July 2012. Several countries in Europe are facing a serious sovereign debt crisis, which started with Greece, but quickly threatened to spread to countries with a higher relative economic importance, such as Italy, Spain and Portugal. Sky-high rates had caused the debt to fall into an unsustainable situation, as growth would not be able to generate the revenues to pay it off. The Euro Zone was faltering. In this context, Mario Draghi made a statement that probably saved the existence of the EU currency: "According to our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough". 

I could not but remember those words after learning of the central bank's decision to raise the TPM by 150 basis points. Two hikes of 125 bp had not been enough to control the situation and in the face of that, well, it was necessary to act more firmly. "Whatever it takes" to fight inflation. In any case, I think it is important to review some things that make us project a much higher TPM during the next few months, but that would not necessarily remain there for a long time.

First, for pedagogical reasons, I would like to separate the reasons behind the rise, but, above all, behind the speed of the rise. In a simple, but informative exercise, we construct a measure of "monetary expansion", since the comparison of nominal TPMs over time alone seems incomplete to us, as it does not incorporate other fundamentals of the economy that have also changed. Thus, compared to another period of an "overheated" local economy, monetary policy today would be more contractionary than then. This suggests to us that, considering history, the level of TPM would be in an appropriate range. Hence, our previous estimate of the year-end TPM was between 5.25%-5.75%. 

However, this is not the only thing that is happening and, probably, the Central Bank's concern, which makes it act so aggressively, has to do with that. The problem is that none of the above analysis is very useful if expectations are not anchored. Think of any measure you want: EEE, EOF, asset prices, etc., ALL presume that, within 12 to 24 months, inflation does not converge to 3%. That's a big problem, as it diminishes the effectiveness of the very monetary policy measures the Bank is undertaking today. Therefore, the speed of the hikes, the message that they will continue, and the level likely to reach 7% - 7.5%, all refer to containing this de-anchoring as quickly as possible before it is too late. It is preferable to be left with a "past" TPM, which can then be adjusted, rather than a TPM far behind the curve that becomes ineffective.

Therefore, considering the above, the message of the penultimate paragraph of the statement and the possible inflationary trajectory of the coming months, we believe that: (i) the TPM would continue to rise, probably reaching 7% - 7.5% during 1H22; (ii) the March IPoM will correct upwards inflation 2022 and adjust the TPM corridor upwards; (iii) the monetary policy corridor will continue to show that, after rising, the TPM will start a downward adjustment, but this could take longer than previously estimated (although it could still start such process in 2022).

How assets react depends on the elements that take precedence. For the time being, this should be positive for the exchange rate in the short term (for the long term the story may be different, especially looking at the evolution of the global dollar), bullish for nominal short rates and, although to a lesser extent, for real short rates, causing further flattening of the curve.

For the time being, although it may be painful in the meantime, we can only know that everything necessary will continue to be done. Hopefully, in our case, it will be enough.

Nathan Pincheira

Chief Economist of Fynsa