José De Gregorio: What happened and where are we headed?
Speech by Mr José De Gregorio, Governor of the Central Bank of Chile, at the meeting
Visión Económica y Empresarial 2009-2010, organized by SOFOFA and Universidad del
Desarrollo, Santiago, 23 October 2009.
* * *
I thank the federation of Chilean industry SOFOFA and Universidad del Desarrollo for inviting
me once again to take part in this important annual event.
When I was preparing this presentation, I realized I had two choices: one was to analyze the
current situation in light of our latest Monetary Policy Report, which I already did in another
public seminar and that may overlap other presentations you will hear today. The other was
to take a longer perspective and examine how we came to where we stand today, how we
sailed through the troubled waters of the world economy and where we are headed. I think
this is the perfect audience to take this second option.
To begin with, it is important to bear in mind that the Central Bank of Chile (CBC) complies
with its mandate of safeguarding price stability via a monetary policy based on a flexible
inflation targeting regime. The objective is to keep annual inflation around 3% most of the
time. When deviations occur, monetary policy focuses on correcting them over a period of
two years. In practice, in our discussions we estimate a path for the interest rate that is
consistent with the inflation forecast 24 months ahead converging to the target. This is done
both because we recognize the lags with which monetary policy operates, and because of
our concern about the costs in terms of output loss and employment of adjusting inflation to
the target. If we do not do this, the adjustment would take much less time to complete.
All this is common knowledge. But I feel it needs to be stressed in order to clear, yet one
more time, the mistaken argument that the CBC does not consider the level of economic
activity when making its decisions. Additionally it serves to insist on the issue that the current
global financial crisis was not caused - as some argue - by monetary policy's orientation to
price stability, but by a tremendous failure in the financial systems of the developed world.
Neither the private sector nor policymakers were able to foresee the danger of the
imbalances that were accumulating during this decade. Today, the monetary and fiscal
stimulus packages are precisely what have allowed the world economy, which suffered an
initial shock similar to that of the Great Depression, to show a substantially better
performance. This is particularly true in the case of Chile.
The evolution of the economy and monetary policy from 2007 onwards
In just three years, the Chilean economy has gone through two radically different episodes,
although related to one another. From a significant inflationary shock caused by the rise in oil
and food prices to the effects of an unprecedented international financial crisis accompanied
by a drop in output and a sharp reduction in inflation.
Since mid-2007, the Chilean economy went through a process of significant increase in
inflation, due to the sharp rise in commodity prices in world markets (figure 1). This rise was
caused by supply and demand factors specific to those markets. Therefore, it was an
adjustment of relative prices in foreign markets and not a generalized increase in domestic
prices.
The fact that it was an adjustment of relative prices made us not act with the strength that we
would have if, for example, it had been a widespread increase in prices caused by a demand
shock. In fact, the purpose of the increases in the monetary policy rate (MPR) applied in
2007 and early 2008 were to avoid the incubation of undesired second-round effects that
might unreasonably prolong the inflationary impact of the shocks. Also, in that period we
decided to begin a process of reserve accumulation consistent with the prevailing financial
uncertainty and the evolution of the exchange rate.
As from May of last year, the macroeconomic picture changed. Inflation rates began to show
a fast and unexpected propagation of these shocks to other prices (figure 2). It could be
argued that the Bank reacted too late. However it is worth recalling that when this massive
inflation propagation began, private agents were expecting 4.4% for December 2008
inflation, while May's Monetary Policy Report placed it at 4.7%. The actual figure was 7.1%,
with a peak in October of 9.9%.
The inflationary upsurge certainly took everybody by surprise, coinciding with peaking oil
prices. Chile was, at the same time, one of the countries where inflation rose fastest during
the episodes of increasing commodity prices and also where inflation dropped fastest
afterwards (figure 3).
Why was that? We know it was not because of changes in the traditional variables, such as
the evolution of economic activity or the exchange rate. The speed of the adjustments may
be explained by us being an open, market economy, with few price distortions. The rise in
the oil price may have also created the perception that the increase would be very persistent,
accelerating the adjustment of local prices. However, beyond the need to deepen our
understanding of inflationary dynamics, what counts here is the capacity to react and the
flexibility of monetary policy, two characteristics that it exhibited in its response to this
phenomenon.
In our May Report of last year, when the MPR was at 6.25%, we announced that in the most
likely scenario the path of the MPR would be in line with market expectations, that showed a
further increase of at most 25 basis points in the next twelve months.
