Functions of the Central Bank of Chile

Central Bank policies

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Antique weighing scales displayed in the entrance hall.

A) Description of the Main Policies

1. Monetary Policy

Money plays an essential role in the suitable functioning of any economy. To preserve this role, the Central Bank’s monetary policy must protect the value of the country’s currency, the peso, seeking to keep inflation low and stable. The purpose of keeping inflation low and stable, which is how this price stability concept is interpreted in practical terms, is no mere whim of the law, but rather serves the broader objective of moving the national economy along the path of sustained growth, full employment and, in general, progress and wellbeing for the population. In fact, the Central Bank’s greatest contribution to growth and progress lies in encouraging confidence in the future, which in turn is associated with price stability. This encourages saving, investment and productivity gains, all essential elements for economic growth. Low, stable inflation is, moreover, beneficial from the point of view of distribution, because it favors growth in employment and protects the income of the most defenseless sectors of society.

Monetary policy cannot influence the trajectory of long-term growth in any way other than contributing to price stability. The effects of monetary policy on economic activity and employment, in the short and medium term, arise from the different channels along which changes in monetary policy move until it actually affects inflation. Because of this, monetary policy follows a countercyclic path, which, moreover, preserves price stability, seeking to avoid extreme changes in general expenditure or domestic demand that could lead to unnecessary risk in financial markets and difficult situations in terms of recession and unemployment. In this sense, the focus of the Central Bank of Chile’s monetary policy is price stability over time, taking into account the effects this policy has on economic activity and employment in the short and medium terms.

The Central Bank’s concern for price stability has translated into the application of an inflation targeting monetary approach. Although a mature inflation-targeting regime can be defined in a somewhat flexible way, it must include some essential ingredients. First and foremost, it must establish an explicit numeric target for inflation in a specific time period or horizon – the inflation target as such. Second, its commitment to this target must take priority over any other policy objective that could come into conflict with inflation over the specific time horizon. Third, the Central Bank must have the independence necessary to use its instruments, so it is capable of applying its monetary policy to close any foreseeable gap between estimated inflation and the inflation target. Fourth, the Central Bank must have the technical ability to use reasonable empirical models to predict inflation. Today, the Central Bank of Chile meets all these requirements.

Since 2007, the explicit objective of the Central Bank of Chile is to maintain the annual inflation of the consumer price index (CPI) around 3% most of the time, with a tolerance range of plus or minus one percentage point. This objective should be permanently achieved in a medium-term horizon of two years. The Central Bank is concerned not only with scenarios in which inflation exceeds the target in the relevant horizon, but also with scenarios in which it falls too low. The Central Bank of Chile does not aim for an inflation level below the specified range because of the risk of disinflation, which could be very costly in terms of employment and production. Moreover, the horizon is consistent with the time period over which monetary policy achieves its maximum effect and is therefore the period during which monetary policy can exercise the most control over inflation.

The main merit of this regime is that, while it restricts the discretionary powers of the monetary authorities, it permits the achievement of stabilization policies. An inflation-targeting regime establishes specific objectives, providing the Central Bank with the freedom to use the instruments and policies necessary to achieve same. Communication with the public is optimized using a simple, easily understood indicator, able to strongly influence inflationary expectations. Monetary policy can also play a role in stabilizing output over the short term, as long as it is consistent with meeting the inflation target in the medium term.

2. Foreign Exchange Policy

In September 1999, the nominal objective on the exchange rate – represented by the presence of an exchange rate band – was abandoned, and a free-floating regime adopted. This eliminated a possible source of inconsistency in the design of the policy regime; the Central Bank’s sole commitment is now to maintain inflation within the target range, as well as reflecting the authority’s confidence in the market to determine autonomously the value of the national currency. In a highly volatile world of enormous openness to capital, maintaining a foreign exchange commitment is not only a difficult task, but also, as recent experience has taught, potentially very costly. A flexible approach to the foreign exchange rate eliminates this commitment, focusing Central Bank efforts on the inflation target, which becomes the nominal anchor for the economy, avoiding any possible confusion. Moreover, the floating exchange regime provides the economy with the flexibility necessary to deal with external shocks, thus facilitating corrections that otherwise could be postponed and thereby become more complex.

Foreign exchange flexibility, however, does not mean that the Central Bank of Chile cannot intervene in the market under exceptional circumstances, if it considers that the currency is moving too far away from its equilibrium value, and costly reversions could lie in the future. These interventions, however, take the form of transparent, well-founded measures, which include explicit definitions of the periods and amounts involved, as well as the clear explanation of the reasons behind these exceptional actions.

3. Financial Policy

A stable economy that enjoys sustained growth requires a solid and secure banking sector that can allocate resources with an efficient blend of risk and return, thus ensuring the functioning of the payment system.

The Central Bank is the economy’s lender of last resort and as such provides liquidity to institutions that face temporary cash flow difficulties. The Central Bank also has some regulatory authority over payment of interest on checking accounts and credit ratios.

