Rodrigo Vergara: Chile's March 2014 Monetary Policy Report
Presentation by Mr Rodrigo Vergara, Governor of the Central Bank of Chile, of the Monetary
Policy Report before the Honorable Senate of the Republic, Santiago de Chile, 31 March
2014.
* * *
Accompanying charts can be found at the end of the speech.
Mr. President of the Senate's Finance Commission, Senator Ricardo Lagos-Weber. Senators
members of this Commission, ladies, gentlemen,
Thank you for your invitation to share with you the vision of the Central Bank Board about the
recent macroeconomic developments, its outlook and implications for monetary policy. The
detail of this vision is contained in our March 2014 Monetary Policy Report.
A year ago, when the Board gathered with this Commission on a similar occasion, we
underscored the importance of investment in the Chilean economy's strength and its
connection with the global cycle of mining investments. We then stated that the
implementation of a large number of projects in mining and related sectors, such as energy,
had provided a boom in investment. This had resulted in greater domestic spending, putting
pressure on installed capacity utilization and the labor market, as well as on imports and the
current-account deficit of the balance of payments.
The Board also noted that it foresaw at the time a gradual maturation of said investment
cycle and expected a normalization of economic growth during 2013, after several years of
expanding above trend. Accordingly, an easing of the pressure on domestic productive
resources was also expected, together with a reduction in the trend current-account deficit.
Later on, beginning last June, we drew attention to the international financial conditions
which were beginning to normalize, after announcements by the Federal Reserve Board of
the United States. We noted then that this process could create increased short-term
volatility in the global economy and the international financial markets, as portfolios were
adjusted and spending plans were reviewed, but that, at the medium term it was a healthy
development because it would create an environment that would help prevent the incubation
of financial vulnerabilities. At the same time, we noted that the Chilean economy was on a
good stand to address this transition in international liquidity. Our inflation-targeting and
floating exchange rate regimes, our sound fiscal accounts and strong financial system,
together with our healthy external financial structure allowed us to confront with relative calm
this process and help cushion its impact on our economy.
Throughout the past year, we have seen both a moderation in the investment impulse in
Chile as the gradual normalization of global financial conditions. Investment has adjusted
more sharply than anticipated, such that our economy grew less than we projected in late
2013, which also reflects in a downward revision of Chile's growth forecast for 2014. Still, I
would like to say that other mineral exporting economies have given a surprise in the same
direction, hand in hand with the worsening of China's economic outlook. The convergence of
metal prices toward their production costs has been somewhat faster than thought a year
ago. In the case of copper, the price forecast for 2014 in this Report has been lowered by
more than 10 percent in one year. Other demand components, such as consumption, have
posted a more gradual deceleration, in line with still favorable, yet moderating, fundamentals.
International financial conditions have also been normalizing, which, while positive over the
medium to long term, has caused increased volatility, higher risk premiums and capital
outflows in emerging markets, together with a widespread depreciation of currencies vis a vis
the U.S. dollar.
In Chile, contrasting with past episodes, the financial effects have been bounded. The risk
premium, for instance, is the same or slightly higher than previous values. Unlike other
emerging economies, Chile has seen a drop in interest rates in the recent past, and the
Central Bank has not intervened in the forex market by selling reserves as have other
countries.
Nonetheless, consistently with our macroeconomic policy regime, we have seen a
substantial impact on the exchange rate. Actually, the Chilean peso depreciation is in the
upper half of the group of emerging economies (figure 1). The real exchange rate has also
depreciated significantly and is above its averages for the last fifteen and twenty years
(figure 2). This depreciation of our currency, however, is an optimal response to the new
circumstances, as it implies an adjustment of relative prices and thus contributes to the
rebalancing of sources of growth across economic sectors. In other words, it shifts the
growth dynamic from domestic demand to exports.
In this scenario, Chilean inflation has returned to the vicinity of 3 percent (bear in mind that
last year it was most of the time in the lower part of the Central Bank's tolerance range:
2 percent) (figure 3).
