Mario Marcel: The Monetary Policy Report and the Financial
Stability Report
Presentation by Mr Mario Marcel, Governor of the Central Bank of Chile, before the Finance
Committee of the Honorable Senate of the Republic, Santiago de Chile, 19 December 2016.
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Introduction
Mr. President of the Senate's Finance Committee, Senator Andrés Zaldívar, honorable
members of this Committee, ladies and gentlemen,
Thank you for your invitation to present the views of the Board of the Central Bank of Chile on
the recent macroeconomic and financial developments and prospects and their implications
for monetary and financial policy. This vision is contained in detail in our Monetary Policy
Report of December 2016 and our Financial Stability Report of the second half 2016.
On this occasion, our reports feature a special characteristic: they were prepared mostly
under the direction of the Bank's outgoing Governor, Rodrigo Vergara, and are being
presented by an incoming Governor. Interestingly enough, this is rather anecdotic, since our
reports rely on the work of the Bank's technical team and the Board's deliberations,
regardless of the Governor in charge. This attests to the continuity that characterizes a
sound institution with permanent responsibility for the Chilean economy's monetary and
financial stability, and that must inspire confidence in economic agents and in the population
at large.
This is remarkable, in my view, as the soundness and reliability of institutions is a matter of
growing concern in Chile these days. Still, we must be aware that accumulated trust does
not suffice; in our present world such trust must be renewed every day, on the basis of the
ability to respond to new demands and challenges. I will comment on some of these
challenges towards the end of my presentation.
On the recent evolution of the economy, the most noticeable event has been the drop in
inflation. After several quarters in which the annual CPI variation was above 4%, in recent
months it fell sharply to 3%, placing y-o-y CPI inflation at 2.9% in November.
We had foreseen inflation declining at a slower pace. In the Monetary Policy Report we
presented to the Senate last September, we projected that annual headline inflation would
close this year at 3.5%. Today, private expectations-as well as our own-put it a little under
3%. In addition, in the baseline scenario I will be describing in a moment, we assume that
this decline will continue, such that during most of 2017 annual CPI inflation will stand in the
lower part of the tolerance range, to start converging back to the target by year's end.
Domestic activity has also shown some surprises. It grew in line with forecasts in the third
quarter and even somewhat better in sectors not related with natural resources-what we
call Other GDP. However, it began the fourth quarter quite poorly. The decline in mining
activity weighed significantly, as has been the trend throughout the year, and so did some
specific industry lines. However, the lower dynamism estimated for the last quarter of the
year leads us to expect that 2016 growth will be in the lower bound of the range projected in
September. Going forward, we estimate that the economy will return to near-potential
expansion rates towards the end of 2017, although at a somewhat slower pace than we
estimated in September.
Abroad, the biggest news has been the changes in financial markets after the US election.
The movements that followed took a toll on financial conditions, despite that they are still
expansionary from a historical standpoint. Last week the Federal Reserve raised the policy
rate for the second time, a decision that was widely expected by the markets. The surprise
was the confirmation of a slightly faster withdrawal of the monetary stimulus, which has
shaken the financial markets in recent days. As for activity and inflation, they continue to
show advances in the developed world, while they are tending to stabilize in the main
emerging economies. We see some improvement in the terms of trade in the near future.
Considering all the above and its effects on the medium-term outlook, the baseline scenario
of this MP Report has revised the 2017 inflation trajectory from September downward. This is
because core inflation-what we call the CPIEFE (i.e. excluding foods and energy)-is
expected to drop significantly, due to the important weight in inflation of import-related prices.
The normally more persistent services inflation will also fall, although considering the basis of
comparison effect, the impact of lower inflation on indexed prices and its own inertia. All this
in a context where, despite some widening, the output gaps are still bounded and the
expected external impulse facing the Chilean economy over the next two years shows no big
change from September.
Still, beyond these changed projections, what merits the most attention is that the range of
risks has increased.
In this context, in our latest monetary policy meetings we have held the monetary policy
interest rate (MPR) unchanged at 3.5%. At the same time, while acknowledging the effects
that the changes in the macroeconomic scenario are having on the medium-term inflation
outlook, in our last meeting we noted that, for us to meet our objective of placing inflation at
3% in two years, a higher monetary impulse might be necessary.
