July 2012. Several European countries are facing a serious sovereign debt crisis, which began with Greece but quickly threatened to spread to countries with greater relative economic importance, such as Italy, Spain, and Portugal. Skyrocketing interest rates had caused debt to spiral into an unsustainable situation, as growth would not be able to generate the revenue to pay it off. The Eurozone was reeling. In this context, Mario Draghi made a statement that probably saved the existence of the single currency: "In accordance with our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough." 

I couldn't help but recall those words after learning of the central bank's decision to raise the MPR by 150 basis points. Two increases of 125 bp had not been enough to control the situation, and in light of that, well, more decisive action had to be taken. "Whatever it takes" to combat inflation. In any case, I think it is important to review some factors that lead us to project a significantly higher MPR over the coming months, but which 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 its speed. In a simple but informative exercise, we constructed a measure of "monetary expansiveness," since we believe that simply comparing nominal MPRs over time is incomplete, as it does not incorporate other economic fundamentals that have also changed. Thus, compared to another period of "overheated" local economy, monetary policy today would be more contractionary than then. This suggests that, considering history, the MPR level would be in an appropriate range. Hence, our previous estimate of the MPR for the end of the year was between 5.25% and 5.75%. 

However, this is not the only thing that is happening, and the Central Bank's concern, which is causing it to act so aggressively, probably has something to do with it. The problem is that none of the above analysis is very useful if expectations are not anchored. Think about the measure you want: EEE, EOF, asset prices, etc., ALL assume that, within 12 to 24 months, inflation will not converge to 3%. That is a big problem, as it reduces the effectiveness of the monetary policy measures that the Bank is implementing today. Therefore, the speed of the increases, the message that they will continue, and the level that will probably reach 7%–7.5% refer to containing this unanchoring as quickly as possible before it is too late. It is preferable to have a "past" MPR, which can then be adjusted, than an MPR that is far behind the curve and becomes ineffective.

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

How assets react depends on the prevailing factors. For now, this should be positive for the exchange rate in the short term (in the long term, the story may be different, especially considering the evolution of the global dollar), bullish for short-term nominal rates and, although to a lesser extent, for short-term real rates, causing further flattening of the curve.

For now, although the interim period may be painful, we can only hope that everything necessary will continue to be done. Hopefully, in our case, it will be enough.

Nathan Pincheira

Chief Economist at Fynsa