One of the things I remember most since I have been working in this profession is the moment when I was talking to a -now- former advisor of the Central Bank and he told me: "Adjustments are made by 25 basis points; the 50 points are reserved for exceptional situations". That was fundamental to sufficiently anticipate almost all the movements made by the Central Bank to date, including the one made to contain an unanchoring of expectations, back in March 2011. 

I mention the above so that the reader understands that what we are experiencing now is "a bit" more than exceptional. We have witnessed one of the most aggressive monetary policy adjustments in recent years. In fact, the most important since the current economic institutional framework has been in place in the country, namely the flexible exchange rate, nominal monetary policy rate, inflation targeting scheme and fiscal rule. In the last three meetings, the Board of the Central Bank has decided to increase the TPM by 125 bp (twice) and, in the most recent one, by 150 bp, to leave the instance rate at 5.5%. In other words, in a little more than seven months, we have seen an increase of no less than 500 basis points.

The immediate outlook is not very different. The market is debating between 100 and 150 bp of increase for the next meeting (end of March), a process that would continue until reaching approximately 8.5%. However, this movement would be seen as transitory, since by the end of the current year, we would see a normalization of this monetary contraction process. This would materialize with some cuts, placing the key rate at approximately 7%.

In this context, the recently appointed president of the Instituto Emisor, Rosanna Costa, will face not only a short-term dilemma, but also a medium-term one, as she will have to choose between the exit strategy being advanced by the market and a more conventional one. Both have pros and cons - like everything else - and her choice will depend on how the risks are weighed by the members of the board (yes, the decision is not made by Rosanna Costa alone, but the title fits better with the Meryl Streep movie).

Continuing to raise the rate to levels close to or above 8% would be useful to re-anchor expectations, which have remained dangerously above 3% for a 2-year horizon. It would also signal to the market the monetary authority's commitment to its target, which would be in line with reducing inflationary pressures coming from the demand side, hoping that those coming from the supply side would eventually dissipate. Once these problems are solved, a monetary "fine tuning" can be done, adjusting the rate to levels more in line with fundamentals, which according to our assessment today would require a TPM around the current value. However, delivering this message correctly could be confusing, running the risk of it becoming ineffective, causing the economy to be affected more than desired, without having been able to control inflationary expectations and having to strongly reverse the contractionary cycle.

The more conventional strategy would involve one or two additional rate hikes, leaving the rate at around 7% and leaving it unchanged for an extended period of time (which should also be communicated in advance). This would allow for more medium-term expectations on rate levels to be accommodated, for the economy to make a slower adjustment and not overreact to inflationary shocks from the supply side, against which the Central Bank can do little or nothing. The problem lies in the fact that, if the following CPI records do not soften, inflationary expectations could be permanently unanchored and this would cause damage that would be too costly to reverse, not only for the Central Bank, but for the country's entire economic institutionality. Thus, we would be left with consistently higher rates, economic agents less sensitive to their movements and, therefore, less capacity to smooth economic cycles.

It is not easy, but in the opinion of the writer of these lines, the first option would be more convenient in this context. Not only because I believe that, beyond the high inflation we have today, in the event of losing the anchor of expectations, we would have a problem of higher permanent inflation, with all the costs that this generates. In addition, it allows us to hedge the risk of a demand that may slow down more slowly than we expect and require a firmer monetary policy action. Finally, the costs of communicating the above to the market can be reduced with a clear strategy and conditioned to the behavior of a set of defined variables. All that remains now is to know Rosanna's decision.

Nathan Pincheira 

Chief Economist of Fynsa