Itaú BBA - Monetary Policy Board Is Split on Rate-Cut Timing

Scenario Review - Chile

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Monetary Policy Board Is Split on Rate-Cut Timing

July 8, 2014

The IMACEC (monthly proxy for GDP) increased by 0.6% from April to May

• Activity improved in May, but not enough to offset the weakness in the previous few months. Our GDP growth forecast for 2014 stands at 2.8% and we still expect 4.0% in 2015.

• Inflation in June moderated substantially, to 0.1% month over month, although it remains above the upper bound of the target range on a year-over-year basis (4.3%). We now see inflation at 4.0% by the end of this year (in our previous scenario we expected 3.6%). For 2015, our forecast stands at 2.9%. 

• Chile’s central bank left the interest rate unchanged at 4.0% in June. The decision was widely expected and the easing bias was maintained. The majority of board members expressed that recent inflation surprises warranted a degree of caution on future policy moves. However, one board member voted for a 25-bp rate cut. We expect the policy rate to end this year at 3.5%, but with rate cuts resuming only in 4Q14. For 2015, we do not expect rate moves.  

• Chile’s external accounts are improving, as the economic slowdown is reducing import growth. We have raised our 2014 trade-surplus estimate to USD 6.0 billion (from USD 3.0 billion) and subsequently reduced the current account deficit estimate for this year to 2.3% of GDP (from 2.5%). We see the peso ending this year at 575 to the dollar and at 600 by the end of 2015.

• The Chilean government decided to reject the controversial HidroAysen energy project. This was an energy project that divided much of the country by proposing to dam Patagonian rivers in order to supply energy to central Chile. President Bachelet has said that, instead, Chile would tackle the energy squeeze by building up alternative energy sources and terminals for liquefied natural gas.

Better Activity in May, But Still Weak

The IMACEC (monthly proxy for GDP) increased by 0.6% from April to May, but it weakened further on a quarter-over-quarter basis (to 1.6% annualized). Many activity indicators improved in May, but their trend continued to be weak. Manufacturing production gained 0.5% month over month and retail sales increased by 2.0%. However, on a quarter-over-quarter basis, manufacturing grew by only 1.1% (annualized) and retail sales contracted by 0.1% qoq/saar. On the other hand, mining production continues to respond to the sizable investment made in the sector previously. In May, mining output was up by 5.2% year over year (5.6% in April), lifting industrial production growth (which aggregates mining, manufacturing and utilities) to 3.4% (from 1.2% previously).

While the unemployment rate is still low, the breakdown of employment growth suggests a softer labor market. In the quarter ended in May, the unemployment rate stood at 6.3%, down from 6.4% one year before. Employment grew by 1.6% year over year in the period, lifted by a 7.8% growth in self-employment. Waged employment growth slowed to a weak 0.2% (0.8% in the quarter ended in April). The central bank’s labor vacancy index also shows a less-dynamic labor market.

The labor market data, together with high inflation and lower consumer confidence, hint that consumption is unlikely to rebound significantly in the short term.

We expect the economy to grow by 2.8%. For 2015, our expectation stands at 4.0%. A looser monetary policy will likely support a recovery of the economy next year.

Inflation Continues to Be High, But It Is Moderating on a Sequential Basis

Inflation in June came in at 0.1% month over month, reducing year-over-year inflation to 4.3% (4.7% in May). Inflation excluding food and energy and non-tradable inflation also moderated, to 3.6% year over year (3.8% in May) and 4.9% (5.1% in May), respectively. So, although inflation remains above the upper bound of the target, it is slowing on a sequential basis.  

We now see inflation at 4.0% by the end of this year (3.6% in our previous scenario). We expect inflation to return to the target range more gradually than we were previously expecting. While we expect inflation to hover above the upper bound of the target throughout the second half of the year, on a sequential and seasonally-adjusted basis, inflation would be running somewhat below the target center over the period. For 2015, our inflation forecast stands at 2.9%.

A Split Monetary-Policy Decision

Chile’s central bank left its policy rate unchanged at 4.0% for the third consecutive month in June. The decision was widely expected and, notably, the board maintained the easing bias in the accompanying press statement, indicating that it “will evaluate the possibility of introducing additional policy rate cuts according to the evolution of the internal and external macroeconomic conditions”.

The meeting’s corresponding minutes revealed that board members were split on the decision to leave the rate unchanged. Overall, the majority of board members expressed that recent inflation surprises warranted a degree of caution regarding future policy moves, in spite of lower-than-expected growth. However, one board member voted to reduce the reference rate (by 25 bps), emphasizing the disinflationary impact of the economic slowdown. The dissenting board member also suggested that the low lending rates (one of the reasons supporting rates on-hold according to other board members) might reflect weak demand (as opposed to loose monetary policy). All in all, the minutes implied that further monetary-policy easing will resume once inflation moves to a more comfortable level.

The central bank released its monetary policy report for 2Q14, in which it lowered this year’s GDP range estimate by 50 bps (to 2.5%-3.5%), due to lower dynamism in private consumption and the poor investment numbers. The central bank reaffirmed the easing bias, highlighting that its base scenario “uses as a methodological assumption that the policy rate will follow a path comparable to that inferred from financial asset prices.” This means that the central bank is considering one or two 25-bp rate reductions in its scenario. While the bank held its view that higher inflation is primarily due to the depreciation of the peso and is therefore transitory, it has adjusted the forecast for inflation this year to 4.0% (from 3.0%).

As the economy has been weak, we expect the central bank to further ease the policy rate. However, we don’t see the easing cycle resuming in the near term, as the central bank will likely wait for clear evidence that inflation is in fact converging to the target center. We expect two 25-bp cuts in 4Q14, resulting in the rate ending the year at 3.5% and maintained there throughout 2015.

Trade Surplus on the Rise, Amid Sluggish Domestic Demand and a Weaker Peso

We still expect the Chilean peso to weaken ahead. Lower policy rates in Chile together with higher U.S. Treasury yields will probably bring the peso to 575 pesos to the dollar by the end of this year and to 600 by the end of 2015.

Chile’s trade balance continued to improve in June, mainly due to the slower domestic demand and the weaker exchange rate. The 12-month-rolling surplus rose to USD 5.4 billion in June, from USD 2.1 billion in 2013.

We now expect a USD 6.0 billion trade surplus this year and a 2.3%-of-GDP current-account deficit. Previously, we expected a USD 3.0 billion surplus and a 2.5% of GDP current-account gap. Higher export volumes and peso depreciation will likely improve the current-account gap further in 2015 (to 2.1% of GDP).

A Major Energy Project Is Rejected

The Chilean government rejected the controversial HidroAysen project. This was an energy project that divided much of the population by proposing to dam Patagonian rivers in order to supply energy to central Chile. Environmental concerns played a major role in the project’s rejection. President Bachelet has said that Chile would tackle the tight energy capacity by building up alternative energy sources and terminals for liquefied natural gas.

The Chilean Senate approved the use of a new fuel-price cap. The so-called MEPCO fuel-price stabilization mechanism would put a cap of 20 Chilean pesos (USD 0.04) per liter per month on how much prices can fluctuate and would replace the current subsidy system, which has been in place since 2011.


 

João Pedro Bumachar
Vittorio Peretti



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