Inflation remains at very high levels. Despite the decline in the annual variation of the CPI to 11.9% in February, it is still well above the 3% target. The core part of the CPI has been at around 11% annually for some time now, accumulating a significant surprise in recent months. Several factors explain why inflation is taking so long to come down. Most importantly, the economy has been unable to undo the impact of the overspending that accumulated in previous years. In fact, the revision of the national accounts showed that the level of consumption in previous years was higher than previously thought. Moreover, the pace of adjustment in recent years has been slower than expected. The improved performance in early 2023 leads to an upward revision of this year's GDP growth outlook. Nevertheless, the economy will further continue its adjustment process in the coming quarters, reflected in a lower forecast for 2024. Considering both years, cumulative growth is not far from our December forecast. Inflation will return to the 3% target in the latter part of 2024. The global economic outlook has become more difficult in recent weeks. The Chilean economy will be affected by weaker external demand and tighter global financial conditions. Overall, the current scenario is associated with a higher-than-usual degree of uncertainty. On the one hand, there is the risk of a more abrupt deterioration of the external scenario, with greater implications for Chile. On the other, the slow decline in domestic consumption could result in a more complex inflationary dynamic. The Monetary Policy Rate (MPR) has remained at 11.25% since October 2022. The Board considers that it will be necessary to keep the MPR at that level until macroeconomic conditions indicate that the process of inflation convergence to the 3% target has been consolidated. As described in the central scenario of this Report, this process will take longer than expected in December. The Board reaffirms its commitment to act with flexibility in case any of the internal or external risks materializes and macroeconomic conditions so require.

Annual inflation is still very high. In February, the CPI posted an annual increase of 11.9% which, while lower than its peaks of the third quarter of 2022, is still well above the inflation target. February’s monthly variation was negative (-0.1%) for the first time in several quarters. However, it responded mainly to a fall in volatile prices. In fact, the core component of the CPI rose significantly in said month (+0.7%).

Even though most inflation fundamentals have been easing, the annual change in core inflation has remained around 11% for several months. On the one hand, the peso has appreciated around 11.5% with respect to the statistical cut-off of the previous Report. On the other hand, global cost pressures have eased. Commodity prices, including oil, have fallen, supply chains have normalized, and transportation costs have declined, all in a context marked by a clearly contractionary monetary policy stance.

In addition, compared with projections in the last Report, core CPI has accumulated a considerable upward surprise, of nearly one percentage point. Most of the difference is concentrated in the prices of non-volatile goods. In any case, services inflation has also exceeded projections, with escalating annual variation rates.

One relevant factor behind the persistently high inflation has been the slow reversal of the excessive private consumption levels of the past few years. The revision to the National Accounts yielded that between 2020 and 2022, household consumption was close to US$4.3 billion higher than previously estimated. With this, national savings figures were revised downward and the current account deficit increased, pointing to larger macroeconomic imbalances. Meanwhile, data for the end of 2022 and the turn of 2023 show that the pace of the reduction in private consumption has been slower than expected.

The slow decrease in consumption is consistent with a recent rebound in employment and lower political and economic uncertainty. In de-seasonalized terms, employment has picked up in recent months, especially in salaried jobs, which has contributed to a slight rebound in the wage bill. Local uncertainty indicators have declined importantly, up to levels comparable to those observed prior to October 2019. The smaller consumption adjustment also coincides with increases in rolling consumer credit flows, i.e., credit lines and credit cards.

Contrasting with consumption, investment has been performing weakly for several quarters. The revision of the National Accounts also shows that, seasonally adjusted, the level of gross fixed capital formation has been stagnant since mid-2021 (box I.2). This is consistent with a scenario in which: the cost of credit increased; entrepreneurial expectations deteriorated; and local political-economic uncertainty was high. Some of these factors have lost significance in recent months.

In the last quarter of 2022, the current-account deficit saw a significant decline, and partial first-quarter 2023 data point to a continuation of this trend. Considering end-of-2022 data, the deficit accumulated over the last four quarters declined to 9% of GDP (10% in the third quarter). This result was significantly influenced by the positive trade balance, due to both higher exports and lower imports. In the services balance, the reduction in transportation costs and the transitory rise in imports of services stood out.