So this big depreciation of the Chilean peso has not altered the forecast that inflation will
remain in line with the target over the policy horizon. This reflects that the pass-through
coefficient, which measures how much of the depreciation is translated into higher prices, so
far has not created unwanted propagation to inflation. Of course there are items that
immediately reflect any exchange rate movements, like fuels, for example. But the
passthrough to core inflation trends and expectations is not so mechanical. On one hand, there is
evidence suggesting that it depends on the economy's cyclical conditions, meaning that in
the present circumstances, where gaps are being formed, this pass-through should be small.
On the other hand, said coefficient has shrunk over time as the inflation targeting scheme
has consolidated. Thus, the credibility of monetary policy also reduces the coefficient,
allowing us to project that, beyond short-term effects, inflation will stay near the target over
the policy horizon. (The Monetary Policy Report contains a box with more details on the
pass-through coefficient).
For the same reason, monetary policy has moved to a more expansionary instance, and the
monetary policy rate (MPR) has been lowered by 100 basis points over recent months to a
level of 4 percent annually. Furthermore, as we said in our last press release, we will
consider the possibility of making additional cuts to the policy rate, in line with the evolution
of domestic and external macroeconomic conditions and its implications on the inflationary
outlook.
Some market players and observers have suggested that the current scenario of slower
growth and higher inflation poses a dilemma to monetary policy makers. This, meaning that,
in the current circumstances of some deceleration and a slight rise in inflation, one must
prioritize one or other of these variables. We believe, for the aforesaid reasons that there is
no such dilemma. Actually, our baseline scenario assumes that, as we will see in a while,
inflation will rise temporarily to the upper zone of the tolerance range, but by the end of this
year it will be close to the target.
But if such a situation was to persist, there could be a dilemma. This is why we continually
watch for the so-called "second-round effects", that is, if a change in the parity puts more
persistent pressure on the other prices. In that case, the Central Bank will take every
measure necessary for inflation to quickly return to the target. That is our mandate.
The way our economy has reacted to the recent changes in the terms of trade and external
financial conditions is precisely a reflection of our policy regime, which allows for timely
adjustments in the real exchange rate and interest rates, letting the economy grow near its
potential, smooth the capital account's adjustments and maintain the credibility of the
inflation target. This marks a difference with our economic history.
Over the years, the Central Bank has given proof of its commitment with price stability and
the inflation target. It has operated with consistency in order to build credibility and trust,
which gives us the necessary flexibility for monetary policy and the real exchange rate to
work as buffers of the business cycle whenever advisable.
In the past, when our economy's fundamentals were not as strong, and the exchange rate
regime was rigid and poorly suited to confront external shocks, when faced by a drop in the
terms of trade or stringent financial conditions, in order to stop a currency depreciation the
Bank had to sell international reserves and raise the interest rate to reduce capital outflows.
Monetary policy, far from cushioning the external cycles, made them worse, generating
economic costs and financial risks. More often than not, these experiences ended badly.
Overall, as usual, the present scenario has varied risks, most of them coming from emerging
economies, because of both their importance in commodity prices and the behavior of world
financial markets. Despite the strong fundamentals of the Chilean economy, we are not
immune. We are a small, open economy, so external developments can and do affect us.
Now, allow me to describe in detail the macroeconomic scenario we believe to be the most
likely one in the coming quarters, and associated risks.
Macroeconomic scenario
Our baseline scenario assumes that in 2014 the emerging markets will grow below their
averages of recent years. China is a case in point, whose growth forecast has been steadily
revised downward during the past several months and is now even below the officially
defined target of 7.5 percent per year (figure 4). Other Latin American economies, including
Brazil, Mexico and Peru, have also revised downward their respective projections. This owes
to a number of factors. On one hand, the weaker fiscal and monetary impulse in Brazil, poor
growth in Mexico and a slowdown in investment and exports in Peru. On the other hand,
Argentina and Venezuela are making substantial corrections to their growth outlooks for the
year, of the order of 3 percentage points down (figure 5).