Let me now present to you the details of our vision of the macroeconomic scenario and the
projections contained in our Monetary Policy Report.
The Monetary Policy Report
As I said, in November the CPI posted an annual variation of 2.9%, almost half of a
percentage point less than we had estimated in September. This sharper decline in inflation
is mainly related to those goods most closely related with the exchange rate and some
foodstuffs. Thus, goods CPIEFE inflation fell to 1.6% in November, that is, 2.1 percentage
points less than in July, in a context where the exchange rate has fluctuated-give or take-
between 650 and 680 pesos per dollar. Services CPIEFE inflation has declined at a more
measured pace, in line with the moderate expansion of capacity gaps and its high content of
indexed prices. In any case, it has accumulated a decline of a little over one percentage point
in ten months. The low inflation for fresh fruits and vegetables was a surprise because of its
atypical behavior compared with the known seasonal patterns (figure 1).
Third-quarter activity figures continued to reveal limited strength. During the first three
quarters of the year, sectors other than natural resources (i.e. Other GDP) grew slightly less
than 2.5% annually, driven by services and trade, while construction and, especially,
manufacturing performed rather poorly.
Meanwhile, in the first three quarters, domestic demand-excluding inventory change-grew
in tandem with Other GDP, driven by private and government consumption. Investment was
better than expected, but in annual terms it was negative again, particularly due to the further
deterioration of construction and other works (figure 2).
The negative annual variation of the Imacec in October was unexpected. Beyond the volatility
of month-to-month figures, the result is still strongly influenced by the poor performance of
mining, coupled with the weak performance of some industry lines (figure 3). Even though
this figure is not a trend setter, it is sufficient to reduce fourth-quarter growth, which in turn
weighs in the revision of estimated 2016 growth, which now stands at 1.5%, i.e., the floor of
the forecast range we estimated in September. Despite the performance of activity in
October, partial fourth-quarter data suggest that the behavior of domestic spending has not
changed significantly. This, in an environment where the labor market is adjusting gradually,
with an unemployment rate that remains low (although strongly influenced by increased
selfemployment) (figure 4). In turn, although with monthly fluctuations, wages show annual
expansions around their historical averages. Bear in mind that the decline in inflation has
accelerated growth in the wage bill in real terms (figure 5).
As I said, the main event abroad was the American election. It opened a number of questions
about the external economic outlook, characterized by highly expansionary monetary policies
in the developed world. One such question is about the potential effects of a fiscal package in
the US, which the financial markets estimate to be very likely. This yielded the way to
increased inflation expectations, prospects of a not-so-expansionary monetary policy, a
strengthening of the dollar and reduced appetite for longer-term securities. Thus, long-term
interest rates have increased substantially in the US, and have been replicated in the rest of
the world with varying intensities. In this context, financial conditions facing emerging
economies have tightened, although they remain positive from a historic standpoint (figure 6).
This deterioration of financial conditions owes not only to increased funding costs, but also to
capitals outflows towards the developed world (figure 7).
In Chile, the markets' first reaction to the American election outcome mirrored that of the rest
of the world, with a significant increase in nominal and indexed long-term interest rates and a
depreciation of the currency. Most recently, however, these trends have been reversed. The
10-year BCP rate, which rose about 60 bp in the wake of the election, stood at 4.4% at the
Monetary Policy Report's statistical cutoff date, that is, 20 bp above its pre-election level
(figure 8). Meanwhile, at this Report's closing, the nominal exchange rate was near 650
pesos per dollar, after trading around 680 CLP/USD on some days in November. Thus,
considering the average of the ten days prior to this and the last Report's statistical closing,
the peso-dollar parity has almost stayed the same, but in multilateral terms it has appreciated
close to 3.5% (figure 9). Immediately after the statistical cutoff, and after the decision of the
Fed, the dollar appreciated again globally, and the peso followed suit. Thus, in recent days
the nominal exchange rate has traded above 670 pesos per dollar. The evolution of the
multilateral parity, combined with the behavior of inflation, domestic and external, and the
copper price, have resulted in a lower real exchange rate (RER) compared with a few
months back. Thus, at the statistical cutoff date it was within the range of estimated
shortterm fundamentals, but below its 15- to 20-year average. The baseline scenario uses as a
working assumption that the real exchange rate will depreciate steadily throughout the
projection horizon, reflecting the interest rate differential with the US rates (figure 10).