Things changed and, naturally, monetary policy decisions changed as well. In four meetings
we raised the MPR by 200 basis points, to 8.25%. The purpose was to limit the propagation
effects, via reducing the demand through a more restrictive monetary policy. Just as we then
stated, although a deceleration of global growth was expected, we did not see that it would
have the necessary force to contain inflation and therefore monetary policy had to be
tightened.
As a matter of fact, our Report of September 2008, before the economic plunge and when
Consensus Forecasts
estimated 2.6% growth for the world this year, we announced that the
MPR would probably be raised above 9%. But the world changed again, and very strongly.
What at first seemed just as a deceleration of global activity, resulted being the first drop in
world growth in over sixty years (figure 4).
This led to a change in policies with no precedent in Chile's monetary history. The drop in
world demand would result in a larger slowdown in domestic demand than the one we
intended to cause via monetary policy. In this new setting, the obvious reaction was to
change the sign of monetary policy.
The first important signal was revising our projections - in November 2008 - and announcing
that the increases that had been forecast in September would not occur. Such an
announcement had an immediate impact on financial conditions. This way, the CBC initiated
the most aggressive interest rate cut ever implemented in Chile, and one of the sharpest in
the world (figure 5).
Likewise, in September and October 2008, at the peak of the world financial crisis, the
spreads of the peso and dollar rates increased significantly. In scenarios of financial stress, it
is imperative to align market rates with the MPR, because the latter may cease to act as a
benchmark for the financial system. Therefore, the first actions we took were to provide the
necessary liquidity and ensure that the financial system could continue operating as usual
(figure 6).
The timing of the interest rate cut can be subject to debate. It is possible that, with the
information we have today, we could have done it sooner. But I must insist that monetary
policy decisions are made with the information available at each moment in time, so it is
useful to refresh some facts.
In December 2008, we entered the monetary policy meeting with an annual inflation rate of
8.9%. The market expected the MPR to be at 6.25% and annual inflation to be at 3.9% by
December 2009. Thus, despite the downward bias of monetary policy, the MPR was not
reduced until January, and began a process rate cuts with a speed and magnitude
unexpected by the market (table 1).
This is how, after accumulating signals that the inflation phenomenon had ended and was
strongly reversing, we began reducing the MPR, and we did it with vigor, taking it to the level
we believe is the minimum it can take without jeopardizing the normal functioning of the
money market.
But this cut did not exhaust our monetary policy tools. In July we took additional measures to
make monetary policy still more expansionary.
Beyond adopting the commitment that we still keep, of holding the MPR at its minimum level
for a prolonged period of time, we made it explicit by creating a time liquidity facility, the
"FLAP." This was meant to ascertain to the market that they would be able to obtain
resources at a rate equivalent to the MPR for three- and six-month terms, and thus generate
an interest rate structure that would allow a faster and stronger transmission of the monetary
stance to market interest rates. The success of these measures is tangible proof of the
diversity of monetary policy tools at the Bank's disposal as well as of its commitment with
meeting the inflation target.
The global crisis and the weakening of economic activity
The effects of the global crisis in Chile, on both the financial and the trade sectors, do not
reflect its full impact on the domestic economy. The increase in risk premiums and the
tensions in the world financial markets last year tightened local financial conditions, with a
direct effect on the demand. Although at some point every country feared a generalized
shutdown of international financial markets, Chile maintained its normal access and the
direct financial impact was milder (figure 7).
On the trade side, Chile has seen a drop in export prices, whose greatest effect can be
observed in disposable income, which affects the demand, although the effects of the lower
copper price are offset by the fiscal rule. Nonetheless, because the Chilean economy is
primarily an exporter of commodity-related products, the effects of the drop in world activity
were smaller than on exporters of manufactured goods. This is because the demand for
manufactures has been the hardest hit by the global recession. In our case, prices have
fallen, but it has been always possible to sell our products. On the other hand, in
manufactures exporting countries, purchase orders came to a sudden halt, giving way to
inventory build-up and a severe drop in production. This explains the magnitude of the initial
fall in many Asian and industrialized economies.
Overall, it is interesting to note that an essentially healthy economy like Chile was hit
surprisingly fast by the international crisis. Here we must underscore that the effects of the
global crisis had an unprecedented degree of synchrony. Roughly 90% of the world's
countries posted a contraction of output the fourth quarter of last year.
