Chile: No Time for Inflation Complacency

These are trying times for Chilean central bankers – inflation is running at the highest level in over a decade and inflation expectations are on the rise. Meanwhile, both domestic and global headwinds suggest that economic growth will remain relatively sluggish over the course of 2008. While these cross-currents cloud the monetary policy outlook, we suspect that upside inflation risks will dominate in the near term, thus requiring further action by Chile’s central bank (BCCh).

Inflation perfect storm

Chile is facing nothing short of an inflation ‘perfect storm’, caused mainly by pressure from soaring grain and energy quotes, in addition to a frost-linked spike in prices for fruits and vegetables. By December, headline inflation was running at 7.8%, the highest rate since June 1996 and well above the central bank’s 3.0% central target. Meanwhile, forecasting near-term inflation in Chile has become little more than a guessing game: monthly CPI surprised to the upside in eight of the past nine months, coming in on average nearly 70% (or 0.4%M) higher than consensus estimates. Not surprisingly, inflation expectations for the year ahead began to deteriorate and, only recently, in the key 24-month forward horizon. On the consumer front, surveys show that almost 60% of Chileans believe that inflation will go up by “a lot” in the coming 12 months. Faced with this challenging inflation backdrop, Chile’s central bank lifted its reference interest rate five times to 6.25% from 5.00%.

Even after 125bp of cumulative tightening since July, Chile’s central bank has more work to do, in our view. In its monetary policy report, published on January 16, the central bank reiterated that while the next rate move will depend on incoming data, “additional adjustments to ensure the convergence to the inflation target” could be necessary even as it characterized the risks to inflation going forward as “balanced”. The central bank has cautiously paved the way for another hike while still leaving its options open; however, in light of the deteriorating inflation backdrop and risk to expectations, we think that this is no time for the central bank to pause.

More work to do

There are at least three reasons why we believe that the central bank has more tightening to do.
First, the argument that the inflation problem remains limited to food and energy is losing strength. Supply shocks have certainly been responsible for most of the surge in inflation to multi-year highs. For example, perishables and fuel quotes alone accounted for 2.0 percentage points of the 7.8% increase in 2007 inflation, despite representing less than 8.0% of the consumer price basket. However, in the final months of the year, the pressure appeared to be broadening. Indeed, measures that better capture ‘trend’ inflation – such as trimmed means or core excluding all food items – have been heading higher and in some cases at an accelerated pace, even as evidence from labor costs has been rather inconclusive. In fact, following its January 25bp rate hike, the authorities highlighted that December experienced “significant increases in (the prices of) a diverse range of products”, suggesting that pressures could be beginning to spread beyond just food and energy. Indeed, our preliminary modeling work suggests that the inflationary pressures could be a more persistent problem over the next two years, thus requiring a more proactive response on the interest rate front.

Second, there is a risk that expectations could be slowly coming unhinged. In the monetary policy report, the authorities maintained that inflation expectations remain well anchored around the target of 3.0% over the relevant policy horizon of two years. It is certainly testament to the central bank’s credibility that despite the surge in inflation in 2H07, two-year forward expectations have only moved to 3.3% in January from 3.0% previously, according to the central bank’s own survey. However, and while this is a modest move, the fact that this particular metric has been so well anchored – and for such a long time – at 3.0% is a reason for concern. In addition, alternative metrics such as breakeven inflation measures have also been heading in the wrong direction.

Importantly, inflation is set to get worse before it gets better − likely peaking above the 8% threshold during 1H08. On the energy front, electricity price hikes at the residential level are on the pipeline and gasoline prices have risen to record levels, with only modest relief – to the tune of 6% – coming from the additional US$200 million allocated to the Fuel Price Stabilization Fund. And 1Q08 will bring adjustments to education and to a series of prices that are indexed and thus backward-looking. In all, we see a very difficult near-term picture, before a powerful base effect brings annual inflation rates lower in 2H08.

