By Alberto J. Boquin, CFA
When it comes to emerging markets, the problem of inflation is not one that Chile faces alone. However, with one of the most respectable central banks in the world among emerging markets, Chile not only serves as a good case study for the challenges faced by many others, but as a potential test for what will come next when interest rates rise monumentally. And relative to developed markets, it contrasts sharply with other central banks that have acted much less proactively.
Faced with rising inflation, the Central Bank of Chile acted quickly, responsibly and substantially. It began a rate hike cycle earlier than most, starting with a 25 basis point (bp) hike in July last year. Rate increases have now reached a substantial total of 650 basis points. Yet, although Chile is doing a decent job of fighting inflation, an inflection point may still be a long way off – suggesting important implications for the lagging normalization of global monetary policy.
Just when you thought we were done with rate hikes…
In January, we started to think that as one of the first to raise rates, Chile could again be a bellwether for emerging market central banks as the first to take a break or even the first to lower. Unfortunately, macroeconomic developments have led us to reassess. In short, high growth and high inflation have proven to be more persistent than anyone expected. For context, the central bank’s forecast in December included a forecast range of 1.5-2.5% for Chile’s gross domestic product and inflation of 5.9% at year-end. The central bank just lowered its growth forecast slightly to a range of 1.0% to 2.0%, but also said annual inflation is likely to hit 8.2% this year. Despite the central bank’s efforts to contain it, the level of inflation remains well above the bank’s 3% target.
… more is needed to avoid second-round effects
The global outlook has become more uncertain in recent weeks, but central banks have little leeway to adopt a wait-and-see approach. Chile’s most recent inflation print pushed annual inflation to 7.8%, the highest reading in a decade. Notably, 10 of the 12 components of inflation contributed positively to the monthly reading, indicating widespread pressures. A measure of core inflation that excludes volatile items posted a high of 6.5%. Even more worrying, inflation expectations are deteriorating. When polled, economists generally assume that Chile’s central bank will achieve the 3% inflation target over the two-year policy horizon. As a result, the average survey response is typically 3%. Lately, the average survey estimate has risen to its highest level since 2008. Two-year inflation break-evens, a measure of market expectations, are just as high (see chart 1).
How high should rates go?
Determining the terminal rate – the level at which rate hikes will stop – in any tightening cycle is more art than science. The terminal rate is a function of r-star (r*), which is the neutral interest rate that balances a long-term economy. However, r* is unobservable, dynamic, and the subject of much debate. A very simple way to approximate r* is to look at the real interest rate history using the policy rate and two-year market inflation forecasts. In Chile, most observations are around 0% or 2% (see graph 2). Notably, most of the 2% observations took place before the oil price crash of 2014, and most of the 0% observations took place after. Even after all the central bank tightening, Chile’s real rate is still around -25 basis points and could well decline if inflation expectations deteriorate further. The key question for the markets is whether we are seeing a regime shift. Given structurally tight oil markets and a number of cyclical inflationary forces, Chile may need to return to a positive real rate above 2%. Given current inflation expectations, a real rate above 2% would mean a policy rate of at least 8%, if not more. After the last hike, Chile’s benchmark interest rate now stands at 7%.
What if the economy slows down?
Unlike the Federal Reserve’s quirky dual mandate of stable prices and maximum employment, most emerging market central banks exclusively target inflation. By design, these central banks can be less focused, but not ignorant, of the growth/inflation trade-off.
Chile’s previous rate hike cycles occurred when system-wide inflation-adjusted loan growth was in the range of 5-10% year-over-year. Current banking forecasts suggest steady loan growth this year. Growth remains strong for now in Chile, but we’ll be watching the credit channel for signs of a slowdown – and for a possible early indication of what might happen next for emerging market central banks. How much will Chile’s central bank have to raise rates before its economy responds? With so many other central banks much further behind, the test case of Chile may offer important clues for the global economy and monetary policy.
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.