All this contrasts with the developed world, where growth forecasts for the year have been
revised upward, although with different nuances. Worth noting is the improved performance
of the United States and confirmed signals of recovery in the Eurozone. Taking these
changes together, that is, higher expected growth in the developed economies and lower
growth in the emerging world, considering their relative weights, drives our forecast for
Chile's trading partners marginally up for 2014 and 2015, to an average of 3.8 percent
(3.7 percent in December).
The financial conditions facing our economy have not changed materially since December,
while the terms of trade have worsened. Overall, compared with recent years, our external
scenario will be less favorable this year. This because, on the one hand, foreign interest
rates have risen as has risk aversion towards emerging markets. On the other hand, the
price of copper has been falling for some months. In fact, at the statistical close of this Report
it had dropped past the barrier of 3 dollars per pound. Our baseline scenario foresees that
the pound of copper will trade at an average of 3 dollars in 2014 and 2.85 dollars in 2015
(table 1).
As I said before, in the past few months output and demand growth fell short of our forecasts
in the previous Monetary Policy Report, particularly in investment-related sectors. Output
grew 4.1 percent annually in 2013, with a sharp deceleration during the second half. One
determinant was the behavior of sectors unrelated to natural resources, especially those
associated with investment such as construction and part of trade and manufacturing.
Among the components of demand, gross fixed capital formation posted the sharpest
downward adjustment. Machinery and equipment posted negative y-o-y growth in the third
and fourth quarters of 2013, while construction and other works decelerated significantly
during the same period (figure 6).
This correction to investment growth owes to various factors. For one, there is the
aforementioned investment cycle of mining and related sectors, plus the postponement of
some investment plans. Although this was an expected development, its magnitude was
unclear. Another factor is the low basis for comparison of the same months of 2012, which
were swollen by unusual imports of transportation material, which affects the y-o-y variation
of capital goods imports. There is also the downturn of expectations reflected in business
confidence surveys and our business perception report Informe de Percepciones de
Negocios. Lastly, there is the drop of public investment in real terms during the last quarter of
the year, and the depreciation of the real exchange rate, which raises the costs of foreign
capital goods.
Accordingly, private growth forecasts for this year have been revised downward. Our March
Economic Expectations Survey lowered GDP growth in 2014 from 4.1 percent in November
to 3.7 percent in March. Thus, the baseline scenario of this Report has lowered the GDP
growth estimate for 2014.
The Board estimates that this year our economy will grow between 3 and 4 percent (3.75 to
4.75 percent in December), that is, less than last year and below trend. This means that this
year investment will fall short of projections, with an annual growth rate that is now estimated
closer to 1 percent (4.1 percent in December). It also inputs first-quarter data available, as
well as the downward revisions to investment in 2013 and the turn of 2014 shown by the
latest survey of the capital goods corporation CBC. Another factor behind the lower growth
forecast for the immediate future is the upward correction to inventory levels, meaning that
this source of expansion will provide a smaller impulse. The baseline scenario also estimates
that, as has been occurring for some quarters, private consumption will post a moderate
slowdown, grounded on a looser labor income and a stable borrowing trend.
This year, growth will go from less to more. Such a trajectory assumes that investment will
stabilize, due to several elements coming together. On one hand, the CBC survey shows an
increase in investment plans in engineering works in the second half of 2014 and for the
period 2015-2016. On the other, there is housing construction that should continue the trend
of last year, considering that the supply of homes is still low, housing sales are strong, and
financial conditions (i.e. credit cost and volume) remain favorable. Meanwhile, the fiscal
budget for 2014 is expected to be more in line with historical patterns, implying greater public
spending with respect to 2013, especially investment. Machinery and equipment imports
have been stable for some months. Plus, the somewhat stronger growth of trading partners
and the depreciation of the real exchange rate should also boost non-mining exports. And
last but not least, there is the increased monetary impulse that has been added to the
economy.
As for domestic inflation, it has returned back to the Central Bank target of 3 percent in
annual terms faster than expected. In recent months, CPI inflation has been driven by energy
price increases that reflect both the higher dollar price of fuels and the depreciation of the
peso. The impact of the depreciation on other prices in the CPI basket has been in line with
expectations; Core inflation (i.e., the CPIEFE that excludes foodstuffs and energy) has also
risen, although at a slower pace than headline CPI. Inflation expectations have remained at
3 percent in the projection horizon, with a slight increase in the near term.
