July 2012. Several European countries were facing a severe sovereign debt crisis, which began in Greece but quickly threatened to spread to countries of greater economic importance, such as Italy, Spain, and Portugal. Skyrocketing interest rates had pushed the debt into an unsustainable situation, as economic growth would not be able to generate the revenue needed to pay it off. The Eurozone was teetering. Against this backdrop, Mario Draghi made a statement that likely saved the euro: “In accordance with our mandate, the ECB is prepared 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 TPM by 150 basis points. Two hikes of 125 bp hadn’t been enough to bring the situation under control, and in light of that, well, stronger action was needed. “Whatever it takes” to combat inflation. In any case, I think it’s important to review a few factors that lead us to project a significantly higher TPM over the coming months—though it wouldn’t necessarily remain at that level for very long.

First, for educational purposes, I would like to distinguish between the reasons behind the rise and, above all, the pace of that rise. In a simple but informative exercise, we construct a measure of “monetary expansion,” since we believe that simply comparing nominal TPMs over time is incomplete, as it does not incorporate other economic fundamentals that have also changed. Thus, compared to another period when the local economy was “overheated,” monetary policy today would be more contractionary than it was then. This suggests that, historically speaking, the TPM level is within an appropriate range. Hence, our previous estimate for the year-end TPM was between 5.25% and 5.75%. 

However, this isn’t the only thing happening, and the Central Bank’s concern—which is driving it to act so aggressively—likely has something to do with that. The problem is that none of the above analysis is very useful if expectations aren’t anchored. Consider any metric you like—EEE, EOF, asset prices, etc.—ALL of them assume that, over the next 12 to 24 months, inflation will not converge to 3%. That’s a huge problem, as it undermines the effectiveness of the very monetary policy measures the Central Bank is implementing today. Therefore, the pace of the rate hikes, the message that they will continue, and the fact that the policy rate will likely reach 7%–7.5% are all aimed at containing this disanchoring as quickly as possible before it’s too late. It’s better to end up with a “too high” policy rate—which can then be adjusted—than with a policy rate that lags far behind the curve and becomes ineffective.

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

How assets react will depend on which factors take precedence. For now, this should be positive for the exchange rate in the short term (in the long term, the story may be different, especially given the global dollar’s performance), bullish for short-term nominal rates, and—albeit to a lesser extent—for short-term real rates, leading to a further flattening of the yield curve.

For now, even though the waiting period may be painful, all we can do is trust that everything necessary will continue to be done. Hopefully, in our case, that will be enough.

Nathan Pincheira

Chief Economist at Fynsa