The culprit of the deteriorated economic activity, in my opinion, was the confidence crisis that
took over the whole world, Chile included. Uncertainty multiplied. There was genuine concern
that the financial systems of developed economies might paralyze completely and that the
economic meltdown would trigger a much deeper recession than the one we see today.
Households and firms reduced their expenditures in preparation for a possible catastrophe,
causing a much larger drop in demand than would have occurred without the crisis of
expectations. In hindsight, you can say that we overreacted, because the catastrophic
scenario did not materialize. But the loss of confidence had a real foundation, both because
of the deteriorated global macroeconomic and financial conditions and because we were
enduring the deepest crisis ever.
In this context, there was also the uncertainty about how and how effectively policies would
operate, which has faded thanks to the determination of central banks and finance ministries
in the larger part of the world. In our case, the quick reaction of macroeconomic policies has
been essential in mitigating the impact of the external crisis.
Although our GDP will fall this year, the performance of our economy, from a historic
perspective, has been remarkable. In 1982 and 1983, the Chilean economy grew nearly 18
percentage points lower than the world's average. In 1998 and 1999, this difference was
around 4 percentage points. In 2009, estimations point at the drop in output in Chile similar to
the world's average (figure 8).
Monetary policy can do little to avoid the immediate effects of this kind of confidence crisis.
However, policies do play an essential role in preventing these crises from aggravating, and
they provide the grounds for the recovery of expectations. To that end it is necessary to act
in a timely manner and with conviction. Any hasty behavior, or, on the contrary, being
complacent and ignoring the severity of the crisis, could have eroded the effectiveness of the
policies and deepened the recession.
There will be plenty of time to analyze the phenomena that deepened the crisis, but what is
clear is that the confidence crisis exacerbated the effects of the world turmoil on global
economic activity. The upside is that the reaction of policies and the responses of firms have
set us on the right foot for the recovery of the local economy. The adjustment of demand has
put households and firms in a healthy financial position to resume demand growth. The
various indicators of demand, expectations and production suggest that the Chilean
economy has begun the process of recovery we foresaw for this half. The monthly index of
economic activity, Imacec, seasonally adjusted, has been rising since May and the
unemployment rate, which at some point was thought to be headed to exceeding 12%, has
stabilized under 11%. Also, monetary policy will continue to be expansionary for a prolonged
period of time and, as we stated in our last Report, in the most likely scenario, the slow
withdrawal of the monetary stimulus will begin during the second quarter of next year.
Meanwhile, the Chilean peso has remained somewhat more depreciated that the currencies
of other commodity exporters. There are several hypotheses to explain this, including the
effect of the monetary policy stance. Anyhow, the real exchange rate is currently at levels
believed to be consistent with its long-term fundamentals (figure 9). Accordingly, in a context
of high uncertainty about the evolution of global exchange rates, the CBC will continue
monitoring the impact of the exchange rate path on expected inflation in its monetary policy
decisions.
In this scenario, annual inflation will be in negative territory for some months, to gradually
converge to 3% toward 2011, while the economy will grow between 4.5% and 5.5% in 2010
(table 2). This scenario is consistent with a gradual closing of output gaps, a necessary
condition for inflation to return to 3%. If we consider that trend GDP growth will be in the
4%4.5% range in 2010, a figure estimated by the CBC and consistent with the opinions of the
committee of experts that perform the estimation for the design of the budget, such a range
seems not excessive but rather moderate to close the output gap. If growth falls short, the
economy will not close the gaps and, therefore, inflation will continue dropping or will adjust
at a much slower pace, which obviously would require a stronger monetary impulse.
Final remarks
We have suffered the worst financial-economic crisis in many years. The strength of the
Chilean economy, rigorously built over a long time period, has allowed us to mitigate the
costs of a crisis that in the past would have impacted us much harder. The lessons about the
need to maintain a solid financial system and the capacity to apply countercyclical policies
have been critical in this performance. At the same time, they serve as a solid foundation for
a steady recovery. There are many tasks ahead of us, in particular to reinforce Chile's growth
capacity, but our macroeconomic fundamentals are consolidated.
However, the horizon is not completely clear. Although risks are more limited than they were
a few quarters ago, vulnerabilities remain. The financial systems of developed economies
remain weak. World growth forecasts point to a slow recovery and the world will hardly
regain the growth rates of 2006-2007 in the coming years. A proper conduct of economic
policies should provide the support for such recovery.