Likewise, the Central Bank has directly contributed to both completing and deepening markets. The emission of instruments indexed to changes in the exchange rate has provided the market with coverage of this risk. The exchange of promissory notes payable in coupons for zero coupon notes has satisfied the demand for longer term instruments, as well as helping to build a zero coupon yield curve that serves as the axis for the functioning of a market in interest rate derivatives. For the more efficient development of the foreign exchange market, the Bank has also authorized interbank loans and pacts between financial institutions in foreign currencies.

Today, the risks that banks face are suitably under control. The Central Bank has gradually introduced important improvements to regulations governing the matching of foreign currency assets and liabilities, maturities and interest rates.

Externally, the maturity of the Chilean economy, along with the adoption of the floating regime, today permit full mobility of capital, with the complete elimination of controls and restrictions on foreign capital flows. Nonetheless, the Central Bank participates in regulating bank investment abroad, both in the foreign exchange sphere and in terms of financial regulation, protecting the interests of depositors in operations such as the purchase of shares and the establishment of subsidiaries and companies, or the regulation of financial investment, and international credits. In the case of this last area, the Central Bank has its own powers, as well as sharing responsibilities with the Superintendent of Banks, to establish the equity requirements and provisions for these sorts of operation.

A stable economy that enjoys sustained growth requires a solid and secure banking sector that can allocate resources with an efficient blend of risk and return, thus ensuring the functioning of the payment system.

The Central Bank is the economy’s lender of last resort and as such provides liquidity to institutions that face temporary cash flow difficulties. The Central Bank also has some regulatory authority over payment of interest on checking accounts and credit ratios.

Likewise, the Central Bank has directly contributed to both completing and deepening markets. The emission of instruments indexed to changes in the exchange rate has provided the market with coverage of this risk. The exchange of promissory notes payable in coupons for zero coupon notes has satisfied the demand for longer term instruments, as well as helping to build a zero coupon yield curve that serves as the axis for the functioning of a market in interest rate derivatives. For the more efficient development of the foreign exchange market, the Bank has also authorized interbank loans and pacts between financial institutions in foreign currencies.

Today, the risks that banks face are suitably under control. The Central Bank has gradually introduced important improvements to regulations governing the matching of foreign currency assets and liabilities, maturities and interest rates.

Externally, the maturity of the Chilean economy, along with the adoption of the floating regime, today permit full mobility of capital, with the complete elimination of controls and restrictions on foreign capital flows. Nonetheless, the Central Bank participates in regulating bank investment abroad, both in the foreign exchange sphere and in terms of financial regulation, protecting the interests of depositors in operations such as the purchase of shares and the establishment of subsidiaries and companies, or the regulation of financial investment, and international credits. In the case of this last area, the Central Bank has its own powers, as well as sharing responsibilities with the Superintendent of Banks, to establish the equity requirements and provisions for these sorts of operation.

B) Passthrough Mechanisms and the Policy Horizon

The passthrough of changes in monetary policy to the rest of the economy occurs along different channels and takes a relatively long and variable time to materialize. Thus, several mechanisms exist to ensure that a specific policy action (reflected in a change in the policy interest rate) can affect inflation and activity.

A more restrictive monetary policy approach (reflected in an increase in the policy interest rate) leads to lower private expenditure on investment and consumption and, by this route, affects the gap between aggregate demand and potential output, and ultimately, inflation. Moreover, an increase in the policy interest rate can also affect the exchange rate (causing the peso to appreciate), thus eventually causing inflation to fall in the case of imported goods, as well as affecting external demand, and the expenditure to output gap. Policy action can also affect asset prices (by changing the relative yield for different financial instruments), which can affect real wealth and by that route aggregate demand and inflation. It is possible that the supply of credit in the banking sector may also be affected, which is particularly relevant for those firms whose access to other sources of financing is closed. Finally, policy action affects economic agents’ expectations, which can be reflected in their decisions regarding consumption or investment, along with determining contracts and wages.

It can take 4 to 8 quarters for inflation to react substantially to a change in the policy rate, which operates through a set of transmission channels. This period is taken into consideration in defining the reasonable time-span that the Central Bank considers as the horizon for monetary policy. For this reason, monetary policy actions are based on the expected evolution of inflation over a period of around two years and not necessarily on its current behavior. Thus, even if inflation stands near or even at 3% at a given point in time, it may be necessary to take preventive action to avoid future deviations of inflation from the target. At the same time, isolated movements of inflation outside the tolerance range may not require policy actions if there is a well-founded presumption that the movements are very short term and that there is no risk of inflation becoming unanchored from the trend.

C) Characteristics of Monetary Policy Conduction

Transparency plays a key role in the conduction of Central Bank policies. The Central Bank is not isolated from the rest of society and has enormous political responsibility, maintaining both the president of Chile and the senate informed of its actions. In this sense, the Board’s meetings with the senate’s finance commission are fundamental to keeping society informed and involved in macroeconomic policy debate and conduction, as well as ensuring that the Central Bank receives feedback on the policies applied and perceptions regarding them.