Internationally, up to early March, a scenario was being configured of stronger growth and inflationary concerns. On the one hand, the increase in global growth expected for this year was based on upward surprises in activity of several important economies, including the United States, China and the Eurozone. On the other hand, developed economies reported high core inflation indicators, despite the fall in headline inflation. All this raised concerns about inflation and the need for interest rate hikes by the main central banks. In this environment, commodity prices rose and risk aversion decreased. In general, interest rates rose as a result of the higher inflation outlook.

The tone of the external scenario changed significantly in the last month. The problems of several banks in the U.S. and Europe generated a scenario of greater global uncertainty. This has spurred volatility in financial markets, which has reduced risk appetite and led to a decrease in government bond yields, anticipating a slower pace of rate hikes by the main central banks. It has also led to declines in stock markets and reductions in the prices of some commodities.

There is significant uncertainty regarding the evolution of financial situation. Policymakers in involved countries adopted measures to contain the impact of these episodes. Worth noting are the coordinated actions among central banks to safeguard the provision of liquidity to the markets. Private banks have also made efforts, especially in the U.S. However, market agents remain worried and volatility remains high.

The Chilean banking system is subject to adequate regulation and supervision standards that prevent the occurrence of situations like those that triggered the current episode of uncertainty in international banks. The dominant banking business model in Chile is traditional in nature. It is focused on granting credit on a more diversified basis of financing and proper management of maturity mismatches. The regulatory framework has been updated and considers Basel III capital and liquidity standards for all banks. All of them are subject to exhaustive annual risk management, capital adequacy, liquidity and transparency supervision processes. Furthermore, both the Central Bank and the FMC permanently monitor the banks' capacity to withstand adverse events through stress tests.

Still, changes in the external scenario will have effects on our economy. As foreseen in this Report’s central scenario, projected growth for the U.S. and Europe will be negatively affected by slower credit expansion and increased global uncertainty. This effect will be mostly visible in the second half of 2023 and early 2024. For these years, growth in developed economies that are Chilean trading partners is expected to average 0.4% (0.7% in December). Emerging economies will face tighter financial conditions, which will also affect external demands relevant to Chile.

The Chilean financial market has followed the trends of global markets. Particularly, the Chilean bond market showed significant falls in sovereign bond rates, while allowing the placement of bank and corporate debt. Although these developments are positive, it is important to note that the depth of the Chilean capital market has been significantly reduced in recent years. For the same reason, a relevant factor for the resilience of the Chilean economy is that this market is not affected again.

Projections

The central scenario projects that headline inflation will decline further over the coming quarters and will converge to the 3% target towards the end of 2024. Inflation will end 2023 at 4.6% annually, up from the forecast in the last Report. This correction stems from the higher levels of inflation of recent months —particularly its core component—, the slower adjustment of consumption and the activity gap closing later than expected. In this scenario, core inflation exceeds the previous estimate and will reach annual variations in the order of 3% only towards the end of the projection horizon.

For 2023 and 2024, our projection assumes that, on average, the real exchange rate will be lower than estimated in December. This is largely due to the nominal appreciation of the peso since last December. Going forward, it factors in the impact on the dollar of a scenario of tighter global financial conditions. In any case, the pass-through of the lower exchange rate to inflation is expected to be relatively slow. This is a phenomenon that usually occurs in episodes of currency appreciation, even more so considering that corporate margins have not recovered all the fall that it is estimated they had in previous years. For the period 2023-2025, the projection considers oil prices to be 8% lower than those forecast in December, which reduces the variation of the volatile component of the CPI.

The convergence of inflation to the 3% target continues to consider that the economy needs to adjust from its high spending levels of 2021 and 2022. Non-mining GDP completed three quarters of contraction during 2022. In the central scenario, this trajectory will be temporarily interrupted in the first quarter of 2023. Towards the second quarter of this year, the activity gap will narrow again and will be in negative territory during the second half of 2023 and all of 2024.

