Itaú BBA - CHILE – Monetary Policy Report: High inflation forecast bodes caution

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CHILE – Monetary Policy Report: High inflation forecast bodes caution

Dezembro 5, 2019

Rate moves will depend on the evolution of activity, the labor market, exchange rate and inflation expectations

Following Wednesday’s unanimous decision to hold the policy rate at 1.75% and adopt a neutral stance, the release of the quarterly Inflation Report (IPoM) reaffirms that high uncertainty is favoring a cautious approach. Activity expectations dropped significantly, with the labor market seen abruptly loosening, while significant pass-through to consumer prices is envisioned on the back of notable idiosyncratic CLP depreciation against the dollar. For the time being, the board recognizes that the monetary stimulus in place is already large, and given the announced fiscal impulse and the FX intervention scheme, it is hinting at a wait-and-see approach. In this context, the central bank indicated in the IPoM that rate moves would depend on the evolution of activity, the labor market, the exchange rate and inflation expectations. If the pressure of a widening negative output gap on prices dominates inflation dynamics ahead, the board acknowledges that it could utilize the remaining monetary policy space. The worst-case scenario for the central bank would be if regulatory changes significantly raise labor costs in an already fragile economy (likely referring to the labor law to reduce the workweek as well as swift wage adjustments), that would lead to rising unemployment, weaker activity, while inflationary pressures rise, ultimately limiting the countercyclical role of monetary policy.

No significant impulse from the international front is expected as global growth is seen remaining at its lowest levels for the last decade, while the terms-of-trade is seen deteriorating further versus the 3Q19 scenario.

An implosion of confidence and heightened uncertainty would result in a 4% investment contraction next year (compared to a 4% rise expected in the 3Q19 IPoM). The investment slump next year comes from the non-mining component, which apart from low confidence would also be hampered by increased costs of imported machinery and the deterioration of financial conditions. The negative impacts on investment would be partially offset by the continuation of the large investment projects already initiated, especially in the mining sector, the increase in public investment and an expansionary monetary policy. Consumption growth is seen slowing to 1.1% next year (3.1% previously), as the labor market loosens. Overall, disruptions to activity at the close of 2019 led to a growth expectation downgrade from a 2.25%-2.75% range to 1.0% this year. For 2020, a range of 0.5%-1.5% is now anticipated, down by 2.25pp from the 3Q19 edition. For 2021, a growth recovery to 2.5%-3.5% is expected but key behind this estimate is lower uncertainty and that the different economic sectors can resume their production processes. With slumping domestic demand amid stable external demand and a weaker currency, the current account deficit is seen narrowing sharply from 2.9% of GDP this year to 0.2% next year.

The board notes that various information sources already point to a labor market deterioration. A central bank survey conducted in late November showed that just over half of the responding firms expect to decrease their labor force next year, while the labor ministry reported a 13% yoy increase in November of job dismissals by companies, the majority due to economic hardships. Overall, the central bank notes that the unemployment rate could surpass 10% at the start of 2020 (7.0% in 1H19). 

The depreciation of the Chilean peso has led to a sharp increase in inflation forecasts. A pick-up to 3.4% by December (from the 2.5% recorded in October) reflects the expectation of pass-through from the weaker currency (while the market still sees inflation close to the 3% target). Headline inflation is seen averaging 3.9% next year (2.7% in the 3Q19 edition), while ending the year at 3.6% (2.8% in 3Q19, compared to 3% in the most recent financial operator’s survey), thereafter edging towards the 3% target in 2021 as the larger negative output gap diminishes inflationary pressures. Core inflation is expected to average and end 2020 at 3.5% (2.5% average and 2.7% yearend forecast in 3Q19 IPoM). We note that the discrepancy with market inflation expectations could come from central bank estimates (in the 1Q18 IPoM) of a larger pass-through coefficient when depreciation is driven specifically by idiosyncratic events (as opposed to the traditional estimate of 0.15pp accumulated over two years for a 1% depreciation). Risks to the inflation scenario are deemed symmetric reflecting a degree of uncertainty to determine which force (output gap or exchange rate) would dominate inflation dynamics ahead. 

In our view, the highly uncertain domestic environment means stable rates at 1.75% for now. If volatility dissipates (specifically related to the FX), and pass-through to consumer prices underwhelms, the central bank could significantly reduce intervention, and increase the monetary impulse during a period of sharp activity deceleration. However, the inflation report also leaves open the possibility of reducing the monetary stimulus should FX dynamics remain adverse.


Miguel Ricaurte
Vittorio Peretti

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