The baseline scenario assumes that y-o-y CPI inflation will rise temporarily to the 3.5 to
4 percent range, in the coming months, reflecting the direct propagation of the peso
depreciation to the prices of goods and services. The lower use of installed capacity -
proxied by the behavior of output - should mitigate inflationary pressures and the direct
effects of the depreciation. As I just said, the credibility and consolidation of our
inflationtargeting scheme also help. Therefore, already by the end of 2014 headline inflation should
move closer to 3 percent, where it should stay until the end of the projection horizon, that is,
the first quarter of 2016. Core inflation will hover around 3 percent throughout the same
horizon (figure 7).
The current account deficit of the balance of payments is forecast to stand at 3.6 percent of
GDP in 2014, up a little from 2013, but below the December estimate. Behind it is the
expected decline in the copper price this year, which more than offsets the lower growth
foreseen in domestic demand and imports. This implies that, measured at trend prices, the
deficit will narrow further, approaching 3 percent of GDP. As for GDP, the rate of total
investment will go slightly above 23 percent in nominal terms (somewhat more than
25 percent in real terms), while national savings should amount to 19.5 percent (table 2).
Aside from the already discussed trajectories foreseen for domestic growth and the world
economy, this forecast uses as a working assumption that nominal wages will be adjusted in
line with productivity and the inflation target. It also uses as a methodological assumption
that the real exchange rate will remain stable, considering that it is now inside the range
believed to be consistent with its long-term fundamentals. Finally, the baseline scenario uses
as a working methodological assumption that the MPR will follow a trend comparable with
the one that can be derived by the prices of financial assets prevailing at the statistical
closing of this Report (figure 8).
The baseline scenario reflects those events that are believed to be the most likely to occur
with the information at hand at the closing of this Report. There are risk scenarios, however,
which if materialized, may reshape the macroeconomic environment and, therefore, may
modify the course of monetary policy. On this opportunity, having evaluated the alternative
scenarios, the Board estimates that the risk balance is downward biased for output and
unbiased for inflation.
Abroad, one first risk has to do with the behavior of emerging economies, especially China.
The latter risk has been present in several Reports already and has recently been
exacerbated because of growing doubts posed by the fragility of the Chinese financial
system and the overall increase in the risk perception of the emerging world. In particular,
adeterioration in the Chinese economy would have first-order effects on Chile and the group
of emerging economies, spreading through both real and financial channels. Of particular
importance is its impact on the prices of commodities, including copper, as well as on the
growth of other important trading partners. Moreover, it cannot be ruled out that the
vulnerabilities that some emerging economies have accumulated may generate new
episodes of volatility
It is also possible for the recovery process in the U.S. to end up being stronger than
expected. The timing of its effects shows different signs. In the short term, the anticipated
normalization of the monetary stimulus could lead to a worsening of financial conditions for
the emerging world, inducing new episodes of volatility as in recent quarters. Going forward,
the effect of increased external demand and higher commodity prices would prevail, with
positive effects on economies like Chile that have solid fundamentals. Overall, the risk
associated with the complex fiscal and financial situation in the Eurozone is still present and,
moreover, heightening of geopolitical tensions in Ukraine could affect commodity prices, as
well as confidence in Europe.
At the local level, an important part of the economic slowdown of recent quarters is due to a
drop in investment. The baseline scenario assumes that this phenomenon will not deepen
and for some components it will even be reversed. But there are risks, particularly since the
drop in investment in late 2013 was sharper than expected. For example, it is possible that,
due to its natural inertia, investment may remain weak for longer than foreseen. Another risk
is that a deterioration of the global economy may pull down the copper price below its
longterm level, deferring new projects and slowing economic growth.
Still locally, inflation of recent months, like the projections included in the baseline scenario,
show limited pass-through of the peso depreciation to prices, in line with economic
fundamentals. As I said, the consolidation of the inflation-targeting regime and the economic
slowdown restrict the degree of propagation to final prices, wages and expectations, so the
recent rise in inflation is believed to be transitory. However, it is necessary to watch out for
second-round effects to make sure they remain contained, particularly considering that
margins have narrowed in some sectors due to increases in costs, such as energy, and that
the labor market remains relatively tight.