In the central scenario, activity will accumulate growth in the order of 1.5% between 2023 and 2024, close to the forecast in the last Report. For 2023, the growth range is corrected upward to -0.5% to +0.5% (between -1.75% and -0.75% in December). This responds mainly to the slower speed of consumption adjustment in late 2022 and upside surprises in early 2023. For 2024, the growth range is reduced by an equivalent magnitude, between 1% and 2% (2% to 3% in December). By 2025, the economy is projected to grow between 2% and 3%.

Private consumption is projected to make further adjustment going forward. Compared with December, this component of spending will see a more moderate fall in 2023 and a more moderate rise in 2024. This projection considers wider gaps in the labor market, consistent with the expected performance of the economy. It also foresees greater uncertainty associated with external conditions and a local monetary policy that will remain contractionary for a longer period of time. Access to credit will imply higher restrictions to consumption than in previous quarters, in line with a financial burden and household delinquency that has increased rapidly in recent quarters, especially among lower-income households. This will occur in a context of tighter international financial conditions. Information from the March 2023 Bank Lending Survey reports a perception of lower demand for consumer credit and more stringent conditions in its supply.

Investment will continue to perform poorly this year and next. This estimate includes a more deteriorated external scenario, greater global uncertainty and still tight financial conditions. Information from surveys —prior to the recent international developments— showed low investment levels for the coming quarters.

The current account deficit will continue to narrow, reaching a figure of around 4% of GDP by the end of this year. The continuation of the rebalancing between savings and investment will be a determining factor in this result. Deficits of similar magnitude are expected for 2024 and 2025.

The Board considers that it will be necessary to keep the MPR at 11.25% until macroeconomic conditions indicate that the process of inflation convergence to the 3% target has been consolidated. As described in the central scenario of this Report, this process will take longer than expected in December. For inflationary convergence to consolidate, among other factors, the resolution of the imbalances that have affected the economy in recent years should be considered, including a significant slowdown in consumption, the activity gap gradually turning negative and core inflation showing a clear downward trend.

The borders of the MPR corridor reflect sensitivity scenarios where the speed of the inflationary convergence process gives way to earlier or later adjustments of the policy rate with respect to the assumption in the central scenario. Particularly relevant will be the occurrence and sign of new inflation surprises, the evolution of consumption and the unfolding of external conditions.

The upper bound of the corridor reflects scenarios where inflation stays high for a longer period, consumption maintains low pace of adjustment and the external economy performs more favorably than expected. In such case, the MPR would remain at its current level for longer than assumed in the central scenario.

The lower bound of the corridor represents a scenario where the international context deteriorates more than expected, causing increased global risk and affecting financial conditions, world activity and commodity prices more intensely. In such context, a faster adjustment of the domestic economy could lead to a somewhat earlier reduction in inflation and of the MPR.

The Chilean economy continues to be exposed to significant risks. On the one hand, the evolution of the external scenario requires constant monitoring. In a scenario of major disruption of global financial conditions, a significant deterioration of the global and local economy is to be expected, which would lead to a faster convergence of inflation and would be consistent with more abrupt reductions in the policy rate than those signaled by the lower bound of the MPR corridor.

On the other hand, the inflationary problem is still present. The inflation convergence process has yet to be consolidated. Inflation continues to be very high, with its core component showing no declines in recent months. The adjustment in private spending has been slower than expected. Some measures of inflation expectations remain above 3% in the two-year term. A scenario where private consumption resumes more significant growth rates would compromise the convergence of inflation to the target and would require a significant monetary policy reaction to ensure that it is achieved.

The Chilean economy is experiencing a complex moment. Inflation has remained high for a long period, overspending has not been fully corrected and the external scenario has become more uncertain. Reducing inflation is an unavoidable condition for the economy's performance to improve in a sustainable manner and to be able to cope as effectively as possible with the impact of external shocks. It is particularly important that all policies point in the same direction, which means avoiding any measures that push private spending beyond its possibilities. The Board considers that it will be necessary to keep the MPR at 11.25% until the macroeconomic conditions indicate that the process of inflation convergence to the 3% target has been consolidated. Additionally, the Board reaffirms its commitment to act with flexibility in case any of the internal or external risks materializes and macroeconomic conditions so require.