MONETARY POLICY REPORT
TO THE OF THE
PRESENTATION FINANCE COMMITTEE
∗
OF THE
HONORABLE SENATE REPUBLIC
Mario Marcel
Governor
Central Bank of Chile
3 April 2017
∗The Monetary Policy Report of March 2017 can be found at http://www.bcentral.cl/en
Introduction
Mr. Governor of the Senate's Finance Committee, Senator Carlos Montes, honorable
members of this Committee, ladies, gentlemen,
Thank you for your invitation to present the views of the Board of the Central Bank of
Chile about the recent macroeconomic developments, their projections and implications
for monetary policy. This vision is contained in detail in our Monetary Policy Report (the
Report) of March 2017. It is worth mentioning that this Report includes for the first time
economic forecasts for 2018, as I will show you throughout this presentation.
I am here with the full Board and all the staff responsible for the topics covered in our
Report. I wish to make a special mention of our new Board member, Ms Rosanna Costa,
recently confirmed by this Senate, and Ms Solange Berstein, our Financial Policy
Division Director, as of today.
In recent months, annual CPI inflation has continued to decline, in line with forecasts in
the December Report. Goods inflation continues to be shaped largely by the movements
of the exchange rate, while services inflation has continued to drop gradually, marked by
the widespread indexation and consistently with the business cycle.
Meanwhile, in late last year and into this, GDP of non-natural-resources sectors
performed weaker than forecast. Furthermore, incoming data suggest that it will take
longer than expected to recover. This, coupled with recent events that have considerably
eroded mining activity, will pull down annual GDP growth in 2017.
However, as can be seen in the outlook I will be sharing with you in a few moments, a
number of elements will help the economy to regain momentum within the projection
horizon. Worth noting among these are that no significant macroeconomic imbalances
are observed, that the negative impact of the mining investment adjustment has
diminished, that the external scenario has improved, and that monetary policy will remain
clearly expansionary. Overall, capacity gaps foreseen for the next two years will be
somewhat wider than we thought in December, toning down medium-term inflationary
pressures.
In this context, the Board lowered the monetary policy interest rate (MPR) by 50 basis
points during the early months of the year, speeding up the cuts with respect to provisions
made in December. At the same time, we considered that, to ensure the convergence of
inflation to the target, it will be necessary to enhance the monetary impulse somewhat,
which reflects in an MPR trajectory similar to the one implied by financial asset prices
during the ten days prior to the statistical closing of this Report.
Macroeconomic scenario
In February, annual CPI inflation was 2.7%, while core inflation-CPIEFE; CPI
excluding energy and foodstuffs-was 2.2%, driven mainly by its goods component,
whose annual growth fell to 0.4% in February, in line with the nominal exchange rate,
which is now below its year-ago level. The services component of the CPIEFE posted an
annual change of 3.4% in February, a quite milder fall than its goods component,
reflecting its greater inertia (figure 1). About this, it is worth noting that one feature of
the CPI services basket is that 75% of its prices are either managed or linked to another
indicator or to past inflation, meaning that they are indexed. This fact in practice
augments their inertia and causes the effect of any change in the activity gap to take
longer to show up. Of course, this is not the case for every service price, as non-indexed
or non-managed prices tend to show a more visible effect from changes in the gap. One
of the boxes in the Report is devoted to this, showing how the differences in the recent
evolution of services inflation appear when these recently mentioned price groups are
taken separately.
In this Report's baseline scenario we foresee that headline inflation will continue to
decline for some months, to return to 3% by year's end and hover around that mark until
the first quarter of 2019, when the current projection horizon ends. The CPIEFE will
decline steadily until the second half of 2017 and will take longer to hit 3% (figure 2).
This inflation path relies on two assumptions: first, a fairly stable real exchange rate
around its current levels, which are estimated to be in line with fundamentals; second,
that although the output gap will exceed the December estimate for some time, it is
projected that, for the aforesaid reasons, it will begin to close towards the end of this year.
Activity growth ended 2016 in line with the December forecast, although characterized
by a steeper slowdown during the year, which is expected to continue well into 2017. On
20 March, the Bank published the first National Accounts figures based on the new
benchmark compilation that uses the base year 2013. This change is intended to update
the way the evolution of the national economy is gauged, incorporating new estimation
methodologies, changes in international standards and new sources of information. The
Bank makes these changes regularly every five years, according to the respective
international standards set by the IMF and the OECD. The most salient changes are
depicted in a box in this Report, and all the details can be seen in several documents
uploaded on our website.