Abroad, incoming figures for output and inflation show no big changes in these tendencies so
far. In the United States, activity and labor indicators point to a strong economic performance.
In other developed economies, there are signs of an incipient recovery. As regards emerging
economies, China's growth is stable and Latin America shows heterogeneity. In this context,
the need for further monetary stimulus in Europe and Japan is not so urgent anymore, and
the expectation of a new policy rate increase by the Fed has consolidated. As I said earlier,
this decision occurred after we had stopped the presses for this Report. It is worth noting that
the Fed announced that the withdrawal of the monetary stimulus would be slightly faster. The
copper price was fairly stable up to early November, when it jumped from around 2.2 dollars
per pound to nearly 2.6. Nonetheless, this movement seems excessive given the evolution of
its fundamentals. Oil, in turn, over the past few months, has fluctuated between 45 and 50
dollars per barrel most of the time. Most recently, after OPEC agreements and
announcements by other producers that they would limit production, it is trading around 55
dollars per barrel.
I now turn to our projections and associated risks.
In the baseline scenario of the MP Report I present today, this year's growth is estimated at
1.5%. As I said, this is the lower bound of the range we estimated in September, considering
the slower growth foreseen for the fourth quarter. About 2017, the slower initial pace, in a
context of higher risks and still very pessimistic confidence levels, we foresee that activity will
take longer to resume near-potential growth. Accordingly, our growth estimate for 2017 has
been adjusted to a range between 1.5% and 2.5% (1.75% to 2.75% in September). This
higher growth in 2017 compared with 2016 is based on the fact that the economy does not
present any imbalances, the mining sector will not to repeat the sharp drops of previous
years, and investment will post some increase after three years in a row falling in annual
terms. The effects of these changes will be seen more clearly in the second half of the year.
All this, in a context where the fiscal consolidation announced by the government continues
and monetary conditions remain expansionary.
Excluding inventories, domestic demand will grow 2% in 2017. Just as in 2016, we expect
private consumption to boost expenditure, considering a further gradual adjustment of the
labor market and lower inflation driving real wages. Plus the already mentioned fact that
November's consumer goods imports showed a rebound and that, while still pessimistic,
consumer expectations have shown some increase in recent months, especially for
durables. About investment, in the near future we see no significant projects, low activity in
housing construction and still bad business expectations. Nevertheless, this component is
expected to post positive growth in 2017, as assumed in September, after contracting for
three years in a row (figure 11). Thus, the baseline scenario estimates that, as a percentage
of GDP, gross fixed capital formation will continue to drop in both real and nominal terms, to
22.9% and 21.7% of GDP, respectively (22.6 and 21.8% in September).
As for the external scenario, a current account deficit is expected with no major changes
between 2016 and 2017, very close to September estimates: 1.7% and 1.9% of GDP,
respectively. However, as this figure contemplates an improvement in the terms of trade, at
trend prices the current account deficit is bigger than was implicit in the last Report, by about
half a percentage point in 2017. Our current account forecast assumes that Chilean exports
volume will grow about 2% in 2017, after a fairly flat 2015 and a down-sloping 2015. By
sectors, we expect increased volumes of both mining and non-mining shipments (table 1).
In this scenario, annual inflation will decline further, to less than 3% during most of 2017, and
remain stable through the rest of the projection horizon. This course reflects a significant
reduction in the CPIEFE in 2017, owing to different elements. On one hand, the exchange
rate trajectory will continue to contribute to reduce imported goods inflation. On the other
hand, beyond the effects of comparison basis related to the stamp tax, services inflation is
expected to continue to decrease gradually, especially because the reduced inflation at the
end of 2016 will affect indexed prices during the early part of 2017. This, in a context where
medium-term inflationary pressures are bounded, and where capacity gaps will continue to
exist during the entire projection horizon. Meanwhile, energy and foods inflation is expected to
rise, partly offsetting the effects of the aforementioned elements on headline inflation (figure
12).
