Itaú BBA - A more cautious Central Bank

Scenario Review - Chile

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A more cautious Central Bank

April 8, 2015

As a response to the worsened inflation outlook, the Central Bank introduced a tightening bias in the first Monetary Policy Report of the year.

• Chile’s activity weakened in February, as weaker mining and manufacturing output more than offset gains in retail activity. On the other hand, the labor market remains robust and business confidence improved. We expect the economy to expand by 2.8% this year and by 3.5% in 2016, a recovery from the 1.9% expansion in 2014. 

• Inflation slowed in March, but it remains above the upper bound of the target together with its most significant underlying measures. We now expect inflation to reach 3.3% by the end of 2015 (3.0% in our previous scenario) and 3.0% in 2016 (from 2.9%).

• As a response to the worsened inflation outlook, the Central Bank introduced a tightening bias in the first Monetary Policy Report (IPoM) of the year. However, Governor Rodrigo Vergara made it clear that rate hikes are unlikely in the short term. In our view, the bias seeks to maintain expectations anchored at the target. We continue to expect no rate moves in our forecast horizon, but if inflation surprises to the upside or if inflation expectations for the medium term rise, rate hikes will become very likely. 

• Since the Fed’s most recent monetary-policy decision, U.S. Treasury yields have fallen, supporting emerging-market currencies. The more conservative stance of Chile’s central bank contributed to an outperformance of the Chilean peso. However, as we expect the Fed’s liftoff in September, we see the U.S. dollar resuming its appreciation trend this year. Our forecasts for the Chilean peso stand at 645 and 665 to the dollar by the end of 2015 and 2016, respectively. 

• Amid lower popularity, we expect the government to continue with its reform agenda, as highlighted by the ongoing discussions on the labor reform. 

Bumpy recovery

The Imacec (monthly proxy for GDP) weakened in February, due to lower mining and manufacturing output. The index fell 0.6% from January, after two consecutive strong monthly gains (0.8% in January and 1.0% in December). Mining production declined 3.5%, while manufacturing output was down 1.6%. On the other hand, retail activity was up 2.0% from January.

In spite of subdued growth, the unemployment rate continued low in February and waged employment growth was solid. The unemployment rate came in at 6.1%, almost flat from one year before. While total employment slowed to 0.6% year over year, waged employment grew by 2.0%, which is the same growth rate as January’s but far above the rates seen throughout 2014.

March business sentiment improved to 48.6 from the 41.9 registered in February, sitting above the 45.1 average for 2014 and reaching its highest level since April 2014. At a sectoral level, the largest gain came from Mining confidence (which is highly volatile). But confidence within the other sectors of the economy also kept improving, with Commerce returning to optimistic territory for the first time since April last year.

We continue to see the GDP growth rate picking up from 1.9% in 2014, to 2.8% for 2015 and 3.5% in 2015. The low level of real interest rates and an expansionary fiscal policy are the drivers of the moderate recovery that we expect. However, we note that the recent floods that affected the country’s northern regions will likely reduce temporarily the growth of mining production and domestic trade. Thus, we expect weak data readings in March and (especially) April, and a rebound thereafter.

Inflation slows, but not much

Annual inflation in March slowed to 4.2%, from 4.4% in February. Still, it remains above the upper bound of the target, together with its most significant underlying measures. In fact, inflation excluding food and energy – the core measure closely tracked by the central bank – is even higher than the headline, at 4.6% (down marginally from 4.7% in February). Inflation for non-tradable items stood at 5.1% in March (unchanged from the previous month). Moreover, inflation diffusion indexes point at an uncomfortable price dynamics. In addition, nominal wage inflation in February (the most recent figure available) remained at 7.1%.

We now expect inflation to reach 3.3% by the end of 2015 (3.0% in our previous scenario) and 3.0% in 2016 (from 2.9%). Below-potential growth, lower exchange-rate depreciation and lower oil prices will likely bring inflation down from the year-end 2014 level (4.6%). Still, considering that high inflation has been more persistent than we previously thought, we now expect a slower convergence to the target.

Introducing a tightening bias

As widely expected, the central bank left the policy rate unchanged at 3.0%. According to the minutes, the decision was unanimous and it was the only option considered by the board.

However, the March IPoM, released a few days later, shows a tightening bias. In its baseline scenario, the central bank considers a path for the policy rate that is slightly above the survey’s expectations (3% by the end of this year and 3.5% by the end of 2016). When presenting the report, Governor Rodrigo Vergara reinforced that the central bank is moving away from its neutral bias (“the scenario eliminates the possibility of rate cuts”), but also indicated that hikes in the very near term are unlikely, as he said that the board would likely discuss the appropriate time for hikes only by the end of the year.

