is also a resurgence of the possibility of a no-deal Brexit.
Scenarios where these risks intensify could lead to an abrupt deterioration of financial conditions. In view of
this, the main central banks are likely to make their monetary policies more expansionary; however, this could
be insufficient to contain the loss of appetite for risk and the decreases in the prices of assets and commodities.
The high level that the prices of some riskier assets have reached-in some cases matched by increased
borrowing-shapes a much more complex scenario. In addition, the materialization of any of these scenarios
could have a negative impact on local investment decisions and expectations.
At home, it is estimated that the balance of risks for activity is biased downward. The baseline scenario projects
that, beyond the result of the first quarter, investment will see a significant recovery in the next two years, which
includes both large-scale mining projects and investment from other sectors. However, there are risks derived,
for example, from the greater uncertainty of the external scenario and the various costs associated with
investment projects' red tape. Also, worth mentioning are the risks coming from the mining sector. Although
its poor performance of recent quarters has responded in part to specific factors, there are more permanent
elements, such as the lower grade of mineral ore, that could prolong this weakness.
Regarding inflation, the Board estimates that the risks are unbiased. The updating of structural parameters has
a significant degree of uncertainty, particularly due to the macroeconomic effects of immigration. On the one
hand, it is possible that the absorption of immigrants into the labor force is associated with a productivity fall
that is more persistent, causing a lower potential growth in the projection horizon, a narrowing of the activity
gap and, therefore, higher inflationary pressures. On the other hand, it can happen that the increase in the labor
supply occur with greater intensity, which would push up potential GDP growth, widen the activity gap, and
reduce pressures on wages and prices. It should also be considered that the negative balance of external risks
has exchange-rate effects that could raise short-term inflation beyond our current estimate (Table 5).
Summing up, the evaluation of the macroeconomic scenario and its outlook, which include the updating of the
structural parameters and the recent evolution of the economy, pointed to the need to recalibrate the monetary
impulse. Consistent with this, we decided to cut 50 basis points off the MPR, taking it to 2.5%, in our Meeting
of last Friday. We estimate that, by keeping this rate until we see clear signs of an upturn in inflation, it will be
possible to ensure the convergence of inflation to the target, in a scenario where the capacity for long-term
growth is strengthened by the immigrants' contribution. However, recent developments increase the downward
risks, especially in the external economy, for which the Central Bank must be ready to respond.
IV. Final remarks
Mr President, dear Senators, the MPR cut decided by the Board last Friday has been described as "surprising"
or "unexpected" by the observers. Indeed, it was an adjustment that most analysts did not see coming, in either
its timing or magnitude. However, it was not an unpredictable change in light of the background, analysis and
communication that the Bank had been delivering in the preceding months. Moreover, it is a decision based in
depth on the report that I have presented today.
Before I finish, I would like to draw your attention to the exceptional nature of the circumstances that led to
this decision and its implications for the Bank's communication and actions in the future. At the beginning of
this presentation, I mentioned that we have defined this decision as a "recalibration" of monetary policy, as it
is an adjustment of the MPR to generate a monetary impulse compatible with the inflation target in the face of
significant and consistent changes in the estimates of capacity gaps, inflation and the policy rate. This time
around there has been an unusual combination of new information for all the structural parameters plus the new
inflation measurement, pointing in the same direction.
Indeed, it is unusual for any economy to experience a change in the production factors of the magnitude and
speed that immigration has triggered in Chile in the last three years. It is also unusual for an increase in potential
growth to be accompanied by a reduction in the neutral MPR, which in this case has occurred due to the
magnitude and persistence of the fall in interest rates in the world. In previous episodes of CPI basket changes,
we had not seen so important corrections to the inflation measurement as this latest one.
Faced with this unusual configuration of circumstances, the Central Bank of Chile needed to be rigorous in its
analysis, clear in its conclusions and quick in its response. It was helped by the research work and the updating
of his models that have been progressing for some time. But once all the pieces of this puzzle have been
assembled, the Board has preferred acting over postponing a decision. It is an unusual action in the face of
unusual circumstances.
Central bank