The new data, which included a very small revision to 2014 and 2015 growth, confirmed
the further weakening of the economy in the last quarter of the year, and at the same time
modified the growth trajectories of the already published quarters of 2016. In particular,
the economy would have slightly outperformed previous estimates for the first part of
that year. By sectors, it confirmed that Mining posted negative y-o-y growth throughout
the whole year, while activity in areas unrelated to natural resources (i.e. Other GDP)
continued to worsen, going from growing 3% in the first quarter to 1% in the fourth
(figure 3). In the other sectors, most weak in the fourth quarter were particularly those
sectors linked to investment in construction and related services, which are usually more
persistent. Also personal services decelerated, although it is estimated that it responded
partly to the effects of the public sector strike at the end of last year (figure 4).
On the domestic expenditure side, y-o-y growth in final demand-minus inventory
change-also showed a downsloping trend throughout the year. The biggest loss of
dynamism was seen in investment in construction and other works, whose annual rate of
change was -4.9% in the fourth quarter (0.5% average between the first and third
quarters). Private consumption, as has been the case for some years, provided support to
the economy, growing by over 2% annually throughout 2016. This was helped by growth
in labor income, falling inflation and persistent low unemployment by historic standards.
It is worth noting that while growth in non-durable consumption has remained stable,
durable consumption growth has recovered, partly due to the appreciation of the peso in
the last year and partly due to the necessary replenishment of stocks after several years
of low or even negative expansion. Something similar is observed in gross fixed capital
formation in machinery and equipment. Discounting unusual purchases of transportation
equipment, this investment component has tended to perform better in the past few
months (figure 5).
The labor market has continued to adjust. Salaried employment stands out with a fall of
2.1% annually in the December to February moving quarter, as does the moderation of
annual wage growth. Plus the reduction in hours worked, at a time where a growing
number of workers claim that they work fewer hours than desired. Anyway, self-
employment, while more precarious, has significantly cushioned the disturbances coming
from salaried employment (figure 6).
A constant concern in recent years has originated in the evolution of the labor market. In
several Reports we have included boxes and research notes addressing various related
topics, including the degree of working flexibility and how changes in labor conditions
affect unemployment. Our last issue includes a box that explores the effects of the
business cycle on workers' wages. Normally, wages are analyzed using aggregate data
that, by their very nature, conceal the movements of individual wages. Using data per
worker, we show that the dynamics of individual wages are much more correlated with
the business cycle than what aggregate wages would suggest. In particular, because the
wages of workers changing jobs-either voluntarily or involuntarily-are affected, for
better or for worse, depending if the business cycle is favorable or not. This is a line of
ongoing research that allows us to better understand the evolution of the labor market and
its implications for medium-term inflationary pressures.
Domestic financial conditions, meanwhile, are still good in terms of interest rates.
However, lending volumes have slowed compared to previous years, which the
respondents to the Bank's Business Perceptions Report and Bank Credit Survey interpret
as the consequence of weak demand (figure 7).
In our baseline scenario, we estimate that this year the economy will grow between 1%
and 2%, down from the range we projected in December, 1.5% to 2.5%. Around 0.2
percentage points of this correction originate in the effects of the Escondida mine
downtime. Because of the importance of this mine in the country's copper production-
15% to 20% in 2016-, this downtime will have a substantial impact on first-quarter
GDP, around 1 percentage point of reduced growth, taking the figure to near zero.
Despite its economic impact, the Escondida deadlock, plus the effects of massive forest
fires in January and February, are all one-time events that not only do not affect the long-
term trajectory, but neither do they influence the dynamic of the business cycle. Thus, we
do not expect these events to have any material repercussion on the performance of other
economic sectors or on inflation. In the case of mining production, although its impact
on GDP of the first quarter is significant as it is determined mostly by supply-side factors,
it is deleted from the Other GDP calculation that the Bank uses in its models to measure
the activity gap and the medium-term inflation outlook.
