One of the things I remember most clearly since I began working in this profession is the moment when, while talking with a—now—former Central Bank advisor, he told me: “Adjustments are made in increments of 25 basis points; 50 basis points are reserved for exceptional situations.”  That insight was crucial for accurately predicting almost all of the Central Bank’s moves to date, including the one taken to prevent expectations from becoming unanchored back in March 2011. 

I mention this so that the reader understands 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, the most significant since the country adopted its current economic framework, namely a flexible exchange rate, a nominal monetary policy rate, an inflation-targeting framework, and a fiscal rule. In its last three meetings, the Central Bank’s Board has decided to raise the monetary policy rate by 125 basis points (twice) and, at the most recent meeting, by 150 basis points, bringing the current rate to 5.5%. In other words, in just over seven months, we have seen a rise of no less than 500 basis points.

The immediate outlook does not suggest a very different situation. The market is split between a 100- and 150-basis-point increase for the next meeting (late March), a trend that would continue until the rate reaches approximately 8.5%. However, this move would be viewed as temporary, as by the end of this year, we would see a normalization of this monetary tightening process. This would take the form of several rate cuts, bringing the benchmark rate to 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, as she must choose between the exit strategy the market is anticipating and a more conventional one. Both have pros and cons—as with everything—and her choice will depend on how the board members weigh the risks (yes, Rosanna Costa doesn’t make the decision alone, but that title fit better with the Meryl Streep movie).

Continuing to raise the rate to levels close to or above 8% would help re-anchor expectations, which have remained dangerously high at around 3% over a two-year horizon. Furthermore, it would signal to the market the monetary authority’s commitment to its objective, which would also help reduce demand-side inflationary pressures, with the expectation that supply-side pressures will eventually subside. Once these issues are resolved, monetary “fine-tuning” can be undertaken, adjusting the rate to levels more in line with fundamentals—which, according to our assessment, would currently require a TPM around the current level. However, conveying this message correctly could be confusing, running the risk of rendering it ineffective—causing the economy to be affected more than desired, without having been able to control inflation expectations and having to sharply reverse the contractionary cycle.

The most conventional strategy would involve one or two additional rate hikes, bringing the rate to around 7% and keeping it unchanged for an extended period (which should also be communicated in advance). This would help align medium- to long-term expectations regarding interest rate levels, allow the economy to adjust more gradually, and prevent an overreaction to supply-side inflationary shocks—against which the Central Bank can do little or nothing. The problem is that if future CPI readings do not moderate, inflation expectations could become permanently unanchored, causing damage that would be far too costly to reverse—not only for the Central Bank but for the country’s entire economic institutional framework. As a result, we would be left with consistently higher rates, economic agents less responsive to rate changes, and, consequently, a reduced ability to smooth out economic cycles.

It’s not easy, but in the opinion of the author of these lines, the first option would be more appropriate in this context. Not only because I believe that, beyond the high inflation we’re experiencing today, if we were to lose the anchor for inflation expectations, we would face a problem of higher, persistent inflation, with all the costs that entails. Furthermore, it allows us to hedge against the risk that demand might slow down more gradually than we expect, requiring more decisive monetary policy action. Finally, the costs of communicating this to the market can be reduced with a clear strategy contingent on the behavior of a set of defined variables. Now we just have to wait for Rosanna’s decision.

Nathan Pincheira 

Chief Economist at Fynsa