Policy decisions are made at monthly meetings, which are publicly announced six months in advance. This does not prevent, where necessary, making policy decisions at special meetings. Policy decisions are made by a simple vote of board members present at the meeting, with the governor of the Central Bank empowered to cast the decisive vote in the case of a tie. The finance minister is allowed to attend Central Bank of Chile meetings, with a voice in deliberations, and the ability to suspend for up to 15 days the implementation of any resolution, provided this has not been decided unanimously by the members of the Board. Once this period has expired, and provided the majority of Board members remain in favor, the Board’s decision comes into effect with the simple publication of the resolution in the official gazette (Diario Oficial).

The minutes of these meetings are made public on the fifth bank business day prior to the date set for the next Monetary Policy Meeting, or the fifteenth day after the respective session if fifteen days have not passed since the last Monetary Policy session. The document reports the vote of each of the Board Members on the resolutions passed during the session.

Another important element for the Central Bank’s policy transparency is the publication of the Monetary Policy Report beginning in May 2000 and the Financial Stability Report since 2004.

The Monetary Policy Report (IPOM), which is published every four months, presents the past evolution of inflation, a base scenario with explicit forecasts for future inflation (and growth), and a statement on the risks that the Central Bank’s Board perceives as potentially affecting the base scenario over a horizon of the next two years. This high degree of transparency allows focusing on inflation projections that are an intermediate target in and of themselves. Since the forecasts are contrasted with market expectations, credibility comes to depend more on whether the Central Bank reacts in a timely and appropriate manner to a change in these inflation forecasts, than whether a specific number is achieved on a given date.

The Financial Stability Report (IEF) is a semi-annual publication that comprises the study of the macroeconomic and financial environment in Chile and abroad, as it pertains to the stability of the financial system. It includes an analysis of the evolution of the debt and payment capacity of credit users, the situation of nonbank financial intermediaries, and the impact of alternative macroeconomic scenarios on the banking system and on the international financial position of the national economy.

D) Operational Conduction of Monetary Policy

The medium-term operational target is defined in terms of changes in the consumer price index (CPI). This indicator, however, can present a relatively high degree of month-to-month volatility, as a result of fluctuations in perishables and fuel prices. Therefore, to interpret periodic and short-term price information (up to two months), the Central Bank also considers measures of underlying or trend inflation, such as variation in the underlying CPI (the total index excluding fruits, vegetables, and fuels) maintained by the National Statistics Bureau (INE).

The Central Bank implements its monetary policy by defining a target level for the nominal interbank interest rate, which is known as the monetary policy rate (tasa de política monetaria, TPM). To ensure that the interbank rate falls within the desired range, the Central Bank must regulate financial system liquidity (or reserves), through the use of several instruments: open market operations, buying and selling short-term promissory notes, and liquidity deposits and lines of credits (expanded facilities). These tools also include the banking reserve over deposits, although in practice the Central Bank does not use this as an active monetary policy instrument.

Open market operations take place essentially through regular auctions of promissory notes issued by the Central Bank. Banks and financial institutions, pension fund managers, insurance companies and mutual funds can participate in these auctions. Promissory note auctions take place in the form of a single price per auction, that is the cut-off rate applies to all the winning participants in the auction, a system known as the “Dutch type”. The above encourages competition among auction participants and tends to reflect more appropriately the conditions prevailing in the marketplace. In the event of deviations from the (average) interbank rate away from the desired policy rate, for example because of a lower level of liquidity than that required, liquidity is injected to reduce the interbank rate and make it converge toward the TPM. In general, liquidity is injected by purchasing promissory notes using a repurchasing clause (REPO) overnight. In the opposite situation, when excess liquidity is present and the interbank rate is tending to fall below the target rate, the temporary excess is withdrawn by selling short-term notes. These last operations take the form of “dematerialized” documents (that is, the documents are not physically issued).

Other tools at the Central Bank’s disposal are the liquidity credit line and the liquidity deposit account. Using the first, the Central Bank provides financial institutions with one-day loans without collateral, for limited amounts and by interest rate tranche. Similarly, the liquidity deposit allows financial institutions to deposit, for one day, temporary liquidity surpluses in the Central Bank and obtain a minimum return. To suitably regulate liquidity in the financial system, the Central Bank prepares a cash flow program that covers the period during which the reserve requirement is measured. To develop the cash flow plan, both supply of and demand for banking reserves, that is bank notes and coins in the power of banks and bank checking account balances in the Central Bank, are projected. Demand is of a derivative nature that basically depends on reserve rates and trends foreseen for demand and time deposits such as the behavior of currency in the hands of the public. The supply of banking reserves depends on the behavior of currency in the public’s hands and the main sources of emission, including the expiry dates for promissory notes auctioned off during previous periods and other sources of monetary expansion that are more autonomous and require their own projections. These operations include the State’s financial operations with monetary impact.

Once the supply and demand for banking reserves has been determined, the amounts of promissory notes to be auctioned off by the Central Bank are decided. The auctions calendar is provided to the public the day before a new reserve period begins.

Daily follow-up of the liquidity projection is essential to ensure, wherever necessary, that the operations necessary to fine tune bank reserves take place, through the REPO operations mentioned above or special sales of short-term promissory notes.