Thus, the change in the projected range for 2017-of half of one percentage point-
responds to two major factors. On the one hand, about half is explained by Escondida
mining downtime and other incidents during the first quarter. On the other hand, the
greater weakness we saw in the course of 2016 gives a lower starting point for the
economy this year. In particular, because this weakness has been observed in sectors that
tend to be more persistent in their dynamics, such as construction and associated areas.
We must not forget that this sector received a significant boost in 2015, which lasted into
early 2016, as a result of the new VAT that would be charged to the sector under the tax
reform. Such reduced strength responds largely to the end of this boost. There is also the
effect that the lending standards of mortgage loans have tightened too, given the higher
down payment demanded by the banks. Another important issue worth looking into are
the changes in inventories over recent years. The year 2016 completed three years of
inventory depletion, which is quite uncommon. In general, inventory movements reflect
how companies predict the future: if they are optimistic about it, they accumulate, and
vice-versa. Recent years' relentless downward revisions to growth prospects have
permeated companies' desired level of inventories and part of what we see in the 2017
growth outlook is also related to that.
For 2018, the baseline scenario assumes that the economy will perform better than this
year, growing in the 2.25% to 3.25% range. This will allow the activity gap to narrow
steadily throughout next year, keeping in mind that the Board still estimates our
economy's potential growth rate between 2.5% and 3%, and trend growth at 3.2%.
These projections assume that, after a three-year-long fall, gross fixed capital formation
(GFCF) will post a slightly positive growth in 2017 and a clearly stronger expansion in
2018. This result will be decisively influenced by higher investment in non-mining and
non-housing investment (mainly machinery and equipment). This, because the former is
expected to regain its positive numbers during 2018 and the latter to continue to adjust
for a few more quarters, after the boom triggered by amendments to VAT payment
regulations in the sector. As a percentage of GDP, in 2017 GFCF will reach 21.7% and
22.5% in real and nominal terms, respectively.
On the consumption side, no major changes are expected in annual growth, and it is
foreseen that it will continue to sustain domestic output and expenditure. Our baseline
scenario assumes that consumption will grow at a pace of 2.5% and 3% this and next
year, quite like 2016. It also assumes that export volume will grow a little over 1.5% this
year, and the rate will double in 2018. Behind this increase is an improved external
scenario, which I will discuss in a moment. In this context, the current account deficit
will be smaller than projected in December, and 2017 will be better than 2016, due to
slower growth in domestic demand and improved terms of trade (table 1).
As I said earlier, the greater growth expected in 2018 originates in the economy having
no major imbalances, the end of some factors that have hindered growth in recent years-
for example, the four-year plunge of mining investment-an expansionary monetary
policy stance and a stronger impulse from abroad compared with previous years. As for
fiscal policy, it is assumed that the consolidation announced by the Administration will
proceed further.
The recovery that reflects in the annual figures projected for 2018 should begin during
the course of this year, considering the negative impact of the debilitated economic
activity at the end of 2016 and early 2017. In fact, the average annual GDP growth of the
last quarter of 2016 and the first of this year is somewhat above 0%. Already for the
second quarter, in our baseline scenario, it will rise above 1.5% annually, which, on
average, will be sustained and increased in the second half of the year. However, as we
will see later, this scenario relies partly on a stronger monetary policy bias, which is
necessary for the inflation target to be met.
Internationally, in the last few months a somewhat more favorable scenario has been
forming. On the one hand, activity and expectations indicators in the developed world
have revealed a better economic environment. Particularly noteworthy is the situation of
the manufacturing sector, which after long years of stagnation shows improved results
and prospects, which has been added to the greater dynamism of services sectors that has
been observed for several quarters (figure 8). In the United States, persistent positive
consumption figures-sustained by a robust labor market- have coupled with the much
desired rebound in investment. In the Eurozone, the stronger and more synchronized
recovery among its members stands out. In Japan, the depreciation of the yen has given
a boost to the foreign sector. Thus, relative to the December forecast, the growth
projection for 2017 of our trading partners in the developed world is revised upward by
2 decimals, to 1.8%, this year and next.