Beyond the presence of higher risks, this forecast assumes that the external impulse facing
the Chilean economy will be as estimated in September. In particular, external financial
conditions will be less favorable, but better terms of trade are expected. The baseline
scenario projects a copper price of US$2.35 and US$2.40 per pound in 2017 and 2018,
respectively, in line with forecasts by market analysts and with an environment marked by an
appreciated dollar and higher interest rates. The oil price, in turn, is revised slightly upward
from September, to an average of 55 dollars per barrel in 2017-2018. Growth projections for
the world and our trading partners show no changes on aggregate and point to some
acceleration in 2017 and 2018 (table 2).
As regards the MPR, the baseline scenario uses as a working assumption that it will follow a
trajectory comparable to the one assumed in the various expectations indicators. This
ensures that monetary policy will remain expansionary throughout the projection horizon. As
always, the implementation of monetary policy and any possible adjustments to the policy
rate will be conditional on incoming information and its effects on the projected inflation
dynamic (figure 13).
On the external front, although the market anticipates an increase in the fiscal impulse in the
United States, with planned infrastructure works, tax cuts and measures generally intended
to boost growth, their details are still unknown, as is the time it will take to carry them out. In
that sense, there is the possibility of a significant fiscal package that results in higher
economic growth in the US and the rest of the world. However, another possibility is that the
impulse disappoints and financial markets deteriorate, ending up in dominating negative
effects. The US inflation outlook also poses risks, as it could precipitate a more aggressive
behavior of the Fed. For now, after the meeting of last week, the Fed announced a slightly
faster withdrawal of the monetary stimulus. The effects of potential protectionist measures on
world activity and trade has to be considered as well. All this, with Brexit's effects still in the
dark and with several major European economies preparing election processes. Plus doubts
surrounding the soundness of some European banks.
Financial conditions facing the emerging world have worsened, and there is the risk of a
sharper deterioration. In China, despite stabilizing activity, risks remain, especially in its
financial system. In Latin America, there are still economies in need for adjustments and
others making changes that could create some turbulence.
At home, the inflationary surprises of recent months concentrate in prices linked to the
exchange rate and foodstuffs, but some delay in inflation's convergence to 3% cannot be
ruled out, especially if capacity gaps widen more than forecast. Meanwhile, the evolution of
the peso will continue to be subject to a high degree of uncertainty, which could affect
shortterm inflation in either direction.
Regarding activity, the most recent figures put a note of caution, even considering the
volatility of month-to-month data and that demand-side information at hand has been more
favorable. Also, the deterioration of external financial conditions could have a stronger than
anticipated impact. Conversely, the baseline scenario considers that the level reached by the
price of copper in recent weeks will not remain over the projection horizon. This, because
there has not been any corresponding change in its fundamentals and because its increase
has gone counter to the evolution of global interest rates and the value of the dollar. However,
it is possible that the current prices of the metal will last for longer than expected, which could
boost domestic spending once again -for example by an earlier recovery of investment in
the sector- or because it could improve confidence sooner.
All considered, the Board estimates that the balance risk is unbiased for both activity and
inflation.
Summing up, we now face a scenario where inflation has dropped faster than expected- but
will stand at 3% at the end of the projection horizon-and where activity continues to grow
slowly. Both domestic and external risks have increased.
Let me now turn to the issues we explored in our Financial Stability Report.
The Financial Stability Report
Our Financial Stability Report, which we publish in June and December of each year,
presents recent macroeconomic and financial developments that might influence the
financial stability of the Chilean economy.
On the external front, the risks presented in the FS Report are the same of the Monetary
Policy Report I just described. Worth mentioning is the uncertainty surrounding how the
worsened external financial conditions and the Chinese situation will affect us. In China,
private credit is still on the rise, as is the banks' exposure to the real estate sector, where
house prices continue to grow at two-digit rates in the high demand cities. The quality of
banks' portfolios has deteriorated further, in line with the poor behavior of the corporate
sector. This situation could worsen further with a rise in financial costs, again if international
trade policies move towards protectionism, given the still high dependence of the Chinese
economy on its exports.
At home, the effects of the higher external interest rates on local rates and on the valuation of
mutual and pension funds, especially fixed-income-intensive ones (e.g., the E pension fund)
are worth noting. In the particular case of mutual funds, significant withdrawals have been
observed in medium- to long-term funds, which undid part of the increases reported in
previous FS reports. Although so far there have been no significant hikes in money market
rates, the greater dependence of medium-sized banks on financing coming from these funds
is one risk worth keeping an eye on.