Final remarks
The macroeconomic scenario shows economic slowdown beyond projections of a few
months back, with inflation hovering around 3%. The external short-term outlook for Chile is
less favorable than it was a year ago. In addition, further doubts have emerged regarding the
performance of some of the big economies, especially China.
Just like we have done in the past few years, we are facing challenging conditions. The world
economy is going through a new stage, where the central banks of developing economies
are beginning to withdraw their extraordinary monetary stimulus packages, and the prices of
our exports are returning to normal.
Without a doubt, beyond the volatility and uncertainty that we have seen in recent quarters,
the improved performance and recovery of developed economies is good news for everyone.
It opens the door to markets that have been severely depressed for some years and, in the
end, such unusual and persistent financial conditions eventually create imbalances. And
imbalances are bound to become increasingly costly as time passes.
Chile has managed to navigate this period with no accumulation of imbalances. Still, we will
inevitably be affected. The cycle of high commodity prices is starting to reverse and the
copper price will thus approach its medium-term levels. As I noted, the recent reduction in
investment is partly associated with this factor and is also one defined risk in our baseline
scenario.
Thankfully, our policy regime provides us with the tools to mitigate the effects of a more
adverse scenario. Moreover, our country is well prepared to deal with future challenges. The
depreciation of the peso has been a buffer, especially because it allows relative prices to
adjust and thus rebalance resources and lessen the impact on output and employment. It
also has an effect on inflation. This effect has been limited, in line with our economy's
fundamentals and the state of capacity gaps. This is also related with the credibility of our
monetary policy's commitment with the inflation target.
Inasmuch as macroeconomic conditions warrant, the Central Bank has the room and the
determination to continue contributing to mitigate the cyclical slowdown of the economy. But
we also reaffirm our commitment to achieving price stability, indicating that we will do
everything necessary to ensure that projected inflation is aligned with the 3 percent target
over the policy horizon. As we have said time and again, this is the main contribution that
monetary policy can make to the development and well-being of our country.
Thank you.
Figure 1
Depreciation of emerging economies' currencies (*)
(percent)
30 30
25 25
20 20
15 15
10 10
Chile
5 5
0 0
-5 -5
-10 -10
Fed Withdrawal Most appreciated Early 2014
announcement, begins, Dec. 2013 level in 2013
May 2013
(*) Change between spot and specified date.
Sources: Central Bank of Chile and Bloomberg.
Figure 2
Real exchange rate (*)
(index, 1986=100)
120 120
110 110
100 100
90 90
80 80
70 70
( ) g y
88 90 92 94 96 98 00 02 04 06 08 10 12 14
RER 1994-2013 average Spot 1999-2013 average
(*) The March 2014 figure covers information up to the 26th.
Figure 3
Inflation indicators (*)
(annual change, percent)
6 6
4 4
2 2
0 0
-2 -2
-4 -4
-6 -6
11 Jul. 12 Jul. 13 Jul. 14
CPI CPIEFE CPIEFE goods CPIEFE services
(*) As from January 2014, the new idexes with annual base 2013=100 are used, so they are not strictly
comparable with earlier figures.
Sources: Central Bank of Chile and National Statistics Institute (INE).
Figure 4
Evolution of China's 2014 GDP growth forecast
(percent)
9.0 9.0
8.8 8.8
8.6 8.6
8.4 8.4
8.2 8.2
8.0 8.0
7.8 7.8
7.6 7.6
7.4 7.4
7.2 7.2
13 Mar. May Jul. Sep. Nov. 14 Mar.
2010-2014 growth
Figure 5
Cumulative revision to 2014 growth forecast for Latin America (1)
(percentage points)
0 0
-1 -1
-2 -2
-3 -3
-4 -4
Latin
Colombia Peru Mexico Chile Argentina Venezuela
America (2)Brazil
(1) Between January 2013 and March 2014.
