Itaú BBA - Inflation Hits the Brakes

Scenario Review - Chile

< Back

Inflation Hits the Brakes

January 13, 2015

Industry continues to perform poorly.

• Activity is showing some signs of improvement from earlier in the year, but it continues to evolve below trend and confidence remains depressed. We maintain our growth forecasts of 1.7% for 2014, and 2.5% in 2015. 

• The peso has depreciated further against the dollar, but less than other currencies in the region partly because Chile has the largest net-energy-import bill (as a proportion of GDP) among the main LatAm countries. As we expect the U.S. dollar to continue to strengthen globally this year, we see the peso weakening to 635 to the dollar by the end of 2015.

• Weak internal demand combined with the depreciation of the peso and lower oil prices will likely continue to improve Chile’s external accounts, in spite of weaker copper prices. We expect the current-account deficit to narrow further in 2015 to 1.2% (vs. 1.4% in our previous scenario). This would be an improvement from the 1.5% estimate we now expect for 2014 (previously 1.7%).

• Inflation in December decelerated sharply on the back of falling oil prices. Inflation for core items, wages and non-tradable goods remains concerning. We expect inflation to recede below the central bank’s 3.0% target, reaching 2.3% by the end of the year (2.5% in our previous scenario).

• We see no rate moves during 2015, in spite of our low forecasts for both growth and inflation. As monetary policy in Chile is already loose, we think that the central bank will likely avoid additional easing in an environment of tighter external financial conditions.

• The Chilean government presented its labor reform bill to Congress just before its self-set end-of-the-year deadline. The bill includes various measures which look to empower labor unions. 

• The Chilean economy will likely continue to face important challenges in 2016. We expect growth to improve moderately and see inflation still below the target center, due to the spare capacity in the economy. We see the exchange rate stable next year in real terms. In this environment we don’t expect rate moves.

Small sequential improvement in activity

In November, Chile’s Imacec (monthly proxy for GDP) gained 0.2% from the previous month, resulting in a quarter-over-quarter annualized growth rate of 2.05% (up from 1.65% as of October, 1.4% in 3Q14 and -0.3% as of 2Q14). So, the economy is showing some signs of improvement, but it continues to evolve below trend. On a year-over-year basis, Imacec increased by 1.3% (1.5% in October), and when adjusted for working days, the Imacec gained 1.6% (1.4% in October).

Industry continues to perform poorly. Manufacturing production continued to decline in November, while Mining production fell 5.5% year over year (-1.3% in the previous month), as copper production contracted 7.3% year over year (-2.5% in October). Electricity production once again led the 3.4% increase in Utilities (2.0% in October). As a result, the Industrial production index, which aggregates Mining, Manufacturing and Utilities, contracted 3.0% year over year (-0.1% in the previous month).

Private-consumption data continues very weak. Retail sales contracted 2.9% qoq/saar (-1.4% in 2Q14), while supermarket sales were down by 1.1%.

Confidence levels ended 2014 in pessimistic territory. Business confidence deteriorated further in December, to 40.2% (from 40.7% in November and 50.9% in December 2013), reaching the lowest level since April 2009. Confidence in the Construction sector fell once more to end the year at 26.5%. Consumer confidence came in at a weak 45.3%, but did rebound somewhat from the previous month (41.1%).

In spite of weak growth, the unemployment rate for the quarter ending in November decreased to 6.1% from 6.4% as of the previous month. Employment increased 1.8% year over year (1.3% previously), led by self-employment (3.7% year over year). But waged employment also picked up, to 1.1% year over year (0.7% in October). While higher-wage-employment growth coupled with the decline of inflation (discussed below) will likely lead to a recovery of consumption, we note that the low unemployment rate combined with weak GDP growth hints that productivity might be deteriorating more than expected, a concern that some board members of the central bank have recently raised.

Notwithstanding the low real interest rate, the higher government expenditures and the impact of lower oil prices on real income, we expect only a small recovery of the economy. We continue to forecast a 2.5% expansion in 2015, from an estimated 1.7% growth last year.

Lower oil prices improve the trade balance and shield the peso

The peso has depreciated further against the dollar, but it has performed better than other currencies in the region partly because, within the main LatAm countries, Chile has the largest net energy import bill (as a proportion of GDP). As we expect the U.S. dollar to continue to strengthen globally this year, we see the peso weakening to 635 to the dollar by the end of the year.

The trade balance for 2014 reached USD 8.6 billion, up from USD 2.1 billion in 2013 and the highest balance since the USD 11.0 billion recorded in 2011. This was helped by a surprising USD 1.2 billion surplus in December.

Due to a weaker Chilean peso, subdued internal demand and lower oil prices, imports for 4Q14 dropped 7.6% year over year. Capital goods imports are still weak, down 4.5% in the quarter, but improved markedly from the previous quarter (-27.3%). Imports of consumer goods shrank 11.1% year over year in the quarter (-9.0% in 3Q14), driven by poor durable goods (-18.9% year over year for the quarter). As global oil prices fell, energy imports, which traditionally account for approximately 15%-20% of total imports, declined 15.3% year over year.

