This program will take the Central Bank’s international liquidity position to the equivalent of 17% of GDP, which is comparable with those of other economies similar to Chile (figure 7). The monetary effects of this measure will be sterilized in order to keep a liquidity provision in pesos in the market in line with the target for the monetary policy rate. The hoarding of international reserves entails financial costs for the Central Bank associated to the differential between the return on investments and the cost of financing them. The level proposed for the international reserves is consistent with the Central Bank’s financial sustainability, although additional leeway is limited. The initial reaction to this announcement was a nearly 5% depreciation of the peso. Nonetheless, the intervention does not pursue a specific level for the exchange rate. Our immediate target is to achieve the stated level of reserves, about 17% of GDP, and to alleviate exchange rate tensions. We remain committed to a floating exchange rate system, and the exchange rate will keep floating during the intervention period. For an economy like Chile, which can encounter significant changes in external financial conditions and in the terms of trade, foreign exchange flexibility is an essential ingredient of its macroeconomic and financial stability. Within a volatile environment like that of the past few years, the inflation targeting regime with a floating exchange rate has displayed its benefits in terms of allowing a smoother trajectory of the Chilean economy.

Consistently, monetary policy had a strong reaction. The Monetary Policy Rate (MPR) was increased by 200 basis points in just four months, starting in June. By September 2008, before the collapse of Lehman Brothers, the Central Bank estimated that it would be necessary to increase the MPR further, even above market expectations. Monetary and fiscal policy during the crisis As in most of the world economies, financial tensions in Chile were severe after the collapse of Lehman Brothers. Interest rates in both peso and dollar markets posted substantial increases in the most stressful times from mid-September to mid-October 2008 (Figure 4). The Central Bank acted quickly, providing peso and dollar liquidity facilities to the financial system to mitigate liquidity tensions, but also to ensure financing in foreign currency should foreign loans become scarce. Also, the foreign exchange reserves accumulation process was cancelled. Local money market conditions normalized rapidly, over a period of weeks. The additional liquidity facilities put in place were not used extensively by financial institutions, reflecting their sustained access to external markets. Beyond the stressful episodes in local money markets, the global confidence crisis that swept around the world was very important in Chile. The events of developed financial markets prompted a deep and widespread revision of investment and spending plans of businesses and households, bringing expenditure to a halt. Domestic demand and economic activity dropped significantly and lending standards tightened (figure 5). 2  BIS central bankers’ speeches  The inflation outlook changed radically, and monetary policy reacted forcefully.