Adding to the problems still present in the financial systems and the level of private sector
indebtedness, the fiscal situation of many industrialized economies, which met the crisis with
already fragile positions, leaves several questions open. Global imbalances are not a
problem today, because the drop in demand has taken part of the adjustment, but as the
world economy picks up they could become a threat again. Finally, we have seen an
optimistic attitude in international stock exchanges. They anticipate a healthy recovery, but if
wrong they might result in asset revaluations that could pave the way for new uncertainties.
The role of the Central Bank of Chile is to monitor all these risks and their implications on the
monetary stance, in order to regulate it in consistency with its inflationary objective. We
remain at a stage where making projections is a complex task, but the scenario for output,
inflation and monetary policy path we presented in our last Report remains in force.
Although private forecasts already recognize that the worst is over, it is still too soon to say
that the work is complete. Output gaps are wide and we face the challenge of bringing
inflation back to the target. Markets are incorporating a faster withdrawal of the monetary
stimulus than the Bank considers appropriate for the purposes of meeting the inflation target.
Particularly now that, as in the rest of the world, fiscal policy is entering a consolidation
phase, monetary policy will have to continue providing the necessary stimulus to the
economy for a prolonged period of time. This, in order for the recovery of output and the
normalization of inflationary expectations to be well entrenched. One lesson from past crises
is that a premature withdrawal can be very costly and can lead to subsequent policy
reversals.
Thank you very much.
Figure 1
Commodity prices (*)
(index, January 2000=100)
600 600
500 500
400 400
300 300
200 200
100 100
0 0
00 01 02 03 04 05 06 07 08 09
Grains and cereals Energy Metals
(*) By the Goldman Sachs Commodity Index (GSCI).
Source: Bloomberg.
Figure 2
CPI monthly inflation
(percentage)
2.0
1.5
1.0
0.5
0.0
-0.5
-1.0
-1.5
Jan. Feb. Mar. Apr. May Jun. Jul. Aug. Sep. Oct. Nov. Dec.
2001-2006 Average 2007 2008 2009
Source: National Statistics Bureau (INE).
Figure 3
Accumulated CPI variation by country
(percentage)
South Africa
South Africa
Turkey
Hungary
Chile
Mexico
Indonesia
Brazil
Colombia
Poland
Hungary
Colombia
Peru
Israel
Brazil
Turkey
Czech Rep.
Indonesia
Malaysia
South Korea
Israel
Sweden
Mexico
UK
South Korea
Norway
Norway
Peru
USA
Thailand
Thailand
Canada
Poland
Czech Rep.
UK
USA
Sweden
Eurozone
Eurozone
Hong Kong
Switzerland
Switzerland
Canada Malaysia
Hong Kong
Chile
Japan Japan
0 5 10 15 20 -4 -2 0 2 4 6
(a) Between January 2007 and October 2008. (b) Between October 2008 and September 2009 (*)
(*) For Hong Kong, Japan, Malaysia and South Africa, data at August 2009.
Sources: Statistics bureaus of each country and Bloomberg.
Figure 4
World growth forecasts
(annual change, percentage)
3.0
4
3
2.5
2
2.0
1
1.5
0
1.0
-1
0.5
-2
0.0
-3
09 Mar. May Jul. Sep.
08 May Sep. 09 May Sep.
(a) Forecasts for 2009 (b) Forecasts for 2010
Source: Consensus Forecasts.
BIS Review 145/2009
Figure 5
Monetary policy rate (MPR)
MPR change
MPR level
(basis points)
(percentage)
Japan
Turkey
USA
Chile
Canada
Colombia
Switzerland
New Zealand
Sweden
Peru
Chile
South Africa
Hong Kong
Norway
UK
UK
Israel
India
Eurozone
Brazil
Peru
Sweden
Czech Rep.
Mexico
Norway
Australia
South Korea
Israel
Malaysia
Iceland
New Zealand
South Korea
Australia
Eurozone
Poland
Hong Kong
Colombia
Indonesia
Philippines
Canada
Mexico
Poland
India
Switzerland
China
Czech Rep.
Indonesia
China
Turkey
Philippines
South Africa
USA
Hungary
Hungary
Brazil
Malaysia Argentina
Russia
Russia
Japan Iceland
Argentina
0 2 4 6 8 10 12 14
-1,000 -800 -600 -400 -200 0 200
Between 4 Sep. 2008 and 19 Oct. 2009 At 19 Oct. 2009
Source: Bloomberg.