The financial situation of domestic firms has not changed much from earlier FS reports.
Corporate debt has fallen a little, to 119% of GDP at the third quarter, but it is still near peak
levels. A large part of the variation owes to the peso appreciation against the dollar during the
period (figure 14). The profitability of domestic firms also kept its downward trend at the close
of 2015. A similar pattern is seen for a group of companies reporting to the Superintendence
of Securities and Insurance (SBIF) which maintain low profits and high indebtedness by
historic standards. Meanwhile, various indicators reveal that the exchange rate risk remains
bounded. Finally, firms' bank debt repayment default remains stable and relatively low,
although the increase in the substandard commercial portfolio reflects a slight decrease in
borrowers' capacity to keep their repayments up to date. This situation could worsen in the
face of a more adverse economic scenario resulting from slower economic activity or
increased financial expenses. The latter could be seen if the increases in funding costs were
transmitted to the local lending rates, thus affecting firms needing to renegotiate their
liabilities. Our estimates, however, suggest that a deterioration in activity would have a
greater impact on firms' financial strength than would an increase in financial expenses.
Household risk indicators remain fairly stable, in line with the gradual adjustment of the labor
market. Aggregate household indebtedness continues to increase because of a higher share
of mortgage loans. The lower interest rates seen up to September helped to maintain the
aggregate financial burden relatively stable around 15% (figure 15). At the same time,
delinquency in both consumer and mortgage loans remained bounded with no major variation
from the previous half. Some exceptions include consumer loans granted by Clearing and
Family Allowance Houses and bank mortgage credits in the northern regions, where credit
quality has fallen. Thus, one risk identified in the FS report is that a worsening of labor
indicators could hinder the repayment capacity of households.
Turning to the real estate sector, both housing prices and mortgage credit have moderated
their growth rates. Several housing price indicators posted lower growth rates than in
previous quarters, reflecting the dynamics of their components (figure 16). Data from real
estate companies reporting to the SBIF show no increase in withdrawal rates at the third
quarter of 2016. It is worth noting, however, that this risk persists because a large part of
promised projects in 2015 were due to be delivered between the last quarter of 2016 and the
year 2017. Lately, there has been an increase in the down payment required by the banks to
grant a mortgage loan, which could result in more withdrawn promises by those households
that were unable to meet the necessary savings to comply.
Profitability of the banking system has dropped, as interest spreads have reduced their
contribution. This can be explained by a change in composition of the credit portfolio towards
lower relative return products-fewer consumer and more mortgage loans-and by the
migration towards less risky clients, who are offered lower interest rates. At the same time,
the capitalizations of the first half of 2016 drove up the banking system's capital adequacy
ratios (CAR), strengthening their position to deal with adverse economic scenarios. In fact,
stress tests indicate that banks have the sufficient capital to face severely stressful
conditions. All in all, capital gaps are similar to those in comparable countries. Although
several capital increases have been made lately, no changes in banks' dividend withholding
policies have been observed that would allow increasing the capital base endogenously. In an
international context, the CAR level of the banking system remains below the 25th percentile
in both OECD countries and in the region. Accordingly, it is important to advance in the
discussion of legislative initiatives that help to strengthen the banking system's capitalization,
in line with the efforts that other countries have made to converge with Basel III requirements
(figure 17).
In summary, although in this Financial Stability Report we conclude that there are no
fundamental changes in our risk outlook, we do see that local agents' financial strength has
diminished steadily during the past few years due to weakening economic activity. Household
and corporate debt has increased moderately but persistently, non-financial firms' profitability
has fallen together with the limited expansion of output-reducing their capacity to deal with
greater financial expenses-and the banks' profits and capitalization have dwindled. Although
the lower interest rates have helped these developments not to translate into financial stress,
the agents' capacity to deal with an adverse external scenario is now lower than it was a few
years ago, especially if such scenario causes further economic slowdown. In this context, it
is very important that some of the trends of recent quarters, such as the lower growth in
corporate debt and higher bank capitalization, consolidate.
I would like to end this presentation-my first as the Governor of the Central Bank of Chile-
by sharing some thoughts about the achievements and challenges facing the institution I
have now begun to lead.