Improved conditions in the developed world have given way to expectations pointing to
a normalization of inflation or have at least dissipated the risk of deflation that existed
not long ago. Thus, the Federal Reserve continued normalizing of its monetary policy
and policy makers in Europe and Japan have ruled out further QE. Markets have gradually
incorporated these changes in their expectations avoiding major disruptions (figure 9). In
the past, the processes of raising interest rates in the US were surrounded by complex
economic and financial developments in some economies. In the 1980s, the most critical
case, there was the debt crisis in Latin America. Then in the 1990s, the most significant
effects were circumscribed to some countries. In the 2000s, the emerging world was not
so affected directly, but the subsequent subprime crisis in the United States and all its
implications for the world resulted the Federal Reserve rate hike. Today, the conditions
in which the United States and the emerging world confront the episode are different as
seen from both sides. China's growth and the size of Europe make them a potential risk
for the Fed, so it cannot overlook the effect of its decisions on these economies. At the
same time, economic policy frameworks have changed in emerging markets and are more
capable of dealing with external shocks. Anyway, it is still an element of risk. A box in
this Report provides a deeper analysis of these topics.
Beyond the volatility of recent months, the dollar remains strong with respect to most
currencies, developed and emerging. Our peso, which has depreciated a little more than
30% from its 2013 average, has behaved similarly to most of our trading partners'
currencies, so its multilateral variation has been much smaller. Accordingly, the real
exchange rate index with base year 1986=100 is now near 93, some 3% above its 2013
average (figure 10).
Among emerging economies, the improvement in China's outlook is worth noting. In the
fourth quarter of last year, the Chinese GDP grew 6.8%, so growth for the full year was
6.7%. Conjunctural numbers and financial indicators have been calmer, according to
manufacturing output and foreign trade figures. The renminbi is depreciating gradually
and the large capital outflows and reserves depletion of 2016 have stopped. Meanwhile,
the authorities set the growth objective at 6.5%. Thus, our baseline scenario has revised
the Chinese growth forecast upward by 2 decimals.
In Latin America, the main economies in the region are still adjusting. In Brazil,
consumption and investment are weak, as is manufacturing production in Colombia.
Argentina is also undergoing a difficult process and, although more lagging than in other
countries, has shown signs of milder deterioration of activity, especially concerning
manufacturing output. The Mexican economy could sustain good growth and
performance in the labor market until the markets became aware of the potential effects
of the US elections on trade and migration. This has resulted in weak investment. In this
context, the Mexican authorities have taken steps to strengthen their macroeconomic
fundamentals, through policies aimed at consolidating public finances, withdrawing the
monetary stimulus to deal with inflationary pressures, and managing the exchange rate to
counteract the sharp depreciation that the Mexican peso suffered towards the end of last
year. In general, the inflation outlook has continued to improve in the region, opening
room for further monetary stimulus. In addition, the external imbalances have moderated
and the fiscal accounts continue to consolidate. Still, there is only weak support for a
more robust expansion in the region.
In this context, there has been a widespread increase in risk appetite, raising stock prices,
reducing sovereign premiums and boosting capital flows into the emerging world (figure
11). The terms of trade also show a significant improvement, largely due to a combination
of higher prices for copper and lower for oil than assumed in December. The prices of
other export products have also risen. Copper has remained at its highest price in two
years. This responds partly to the aforementioned better performance of the
manufacturing sectors and the better world growth outlook. Another part is explained by
supply disruptions in some important producers and the lack of new investments. Thus,
we have risen our projections of its price to US$2.55 and US$2.50 per pound for 2017
and 2018, respectively. The oil price, after some rise after the agreement between OPEC
and other producers to reduce output, has fallen in recent weeks. Our baseline scenario
foresees it close to 50 dollars per barrel in the projection horizon. With this, in 2017 and
2018 the terms of trade should not only outperform 2016, but should also be higher than
was anticipated in December (table 2).
In the baseline scenario, monetary policy is providing a somewhat stronger impulse than
estimated in December. As a working assumption we assume that the MPR will follow a
trajectory similar to the one implied by financial asset prices during the ten days prior to
this statistical closing of this Report. Thus, we assure that monetary policy will have
responded swiftly to the changes in economic conditions and will remain expansionary
through the whole projection horizon (figure 12). As always, the conduct of monetary
policy and any possible adjustments to the MPR will be contingent on the effects of
incoming information on the projected inflation dynamic.
