One of the things I remember most since I started working in this profession is when I was talking to a now former advisor to the Central Bank, who told me: "Adjustments are made in increments of 25 basis points; 50 points are reserved for exceptional situations."  That was fundamental in accurately predicting almost all of the Central Bank's moves to date, including the one made to contain a de-pegging of expectations back in March 2011. 

I mention this so that readers understand that what we are experiencing now is "a little" more than exceptional. We have witnessed one of the most aggressive monetary policy adjustments in recent years. In fact, it is the most significant since the current economic institutional framework was established in the country, namely a flexible exchange rate, a nominal monetary policy rate, an inflation targeting regime, and a fiscal rule. In its last three meetings, the Central Bank Council has decided to increase the MPR by 125 bp (twice) and, in the most recent meeting, by 150 bp, leaving the rate at 5.5%. In other words, in just over seven months, we have seen an increase of no less than 500 basis points.

The immediate outlook does not suggest a very different situation. The market is debating between a 100 and 150 bp 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 temporary, since by the end of the current year, we would see a normalization of this process of monetary contraction. This would materialize with some cuts, placing the benchmark rate at approximately 7%.

In this context, the recently appointed president of the Central Bank, Rosanna Costa, will face not only a short-term dilemma, but also a medium-term one, having to choose between the exit strategy being pursued by the market and a more conventional one. Both have pros and cons—as everything does—and her choice will depend on how the board members weigh the risks (yes, Rosanna Costa does not make the decision alone, but that way the title would fit better with the Meryl Streep movie).

Continuing to raise the rate to levels close to or above 8% would be useful in re-anchoring expectations, which have dangerously remained at around 3% for a two-year horizon. It would also signal to the market the monetary authority's commitment to its objective, which would also help reduce inflationary pressures from the demand side, in the hope that those from the supply side will eventually dissipate. Once these problems have been solved, monetary fine-tuning can be carried out, adjusting the rate to levels more in line with fundamentals, which, according to our assessment, would currently require a MPR of 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 sharply reverse the contractionary cycle.

The most conventional strategy would involve one or two additional increases, leaving the rate at around 7% and leaving it unchanged for an extended period of time (which must also be communicated in advance). This would allow for more medium-term expectations regarding interest rate levels, enable the economy to make a more gradual adjustment, and prevent an overreaction to supply-side inflationary shocks, which the Central Bank can do little or nothing about. The problem is that if the next CPI figures do not ease, inflation expectations could become permanently unanchored, causing damage that would be too costly to reverse, not only for the Central Bank but for the country's entire economic institutional framework. This would leave us 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 author of this article, the first option would be more appropriate in this context. Not only because I believe that, beyond the high inflation we are experiencing today, if we lose the anchor of expectations, we would have a problem of higher permanent inflation, with all the costs that this entails. It also allows us to hedge against the risk of demand slowing down more slowly than expected, which would require more decisive monetary policy action. Finally, the costs of communicating this to the market can be reduced with a clear strategy that is conditional on the behavior of a set of defined variables. Now all that remains is to hear Rosanna's decision.

Nathan Pincheira 

Chief Economist at Fynsa