Final thoughts
Let me begin by stressing that I have been handed an institution that can show great
strengths and unquestionable achievements. As I said, the last inflation figure was 2.9% in
twelve months, practically right on the monetary policy target. Financial risks are well
contained and the Chilean economy has successfully weathered a period of significant
slowdown without much trouble.
As an institution, the Bank inspires credibility and trust. Over the past several years, inflation
expectations two years out have remained stable at the policy target. Also, the voice of the
Bank has been heard when it has identified risks emerging in the financial sector, and its
model of organization and autonomy has inspired every agent searching for institutional
schemes granting a transparent and equitable operation in key functions.
It is important to recognize the contribution of the Central Bank of Chile's staff, Board
members and Governors that came before me to achieving those high standards.
Getting to this point wasn't easy, in either substantive or institutional terms. During the past
few years, the evolution of the economy has been determined largely by the swings in the
world economy. The end of the so-called commodity boom, the persistence of very
expansionary monetary policies-both conventional and unconventional-, deflation replacing
inflation as a macroeconomic risk and the profound transformations that the Chinese
economy has experienced, among others, are some of the large-scale phenomena that have
generated major, even atypical, changes in the external scenario facing the emerging
economies.
These changes have been perceived especially clearly in Chile. During the years of
highlypriced commodities, especially when they were coupled with particularly low interest rates,
our economy grew more than 5% annually, the real exchange rate dropped substantially, and
investment boomed. Despite this, they were years of particularly low inflation, driven by the
drop in many tradable goods' inflation.
The situation changed dramatically in late 2013, when Chile's terms or trade reversed
significantly. Since then growth has been near 2% and investment has receded, as has the
current account deficit. Between 2013 and 2015 the peso depreciated largely, pushing
inflation above the tolerance range for longer than expected.
The transition from high growth and low inflation to low growth and high inflation is certainly
uncomfortable for any central bank. More so if this transition features an autonomous
confidence shock as happened in our case. But we do not choose the shocks that hit us.
What we can do is to deal with them and cushion their impact on the overall economy. This
has been possible, to a great extent, because of our appropriate policy framework.
This framework consists of an inflation-targeting monetary policy with a floating exchange
rate. This makes it possible to adjust the monetary impulse so that projected inflation two
years out stands at 3%, allowing relative prices to adjust to changes in external conditions. In
the context of the end of the long cycle of high commodity prices, this policy framework
helped the economy to walk the path of the necessary adjustments it had to make, which
required low real interest rates and a depreciated currency. Thus, although inflation soared in
the years 2014 and 2015, monetary policy was eased, because despite the higher inflation,
we saw that medium-term pressures were pushing down.
This countercyclical operation of monetary policy was accompanied by a policy of structural
fiscal balance that allowed the budget's automatic stabilizers to act. The combination of both
elements and their rigorous application throughout the cycle allowed to attenuate its inherent
volatility, and therefore its social costs. But as the fiscal policy framework assumes a rather
passive role for it, monetary policy has been, and will continue to be, the first line of defense.
The continuity of the monetary policy framework and its fiscal counterpart over sixteen years
has proven effective during booms and busts, passing difficult economic and political tests.
Thus, the continuity with the outlines that our Central Bank has built is not only an expression
of its soundness as an institution, but a logical course of action, when its objectives have
been clearly achieved.
Continuity provides a sound base to face new challenges and to build and strengthen the
institutions. The innovations that the Central Bank of Chile has incorporated into all its areas
of action, from monetary policy to its own corporate management, from generating statistics
to the management of circulating money, are proof that a sound institution is not necessarily
immutable. Also, that an autonomous organization can develop beyond its legal mandates.
The challenges facing the Bank in the future, in both the macroeconomic and the institutional
fields must not be underestimated. The confidence that our citizens put in this institution is
not an insured capital but something that, again, needs to be earned day by day in each one
of its areas of responsibility.
These challenges involve, first and foremost, applying the inflation targeting framework in a
changing macroeconomic context, both externally and internally. The business cycle has
stopped behaving as it was traditionally understood-with a certain regularity between
economic activity in the United States and the emerging economies; between the value of the
dollar and commodity prices; between the money supply and market interest rates.
International trade and investment have been slow to recover, which has been especially
damaging for exporters of natural resources, such as Chile.
China's economic prominence, the integration of