Figure 6
Interest rates in pesos and dollars in the local market
(percentage)
14 14
12 12
10 10
8 8
6 6
4 4
2 2
0 0
Jan.08 Apr.08 Jul.08 Oct.08 Jan.09 Apr.09 Jul.09 Oct.09
Stock Exchange-90 days Libor + 90-day on-shore spread
Sources: Bloomberg and Central Bank of Chile.
BIS Review 145/2009
Table 1
Monetary policy rate and expectations according to EES
(percentage)
Actual level Expected for Expected 2 Expected for
same month months Dec.09
ahead
Oct. 2008 8.25 8.50 8.50 7.00
Nov. 2008 8.25 8.25 8.25 6.63
Dec. 2008 8.25 8.25 7.75 6.25
Jan. 2009 7.25 7.50 6.75 5.50
Feb. 2009 4.75 6.25 5.00 4.00
Mar. 2009 2.25 3.13 2.50 2.00
Source: Economic Expectations Survey (EES), Central Bank of Chile.
Figure Figure 7 7
Fore Fore ign ign credit credit flows flows to to residents residents
(b (b illions illions of of dollars) dollars)
3.0 3.0 3.0 3.0
2.5 2.5 2.5 2.5
2.0 2.0 2.0 2.0
1.5 1.5 1.5 1.5
1.0 1.0 1.0 1.0
0.5 0.5 0.5 0.5
0.0 0.0 0.0 0.0
-0.5 -0.5 -0.5 -0.5
-1.0 -1.0 -1.0 -1.0
-1.5 -1.5 -1.5 -1.5
-2.0 -2.0 -2.0 -2.0
Jan.07 Jan.07 Jul.07 Jul.07 Jan.08 Jan.08 Jul.08 Jul.08 Jan.09 Jan.09 Jul.09 Jul.09
New New credits credits to to banks banks New New credits credits to to non-banks non-banks
Net Net flow flow (*) (*)
(*) (*) Discounting Discounting bank bank and and non-bank non-bank amortizations amortizations from from total total new new credits. credits.
S S ource: ource: Central Central Bank Bank of of Chile. Chile.
Figure 8
World growth (1)
(annual change, percentage)
15 15
12
129630
-3 9630-3
-6 -6
-9 -9
-12 -12
80 84 88 92 96 00 04 08
World at market exchange rate Chile (2)
(1) Gray area shows projections as from 2009.
(2) Figures for growth in 2009 and 2010 stand for the midpoint of the range of projections
shown in the Monetary Policy Report.
Sources: Central Bank of Chile, International Monetary Fund and World Bank.
Figure 9
Nominal exchange rate (*) Chile: Real exchange rate
(indexes 2 January 2008=100) (index 1986=100)
160 160 120 120
110 110
140 140
100 100
120 120
90 90
100 100
80 80
80 80
70 70
Jan.08 Jul.08 Feb.09 Sep.09
88 91 94 97 00 03 06 09
1989-2008 average
Brazil Mexico
1994-2008 average
Australia Canada
New Zealand Chile
(*) Parity with the US dollar.
Sources: Central Bank of Chile and Bloomberg.
Table 2
Economic growth, current account and inflation
(annual change, percentage)
2007 2008 2009 (f) 2010 (f)
GDP 4.7 3.2 -2.0 to -1,5 4.5 to 5.5
Domestic demand 7.8 7.4 -6.2 6.7
Domestic demand (w/o change in inventories) 8.2 7.9 -3.5 3.7
Gross fixed capital formation 12.0 19.5 -12.9 7.4
Total consumption 7.1 4.2 0.0 2.5
Goods and services exports 7.6 3.1 -4.7 4.9
Goods and services imports 14.9 12.9 -13.8 9.0
Current account (% of GDP) 4.4 -2.0 1.9 1.2
CPI inflation 4.4 8.7 1.7 1.5
December CPI inflation 7.8 7.1 -0.8 2.8
CPIX inflation 4.0 8.4 2.8 1.0
December CPIX inflation 6.3 8.6 -1.2 2.6
CPIX1 inflation 4.1 7.8 2.8 1.2
December CPIX1 inflation 6.3 7.7 -0.6 2.6
(f) Forecast.
Source: Central Bank of Chile.