(2) Countries weighted at PPP by share of each economy according to WEO (IMF).
Sources: Central Bank of Chile based on Consensus Forecasts and IMF.
Figure 6
Gross fixed capital formation
(annual change, percent)
60 60
40 40
20 20
0 0
-20 -20
-40 -40
09 10 11 12 13
Total investment Construction & other works Machinery & equipment
Table 1
International baseline scenario assumptions
2012 2013 (f) 2014 (f) 2015 (f)
March'13 Dec.'13 March'14 March'13 Dec.'13 IPoM March'13 March'14
Report Report Report Report Report Mar. 14 Report Report
GDP growth (annual change, percent)
Trading partners' GDP 3.4 3.6 3.4 3.4 4.2 3.6 3.7 3.8 3.9
World GDP at PPP 3.1 3.3 3.0 3.0 3.9 3.5 3.5 3.7 3.8
United States 2.8 1.9 1.7 1.9 2.5 2.6 2.7 2.7 2.9
Eurozone -0.6 -0.4 -0.4 -0.4 1.3 1.0 1.2 1.4 1.5
Japa 1.9 1.1 1.8 1.6 1.3 1.3 1.5 1.0 1.1
China 7.7 8.1 7.6 7.7 8.2 7.4 7.3 7.2 7.2
India 5.1 6.3 4.1 4.5 6.4 5.3 5.4 6.3 6.3
Rest of Asia (excl. Japan, China and India) 3.8 4.3 3.8 3.9 4.7 4.0 4.1 4.5 4.5
Latin America (excl. Chile) 2.7 3.3 2.6 2.4 3.7 2.9 2.3 3.4 3.4
(levels)
LME copper price (US$cent/lb) 361 350 332 332 340 310 300 290 285
Brent oil price (US$/barrel) 112 108 109 109 101 106 106 100 101
(annual change, percent)
Terms of trade -4.1 -0.4 -3.9 -3.2 -1.6 0.2 -0.9 -1.5 -1.1
(f) Forecast
Sources: Central Bank of Chile based on a sample of investment banks, Consensus Forecasts, the IMF and statistics bureaus of respective countries.
Table 2
Domestic scenario
(annual change, percent)
2012 2013 (e) 2014 (f)
Dec.'13 Mar.'14 Dec.'13 Mar.'14
Report Report Report Report
GDP 5.4 4.2 4.1 3,75-4,75 3,0-4,0
Domestic demand 6.9 3.9 3.4 4.8 3.3
Domestic demand (w/o inventory change) 7.1 5.1 4.2 4.5 3.3
Gross fixed capital formation 12.2 3.9 0.4 4.1 0.8
Total consumption 5.6 5.4 5.4 4.7 4.1
Goods and services exports 1.1 5.3 4.3 3.1 3.2
Goods and services imports 5.0 4.4 2.2 4.6 2.4
Current account (% of GDP) -3.4 -3.2 -3.4 -3.7 -3.6
Gross national savings (% of GDP) 21.7 21.1 20.5 20.6 19.5
December CPI 1.5 2.6 3.0 2.5 3.0
December CPIEFE 1.5 1.9 2.1 2.9 2.8
(e) Estimate.
(f) Forecast.
Figure 7
CPI inflation (*) CPIEFE inflation (*)
(annual change, percent) (annual change, percent)
10 10 10 10
8 8 8 8
6 6 6 6
4 4 4 4
2 2 2 2
0 0 0 0
-2 -2 -2 -2
-4 -4 -4 -4
07 08 09 10 11 12 13 14 15 16 07 08 09 10 11 12 13 14 15 16
Dec.'2013 Report
Mar.'2014 Report
(*) Gray area, as from the first quarter of 2014, shows forecast.
Sources: Central Bank of Chile and National Statistics Institute (INE).
Figure 8
MPR and expectations
(percent)
9 9
8 8
7 7
6 6
5 5
4 4
3 3
2 2
1 1
0 0
07 08 09 10 11 12 13 14 15 16
MPR FBS second half March 2014 EES March 2014 Forward, March 2014 Report
Source: Central Bank of Chile.