On the external front, there are some sources of uncertainty that may have significant
effects but by their nature are very hard to quantify. For example, political and economic
uncertainty surrounding European elections, worries about Brexit implementation and
possible shifts towards protectionism in several developed economies. Other risks that
have long lingered in the external scenario have varied in intensity. The US economy has
evolved favorably, averting the risk of a new recession. The much awaited fiscal impulse
could help to sustain somewhat higher growth in the years to come. However, it is also a
source of risk, as its implementation may have problems or inflationary effects that might
trigger a faster withdrawal of the monetary impulse, creating disruptions in financial
markets. China continues to be a source of concern, especially its leverage, although its
authorities have successfully weathered its gradual slowdown without causing
disruptions, and this has been welcomed by markets.
Neither can we rule out an intensification of the recent global trends and a stronger than
expected impulse from abroad, by either a steeper recovery of world activity and/or better
commodity prices. Some of this seems to have permeated financial markets, where the
prices of riskier assets have risen. Although it is still premature to validate such optimism,
it is clear that the markets are in a better mood than last year, including local markets,
which have even been outperforming many of their peers.
On the domestic front, after several years of subdued growth, we cannot rule out that a
more persistent phenomenon may be affecting the economy's ability to grow, in which
case spending plans of both public and private agents would need some revision. One
area calling for special attention is the labor market. While acknowledging that it has
gradually adjusted without significantly increasing unemployment in the past several
years, it is possible that, after years of low growth companies wish to make more drastic
changes in their payrolls, particularly if the expected growth recovery towards the end
of the year stalls. In contrast, in a context where no macroeconomic imbalances are
hindering growth, a scenario where an improved external outlook consolidates, plus the
end of a cycle of mining investment adjustments and a rebound in sentiment, could lead
to a more dynamic recovery than expected.
All considered, the Board believes that the risk balance for both inflation and activity is
unbiased.
Summing up, inflation has evolved in line with December forecasts. However, the
economy has been weaker, widening the activity gap beyond expectations and reducing
inflationary pressures. Accordingly, the Board deemed it appropriate to enhance the
monetary stimulus between January and March. Going forward, we believe that it will be
necessary to increase this monetary impulse a bit more, using as a working assumption
that the MPR will follow a a trajectory similar to the one implied by financial asset prices
during the ten days prior to this statistical closing of this Report. As always, we reaffirm
our commitment to conduct monetary policy with flexibility, so that projected inflation
stands at 3% in the policy horizon.
I will now share some final thoughts.
Final thoughts
The evolution of the economy in recent years has brought great challenges for monetary
policy making around the world. The actions of central banks were paramount to take the
world out of the financial crisis of 2008-2009 and to prevent a relapse in the following
years, especially in those countries with less room for fiscal maneuvering. During this
long period the effectiveness of monetary policy to influence inflation and economic
activity was called into question. Though less dramatic than in other places, in Chile this
discussion is also revisited every now and then.
Before responding to the question of how effective monetary policy is, we must clarify
two points: what objective does it pursue, and how does it operate, and then we can
explore whether the means contribute to the ends.
Chile's institutionality assigns the Central Bank two main functions: to safeguard the
stability of prices and the stability of the payment system, understood as financial
stability. The first of these objectives has been specified under the regime of flexible
inflation targeting, and has governed us for over 15 years, setting the target that annual
expected CPI inflation must stand at 3% in a two-year horizon. This regime also considers
a floating exchange rate, where the Bank reserves the possibility of intervening in the
market, a power it has exercised barely four times since this policy came into effect in
1999.
This should clarify what lies beyond the objectives of our Monetary Policy: on the one
hand, under the foreign exchange policy I have just described, we do not have a target for
the exchange rate. We allow it to settle freely in the market responding to local interest
rates and its other macroeconomic determinants. This is relevant because, as the empirical
evidence shows, in small, open economies the exchange rate is an important shock
absorbing mechanism.
Second, our target is not short-term inflation, but longer-term inflation. Thus, to the extent
that inflation fluctuations are perceived as transient, they should not have much impact
on our policy decisions. A good example of this is the steep increase in inflation we had
between 2014 and 2016. This process originated largely in a shock to the exchange rate
that had transitory effects on inflation. Of course, the duration of the period of high
inflation was long, but it responded to a succession of different shocks and not to the
persistent effect of a single one.
