In its recent Monetary Policy Report, the Central Bank presents a complex panorama for the Chilean economy. Projected inflation to December is corrected upwards by more than 4 percentage points, reaching 9.9%. Core inflation rates are up 2.5pp this year and are more persistent, rising 50bp to 3.8% in 2023. This occurs with private consumption that continues to surprise on the upside while investment contracts. The restrictive monetary policy would be key to resolving the significant imbalances accumulated in 2021. It is necessary to “return” the excess growth over potential that the economy had that year with a slight contraction (between -1% and 0%) the next. With this, according to the Central, inflation would converge right at the end of the 2-year policy horizon.
“If the economy goes into contraction next year, as the BCCh anticipates, it is easy to anticipate that there will be strong pressures on fiscal spending and possible attempts to withdraw new pension funds.”
Unfortunately, there are several reasons why the Report’s macro scenario is likely to end up being overly optimistic on next year’s inflation and growth. First, inflation continues to surprise on the upside and there are no signs that it has peaked. In recent weeks the international scenario would be adding short-term inflationary pressures. A more aggressive Federal Reserve appreciates the dollar globally with the Chilean peso losing 5% so far in June. The situation in Ukraine continues to put pressure on oil with another 5% increase this month. Although these factors can be considered temporary on inflation, with 2-year inflation expectations at 6.1%, the risks of second-round effects on prices and de-anchoring of expectations are asymmetric to any inflationary surprise.
Second, taking the MPR at 9% and subtracting the inflation expectation for the next 12 months, as the BCCh does in its report, it delivers a real 3%, being one of the highest rates among emerging countries. But if one focuses on the rates of government bonds in UF, they are still low. A two-year UF rate of 1% and even a 10-year rate of 2.2% are not restrictive enough for the current level of inflation. This in an environment where there is still a lot of liquidity in the system. For example, M1 money as a percentage of GDP, today at 28%, remains at least 6% of GDP above the pre-2020 trend. This is the liquidity shown by bank balances, for example.
Finally, the most important reason, the BCCh makes all its projections assuming stability of the structural parameters and taking the fiscal trajectory of the Treasury. This is especially delicate at a time when a new Constitution could be approved that radically modifies the economic model and the State’s participation in it. But also where the fiscal anchor is weakened. If the economy enters into a contraction next year as the BCCh anticipates, it is easy to anticipate that there will be strong fiscal spending pressures and possible attempts to withdraw new pension funds. In conclusion, let us get used to high local rates for a long time.