Itaú BBA - CHILE – Monetary Policy Report: Maximum monetary impulse necessary during unusual times

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CHILE – Monetary Policy Report: Maximum monetary impulse necessary during unusual times

Abril 1, 2020

Widening output gap to dominate inflation trajectory

In the flagship quarterly Monetary Policy Report (IPoM), significant downward revisions to activity and core inflation justified the swift move to take the policy rate to its “technical” floor of 0.5% (through 125bp cut over the last two weeks). The board highlights the extreme complexity of the current scenario engulfing the globe that raises forecast uncertainty, particularly due to the difficulty in estimating how the pandemic will evolve and how to ease social distancing measures. In its base case, the central bank expects an economic recovery from the 3Q20 onwards. However, key to the expected bounce back would be the capability of businesses and households to stay afloat aided by the set of announced monetary and fiscal measures.

The previously expected impulse from the international front has evaporated. Global activity is seen contracting 0.2% this year (+3.0% in the 4Q19 edition), while Chile’s trade partners are viewed to shrink by 0.1% (3.1% previously; 2.9% in 2019). The terms-of-trade is set to deteriorate versus the 4Q19 scenario, as lower copper prices (20% down from the last scenario to average USD 2.15/lb this year) are only partly offset by falling oil prices (-42% to USD 35/barrel average). The board notes the real exchange rate has further depreciated to a level above the one recorded in December and historical averages. In this context, we note the board has recently extended its FX intervention program until early 2021 (originally set to expire in May).

The combination of mobility restrictions, reduced global demand and downtrodden private sentiment led to a 3pp growth revision for 2020. The economy is seen shrinking by between 1.5% and 2.5% this year. As some investment projects halt operations amid sanitary restrictions and sentiment takes another hit, gross fixed investment is now expected to contract 8.2% (4.0% decline seen previously; +4.2% in 2019). Consumption is expected to fall 1.9% (+1.1% previously; 0.8% in 2019), as movement restrictions and job insecurity hamper demand. Although economic data is yet to reflect the impact of the shock, the central bank conducted a short business perception survey during the second half of March, which reflected a significant outlook deterioration for activity and employment over the next six months. On the expectation that conditions normalize in 2H20, the board anticipates an activity rebound to 3.75-4.75% next year, with gross fixed investment rising 5.1% and total consumption 4.7%. The slump in domestic demand is viewed to dominate trade dynamics, resulting in a rapid adjustment of external accounts. The current account is expected to record a 0.3% of GDP surplus this year (0.2% deficit previously; -3.9% in 2019), thereafter moving to a 0.6% deficit in 2021 (0.8% previously). Risks to the activity scenario tilt downwards in the short-term and are symmetric for the medium-term.

The significant widening of the output gap is the dominant force for the expected inflation trajectory. At the close of 2019, the board highlighted there was uncertainty over whether the FX depreciation or a weaker demand would dominate CPI dynamics going forward, leading to the adoption of a neutral monetary policy stance. Under the current scenario, the board is confident that loosening demand, along with falling oil prices, will diminish inflationary pressures significantly. Additionally, the latest round of CLP depreciation has been due to a multilateral dollar appreciation and hence the pass-through would likely be lower than if arising from domestic events. As a result, headline inflation is seen moving from the 3.9% recorded in February to reach 3% during 4Q20 (3.6% seen in 4Q19 IPoM), with a 3.3% average for the year (3.9% previously expected). The revision is also significant for the core component (excluding food and energy prices), revised down to 2.9% for yearend and on average (3.5% previously). Core inflation is seen averaging 2.7% during 2021, below the 3% target. Risks to the inflation scenario are symmetric.

In this context, the board estimated it was opportune to maximize the monetary stimulus, taking the nominal rate to 0.5% and signaling that rates are likely to remain at this level for a prolonged period. The technical minimum of 0.5% is deemed necessary to allow for the correct functioning of all sub-sectors of the financial market, particularly corporate mutual funds on whom several banks relied on for funding, whose administration fees hover around 0.5%. In this edition of the IPoM, the board launched a new forward guidance method utilizing an interest rate corridor that encompasses expected rate paths under varying scenarios. Under scenarios concurrent with the upper bound of the growth range (that is, -1.5% this year and 4.75% next year, broadly in line with our base scenario), rates would remain broadly stable for the reminder of the year, reaching close to 1.25% by yearend 2021 and close to 2% in early 2022. Meanwhile, growth closer to the lower bound (-2.5% in 2020, 3.75% next year), would demand rates at minimum levels during the forecast horizon. Additionally, if conditions deteriorate further, the board suggests that it would be necessary to use instruments that go beyond the usual handling of monetary policy, giving priority to financial stability (likely through some form of quantitative easing).

We expect rates to stay at this historically low level for the remainder of the year, with quantitative easing measures expected if risks for the economy increase even further.


Miguel Ricaurte
Vittorio Peretti

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