The more conservative stance adopted by the central bank is consistent with greater concerns over the inflation outlook. The central bank’s inflation forecasts are now at 3.6% by the end of this year (versus 2.8% in the previous report and above market expectations) and at 3.2% by the end of 2016 (3% previously). Prices excluding food and energy (IPCSAE) are mainly responsible for the revision in inflation. The March forecasts have IPCSAE inflation at 3.4% in December 2015, slowing down to 3% twelve months later. These numbers are up from the 2.8% and 2.9% for 2015 and 2016, respectively, forecasted last December. A tighter-than-previously estimated output gap may be the reason behind the high core inflation numbers. In fact, in the IPoM, the central bank included a box arguing that there might be structural aspects behind the low levels of unemployment rate. Meanwhile, the central bank continues to expect GDP growth in the 2.5%-3.5% range for 2015.

We expect the policy rate at 3.0% by the end of this year and the next, but the persistently high inflation, added to the tightening bias introduced by the central bank, means that the monetary stimulus may be removed earlier. We believe that the more-cautious rhetoric of the central bank seeks to prevent inflation expectations (for the relevant policy horizon) from rising. However, as long as inflation continues to converge towards the target and growth remains below what the central bank considers as the potential, rate hikes are unlikely in our view.

Temporarily stronger peso

Since the Fed’s most recent policy decision, the Chilean peso appreciated against the U.S. dollar and against most emerging market currencies. The tightening bias introduced by the central bank likely contributed to the outperformance.

However, as we expect the Fed’s liftoff in September, we see the Chilean peso resuming its depreciation trend. Our forecasts for the exchange rate stand at 645 and 665 to the dollar by the end of 2015 and 2016, respectively.

The full-year current-account deficit for 2014 reached USD 3.0 billion (1.2% of GDP). The figure follows from a USD 0.7 billion deficit posted in 4Q14 (which compares with the USD 2.3 billion deficit one year before). A higher trade surplus and a lower deficit in the income account contributed to the improvement from the USD 10.1 billion deficit in 2013 (3.7% of GDP) and USD 4.6 billion in the four-quarter period ended in 3Q14. Stable terms of trade amid the slowdown in internal demand (in particular of investment) and the weaker exchange rate are the key reasons behind the narrowing deficit.

On the capital account, foreign direct investment remained strong, reaching USD 7.8 billion in 4Q14 and USD 22 billion for the year. This is up from the USD 19 billion recorded in 2013 and was in spite of the weaker prospects for the Chilean economy and for copper prices. Net direct investment (that is, foreign direct investment minus Chilean direct investment abroad) stood at USD 10 billion over the past four quarters, more than tripling the current-account deficit for the period. Foreign portfolio investment was also strong during 4Q14, even with greater external volatility, at USD 4.0 billion in 4Q14 and USD 12.4 billion for full-year 2014.

The trade-balance figures for 1Q15 hint that the current-account gap continued to narrow. The 12-month trade balance came in at USD 8.8 billion in March, above the USD 7.8 billion for 2014. On a seasonally adjusted and annualized basis, we estimate that the trade balance during 1Q15 was slightly higher than the 12-month measure.

However, we continue to see the current-account deficit widening to a still-moderate 1.9% and 2.2% of GDP in 2015 and 2016, respectively. Lower copper prices and some recovery of internal demand would drive the higher current-account deficit.

Political pressure continues to mount

In March, the Labor Commission of the lower house agreed to hold an article-by-article vote on the labor-reform project on the floor of Congress. The voting process began in April and is attracting much attention. More left-wing members of the governing coalition have called the project a mediocre attempt to strengthen collective-bargaining rights, while business-related members are also criticizing the government’s proposal. The administration has stated that they are open to changing the project during the discussion in congress, but defended its general framework.

According to the think tank Adimark, President Michele Bachelet’s approval rating fell 8 percentage points in March, reaching a historically low approval rating of 31%. Her current approval is lower than the one registered in September 2007, during her first administration, when the newly implemented public transportation system for Santiago faced severe shortfalls. It is clear that the president has struggled to capitalize on her opponents’ woes, whose approval is also close to minimum levels.

In spite of waning approval of the government, we continue to expect the reform agenda to be pushed ahead as planned. The labor-reform discussion will fill the political debate over the next few months, alongside some smaller bills regarding the regulation of private activities and the political process. Later in the year, the administration should submit the second bill of the education agenda, dealing with free tertiary education.


João Pedro Bumachar
Miguel Ricaurte

Vittorio Peretti

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