Exports remained sluggish during 4Q14 (+0.4% year over year), but we note that manufacturing exports continue to perform well (6.6% year over year). Mining exports contracted 5.0% from the same quarter in the previous year.

Weak internal demand combined with the depreciation of the peso and lower oil prices will likely continue to improve Chile’s external accounts, in spite of weaker copper prices. We expect the current-account deficit to narrow further in 2015 to 1.2% (vs. 1.4% in our previous scenario). This is an improvement from the 1.5% estimate we now have for 2014 (down from 1.7%). Overall, this would mark a steady improvement to the external accounts when compared with the 3.4%-of-GDP deficit recorded in 2013.

Lower oil prices drive inflation slowdown

Chile recorded a deflation of 0.4% month over month in December, following the zero print in the previous month. The sharp fall in inflation since October has been largely due to the transfer of lower oil prices to consumers. In fact, energy prices fell 5.8% month over month in December (-1.3% in November). A 5.0% drop in the volatile prices of non-processed food also helped. On a year-over-year basis, inflation slowed sharply to 4.6%, from 5.5% in November and 5.7% in October. Energy prices were down by 2.0% from one year before (from 7.7% and 8.8% in November and October, respectively). In spite of the decline of headline inflation, it ended the year above the upper bound of the target. 

However, different underlying inflation measures continue to be very high. When food and energy prices are excluded, annual inflation was unchanged from November at 4.3% (its highest level in 2014). Non-tradable inflation stood at a high 5.3%. Inflation for wages has also remained uncomfortable (it increased to 7.0% in November, from 6.9% in October). Considering the indexation mechanisms of the Chilean economy, we expect that all these inflation measures will start to decline very soon. 

We expect inflation to reach 2.3% in 2015 (down from 2.5% in our previous scenario). However, it must be noted that this considers a recovery of oil prices in the second half of 2015 (with Brent reaching USD 70 per barrel). If this recovery of oil prices does not materialize, inflation would most likely be significantly lower. In addition, the future approach adopted by the authorities regarding the fuel-price-stabilization mechanism will also play a role in the evolution of inflation. But given the weak activity readings, we expect that the government will continue to quickly pass on the benefits of the lower oil prices to consumers. Apart from lower oil prices, the fall of inflation from 2014 would come from lower exchange-rate depreciation, the persistence of a negative output gap amid well-anchored inflation expectations and the fading impact of some tax hikes implemented last year.

Unchanged rates only in the short term?

As widely expected, the central bank unanimously held the interest rate at 3.0% in December. The press release announcing the decision maintained a neutral tone, and the minutes revealed that, like the decision in November, the board considered keeping the interest rate unchanged the only “relevant option”.

Also in December, the central bank published the 4Q14 monetary policy report. Importantly, the central bank uses as an assumption in its baseline scenario that the monetary policy rate will stay “stable in the short term.” In our view, the central bank’s use of “short term” suggests that it is not disagreeing with the current market expectations (measured by surveys and prices) of an additional easing, while at the same time not validating them.

We expect the central bank to remain on hold throughout 2015. Although we acknowledge that the possibility of further rate cuts is not small given our growth and inflation forecasts, the central bank will likely avoid additional easing in an environment of tighter external financial conditions.

Labor reform presented to Congress

The Chilean government presented its labor-reform bill to Congress just before its self-set end-of-the-year deadline. The bill includes various measures that look to empower labor unions, by acknowledging them as the main negotiators in collective bargaining (according to the government, current legislation obstructs collective negotiation), while also banning the practice of replacing striking workers with temporary employees. Furthermore, non-unionized workers would not be able to automatically benefit from deals obtained by the unions. The proposed reform has split opinion, with it being warmly welcomed by the labor unions, while criticized by the business sector and right-wing political parties.

According to Adimark, President Michelle Bachelet’s approval rating fell to 40% in December (down from 42% in the previous month), the lowest rate during her second term in office. Bachelet’s disapproval rating rose slightly to 53% (52% previously). The survey also points out that public opinion is currently against the educational and tax reforms (already passed), with around 63% of respondents believing that the tax-reform bill will negatively affect the middle class.

Looking further ahead

In 2016, we expect a gradual economic recovery to 3.5%, supported by continued monetary and fiscal stimulus. Although growth would continue below potential, we see inflation rising to 2.7%, as oil would not drag inflation down as is expected for this year. In an environment of subdued growth and higher U.S. interest rates, the central bank will probably continue on-hold. We think that most of the interest-rate differential in 2016 will already be priced in this year, so we do not expect further real exchange-rate depreciation next year (the nominal exchange rate would end next year at 640 pesos to the dollar.) 


 

João Pedro Bumachar
Miguel Ricaurte

Vittorio Peretti



< Back