Third, there is a case to be made for a more activist central bank, at least in the near term. In the December monetary policy meeting, a board member put forward the notion that highly uncertain times could require a degree of policy “fine-tuning” that could even lead to a reversal in the direction of rates in a more proactive fashion. We think that this time could be now; thus, we expect additional rate hikes in February and possibly March, which could be then taken partly back late in the year if the global backdrop deteriorates sufficiently as the impact from the US downturn spreads (see “Latin America: Abundance Faces its First Shock”, GEF, January 8, 2008). Indeed, one takeaway from our recent MacroVision workshop – which included Morgan Stanley’s strategists, economists and clients – is that the US is likely to be already in a recession, and now the uncertainty surrounds the duration and depth of the downturn.

As our Brazil watcher, Marcelo Carvalho, rightly argued in a recent note, central banks do not like to flip-flop and change monetary policy too often, something that Chile’s central bank had to do following a surprising rate cut in January 2007 (see “Brazil: No Hike, Maybe Cut”, EM Economist, January 18, 2008). However, uncertain times often call for increased flexibility, and we believe that a more activist approach would not harm the bank’s still strong credentials, while going a long way towards strengthening the commitment to the 3.0% target.

Intervention? Not

Unlike Brazil, Colombia or Argentina – which have been actively involved in the currency markets – interventions by Chile’s central bank have been rare since it allowed the peso to float freely in September 1999. The peso’s recent rally – which breached the 470 threshold in intraday trading – has once again sparked speculation of potential intervention by the central bank. Concerns of imminent action, moreover, increased following comments by the central bank’s president, who argued that recent peso gains could not be fully explained by interest rate spreads, thus suggesting a level of overshooting. In our view, both fundamentals and history suggest that intervention does not appear an imminent threat. Importantly, we suspect that in light of the difficult inflation backdrop, some currency appreciation is a welcome development from the central bank’s standpoint.

The degree of real peso appreciation does not appear significantly out of line with fundamentals as to justify intervention. In its most recent monetary policy report (released on January 15), the authorities argued that the real exchange rate was at levels that were only “marginally” out of line with those “coherent with its long-term fundamentals”. Compared to the levels considered in the monetary policy report, the real effective exchange rate at the time of writing was roughly 4% stronger, a move that falls short of what we would consider a fundamental misalignment. In fact, we suspect that the peso could appreciate further before the central bank steps in. Based on the average of the past 15 years – a metric widely cited by the central bank – we estimate that the peso would have to move to near 455 to match the levels that triggered the major episodes of intervention in 2001 and 2002.

Another consideration is that intervention could be misconstrued by markets as a signal that the policy focus is shifting, even if temporarily, towards the currency and away from the inflation problem at hand. To be fair, unlike the case of Peru’s central bank’s seemingly unsustainable intervention strategy in the past, Chilean authorities have acted in a transparent fashion by announcing the maximum amounts, instruments and length of major intervention periods such as August 2001 and October 2002. In turn, such measured ‘closed-end’ approaches reduce the risk of attracting increased portfolio inflows or boosting liquidity at a time of rising inflationary risks (for a discussion on how central bank policy could exacerbate inflows, see “Brazil: Three, Two, One…”, GEF, May 8, 2007). Still, in the current context of high inflation and deteriorating expectations, the signal that intervention would send is a risky one, in our view.

Bottom line

Chile is experiencing one of its most pressing inflation challenges in over a decade. With little relief expected in the near term, Chile’s central bank will have more work to do even as downside risks on the economic growth front appear to be mounting. Indeed, more tightening today could prevent the need for more aggressive action down the road.

Chile’s difficult inflation backdrop, however, has also a positive side as it partly reflects Chile’s continuous commitment to sound policies. Faced with surging foodprices, Chile has not gone down the road of widespread price controls, trade bans or heavy subsidies, which tend to postpone adjustments and, more often than not, hurt the investment environment. On the energy front, part of today’s price pressure reflects the cost of Chile’s objective of reducing its vulnerability by promoting investment in the sector and by seeking more reliable energy sources away from natural gas from Argentina. The supportive global conditions of the past five years have tended to obscure the line between externally fueled upturns and growth brought about by fundamental improvements. With the region likely to face in 2008 the first test to the abundance enjoyed in the past five years, Chile once again looks well equipped to deal with the coming downturn.

By Luis Arcentales & Daniel Volberg New York
Morgan Stanley
January 23, 2008