Itaú BBA - CHILE – Monetary Policy Report: Slow output gap narrowing, despite more optimistic growth forecasts

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CHILE – Monetary Policy Report: Slow output gap narrowing, despite more optimistic growth forecasts

September 2, 2020

The macroeconomic scenario evolvement continues to be determined by the development of Covid-19 and containment measures

The 3Q monetary policy report (IPoM) highlights signs that the Chilean economy is stabilizing and the expectation that the gradual withdrawal of health control measures and support for household income (pension withdrawals, employment protection program, cash transfers) would aid a recovery.In this context, a milder activity drop for this year and reduced downside inflationary pressures are anticipated. Nevertheless, the retention of a significant monetary impulse for a prolonged period is justified by the assumption that the closing of the output gap and inflation convergence to the 3% target would only consolidate during 2022. As a result, the policy rate is signaled to remain at its technical floor of 0.5% throughout the end of 2021, with the most likely scenario pointing to rates reaching 1.0%-1.75% by September 2022.
The magnitude of the current shock and high levels of uncertainty led the board to postpone the update to structural parameters (long-term potential growth, neutral rates), preferring to accumulate additional information that would support a more comprehensive assessment.In this context, the technical minimum of the policy rate continues to be estimated at 0.5%. With respect to short-term potential growth, the board sees a decrease following the social unrest and coronavirus shock. The pandemic-driven supply restrictions resulted in even lower productivity this year, while more long-lasting impacts derived from bankruptcies and reallocation of employment and investments have led to a further reduction of potential growth to -1.2% and +0.2%, for this year and the next. We note that the central bank had already reduced short-term potential growth estimates in the 4Q19 IPoM (to 1.4% and 1.9% for this year and the next, respectively), reflecting developments related to social unrest.
Despite some encouraging recovery signs, the IPoM reinforces the significance of the negative shock, as reflected by the large number of job losses and business difficulties. Key to the recovery will be how the public policy response tackles issues such as the reversal of job losses and falls in household income, while maintaining sufficient credit flow to support working capital and investment needs of companies. While consumption and investment have been dampened by the loss of income, mobility restrictions and high uncertainty, the central bank acknowledged that the outlook for consumption has improved since the last report as a result of a series of support measures. These include direct aid programs, subsidies, payment deferrals, tax cuts and the approval of the partial withdrawal of pensions. The central bank estimates that the latter will involve resources of around 6% of GDP, of which about half would be used for consumption to be distributed between 2020 and the start of 2021. The assumption is that most of the spending will be directed to goods rather than services, limiting the overall impact on activity (given its larger import component), but still remaining significant.
Apart from the consumption boost, credit and liquidity measures have contained the forecasted investment decline.The GDP contraction for this year was reduced to a range of -5.5% to -4.5%, compared to the -7.5% to -5.5% drop estimated in 2Q20. While total consumption (public and private) estimate remains at a 4.2% fall, the gross fixed investment decline moderated to 10.6% (from 15.9% in 2Q20). The combination of the liquidity provided by the central bank, the state guarantees, various regulatory adjustments and the adequate solvency of banks, has contributed to commercial loans departing from their usual relationship with the economic cycle and growing by more than 10%. The central bank notes that the access to credit has supported the operational continuity of companies and helped mitigate the fall in investment. Meanwhile, the recent evolution of imports of machinery and equipment, energy sector projects and recent announcements of public investment and reactivation measures have supported a less downbeat investment stance. For 2021, GDP is seen growing between 4% and 5% (down from 4.75%-6.25% in the 2Q IPoM) with total consumption up 6.8% and gross fixed investment rising 8.0%. Growth in 2022 remains at 3%-4%. These growth rates are consistent with a health scenario that allows for the economy to continue to be gradually reopened. Risks to the activity scenario are deemed symmetrical.
Inflation is seen converging to 3% by 2022, while in the short-term it is unlikely to drop below 2%.The yearend rate of 2.4% was revised up from the 2Q forecast (2.0%), largely due to the higher projected consumption. This in turn is driving the average inflation for 2021 up to 2.6% (0.4pp higher than in June), which is still affected by the significant output gap. Meanwhile, the yearend 2021 call of 2.8% is unchanged from the previous report. Additionally, the core measure will remain above 2.5% in the short-term, gradually converging to 3%, also in 2022. Two-year inflation forecast remains around 3%. Risks to the inflation scenario are also seen as symmetrical.
In this context, the central bank projects that monetary policy will remain highly expansionary over the forecast horizon, combining low policy rate with the use of unconventional measures.The latter will be renewed or expanded if the recovery of the economy and the convergence of inflation to the target so require. The central bank signals that the policy rate will remain at 0.5% for much of the two-year monetary policy horizon. The rate corridor signals that the updated baseline scenario could lead to a swifter normalization process during 2022 than that envisioned previously. Nevertheless, even under the most severe of scenarios, rates are seen at a maximum of 1.75% by September 2022. While no specific mention of treasury bond purchases (in the secondary market) was made in the report, we believe that its potential use going forward would be to resolve liquidity issues that risk financial stability and not as a mean to keep long term yields low and boost aggregate demand. We note that while congress has passed the initiative to allow for the expanded tool, it still cannot be used as parts of the legal reform must first be cleared by the constitutional court (expected in coming weeks).

Overall, the evolution of the macroeconomic scenario continues to be determined by the development of Covid-19 and the containment measures necessary to protect the health of the population.The central bank will focus on adopting measures that preserve the financial stability that would help sustain credit growth and support the economic recovery. As a result, we expect the policy rate to remain at 0.5% at least until the end of 2021, while the evolution of liquidity and QE measures would be determined by financial market responses.

Miguel Ricaurte
Vittorio Peretti

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