On the contrary, whenever we identify medium-term pressures on inflation, either upward
or downward, we must react with vigor. The same episode which I have just referred to
is illustrative in this regard. While in the short term inflation rose as a result of a shock
on the exchange rate, with transitory effects, medium-term pressures diminished as a
result of a deteriorating economy. Had our target been short-term inflation, we should
have raised the MPR. As it is not, and what we aim at is medium-term inflation, our
decision was to lower the MPR to prevent inflation two years out from falling below the
3% target.
This response of monetary policy is very different from its not so distant past. In the
1990s, when our economy was not yet sufficiently prepared to deal with a currency shock,
the Bank had to choose between an inflation target and an exchange rate target. The result
of the exercise was complex for the Chilean economy. Not to mention what happened in
the early 1980s, when the defense of a pegged exchange rate and changes in external
financial conditions led us to a recession that cost us 15% of lost GDP and escalating
unemployment. Applying our present scheme, monetary policy, coupled with a fiscal
policy based on a structural balance sheet, has achieved its inflation objectives by
dampening external and domestic shocks more strongly. The turbulences that in the past
caused recessions in Chile, today are manifested only as changes in the pace of growth.
To this end, monetary policy operates through several channels. Primarily, it regulates
market liquidity and it sets, through open market operations, an interest rate for the
provision of liquidity to the financial system at very short terms. By way of these two
mechanisms it affects market interest rates, which are the ones that influence asset prices
and economic agents' decisions.
The effectiveness of monetary policy therefore depends on the operation of these
mechanisms at different levels. First, the Bank's ability to ensure the provision of liquidity
is critical, as it maintains market interest rates aligned with the MPR. This is done
regularly through open market operations and the Bank itself operates systems that allow
these operations to be carried out with the appropriate standards. There may be cases
where there is a sudden rise in market rates, because players in the system are faced with
potential or actual liquidity constraints. Such a situation occurred in 2008, when events
associated with the collapse of Lehman Brothers swept over the world economy. On that
occasion, the Bank announced to the market that it would resort to exceptional liquidity
provision mechanisms in pesos and dollars, which allowed local rates not to be altered,
despite severe external risks.
Although the Bank's monetary policy instrument is the short-term interest rate, its
movements affect the complete yield curve. The effectiveness of changes in the MPR in
this area hinges on the credibility of the Bank's decisions as perceived by economic
agents. Here there are several areas, within which communication and transparency of
decisions are essential. To the extent that individuals and companies understand and
validate the Bank's decisions, their consumption and investment decisions will be
consistent with the described scenarios, as well as with asset prices and market rates. For
these reasons, the Bank makes special efforts be transparent and to communicate its
decisions and scenarios in the best possible way. We publish a wide range of information
and all members of the Board are constantly making presentations to raise awareness of
the Bank's vision, among many other efforts.
Other important factors in the effectiveness of monetary policy are the changes in the
external scenario. Being a small, open economy, Chile is subject to the vagaries of other
countries. As we have said time and again, we can cushion their effects, but we cannot
isolate ourselves from them. In that sense, significant fluctuations in the external scenario
that, for example, produce unexpected or major changes in capital flows and external
financial conditions, could affect local market rates. Again, the Bank's ability to provide
liquidity that compensates for possible changes in external conditions is vital. The
example of 2008 I just described is relevant here too.
It will not go unnoticed that several of these mechanisms also affect economic activity.
For example, to the extent that a reduction of the MPR is properly transmitted to the cost
of interbank funding, financial institutions may offer better credit conditions to their
clients or, based on a better spread, bring to their portfolio of clients people and
companies that were left out before because of, for example, a higher risk assessment. At
the same time, as people and companies see a more attractive offer of credit in terms of
amounts or costs, they will decide to spend and thereby boost activity.
Central banks are often caricatured as obsessed with inflation and indifferent to economic
activity. Nothing further from the reality. The deviations of growth are very relevant for
the evolution of inflation in the medium term, which means they play a fundamental role
in our actions. The closer GDP is to its potential, the closer inflation will be to its
mediumterm target. Moreover, in the great majority of cases, monetary policy influences
economic activity and inflation in the same direction, which is not surprising since both
tend to correlate within the business cycle. This is especially important when the
economy is in a weak phase of the cycle and a monetary stimulus can raise inflation and