High inflation is having a major impact on the incomes and expectations of different economic agents. The projections of this Report revise projected inflation upwards for the end of this year and all of 2023, estimating that by the beginning of 2024 it will be back to values closer to the target. The reduction of inflation from its current highs to 3% assumes that the economy will continue to adjust the imbalances accumulated last year, which considers a decrease in activity and demand for several quarters. The Central Bank’s goal is to achieve inflation convergence by an adjustment in economic activity that is brief, orderly and at the minimum cost possible. To this end, it is essential to prevent the inflationary process from becoming more persistent. After the decision of the September Meeting, the MPR is around the maximum level considered in the central scenario of this Report. Future movements of the policy rate will depend on the evolution of the macroeconomic scenario and its implications for the convergence of inflation to the target. The Board will be especially vigilant of the upward risks for inflation, not only because of the high level it has reached but because inflation expectations two years ahead remain above 3%.

Inflation continued to rise, reaching 13.1% annually in July. In recent months, increases in food prices —volatile and non-volatile— continued to stand out, accounting for almost one third of annual inflation as of July. Core inflation (i.e., the CPI minus volatiles) rose to 10% annually, owing largely to the higher contribution of services and non-volatile food prices (figure 1). The rise in total inflation again exceeded expectations. As in June, the surprise was concentrated in volatile prices and non-volatile food.

Regarding activity, data for the second quarter and early third quarter indicate that the economy advanced in its adjustment process after the major imbalances accumulated in 2021. Excluding mining, in the second quarter activity relapsed by 0.5% q/q —seasonally-adjusted series—, a drop that continued into July. By sectors, worth noting was the drop in trade, which was partly offset with increases in some services (figure 3).

The path of consumption adjustment is occurring in a context where real wages continue to contract, job creation has slowed, and the liquidity remaining from the 2021 stimulus measures has been drying up. Between April and July, aggregate employment showed little variation (figure 5). The demand for workers has lost strength compared to the beginning of the year, while supply remains below pre-pandemic levels (Box I.3). In the August BPR, companies reported that, although they perceive an increase in their labor costs, wage adjustments are generally smaller than the increase in the CPI and are now less frequent.

Gross fixed capital formation (GFCF) has declined further in a scenario of high uncertainty and a steadily deteriorating business confidence. Seasonally adjusted, GFCF fell 1% q/q in the second quarter (-7% q/q in the first quarter), a slightly better than expected performance, influenced by some large-scale investment projects. By components, the sharp drop in machinery and equipment stood out. Business confidence continued on the downward trend it has followed throughout this year, especially in the construction sector. This coincides with degrees of economic uncertainty that remain high in a historical comparison, more restrictive credit access conditions and high long-term interest rates (figure 6).

Despite reduced consumption and weak investment, the current account deficit —accumulated over twelve months— widened in the second quarter, still reflecting the magnitude of the 2021 imbalances, which were then compounded with deteriorated terms of trade and high transportation costs. In the moving year ending in the second quarter of 2022, the current account accumulated a deficit of 8.5% of GDP, a figure in which government savings-expenditure imbalance played a preponderant role, resulting from the income support measures adopted during 2021. Households also showed a significant imbalance, due to the liquidation of savings implied by the withdrawal of pension funds to finance increased private consumption (figure 7). Although the impact of these phenomena has been receding, this will only begin to show up in the current account in the second half of this year.

Abroad, the sharp rise in inflation and the reaction of central banks has led to tighter financial conditions, reducing the outlook for global growth, and increasing the risk of a global recession in 2023. Several economies have reported inflation rates that were unseen in several decades. In view of the greater persistence of and high expectations for inflation, most central banks have continued and/or accelerated their interest rate hikes, where worth singling out are the unexpected magnitude of the hikes and the more restrictive message from the Fed. The worsening of financial conditions has begun to impact on the activity and expectations of different agents, in addition to the uncertainty surrounding the unfolding of the war between Russia and Ukraine, the gas supply problems in Europe and the weakness of the Chinese economy and its real estate sector.

Commodity prices have fallen across the board, mainly influenced by lower expected demand and an appreciated US dollar. Compared to the levels prevailing at the close of the June Report, the price of oil and copper have fallen between 15 and 20%. Food prices have also fallen, driven by supply factors. Global supply chains have seen some normalization, with declining shipment costs (figure 8). Although bottlenecks have been resolved, the risk of new quarantines persists given China’s zero-Covid policy. In this scenario, significant external cost pressures remain.

Global financial markets have reacted by being highly volatile in recent months. Doubts concerning the trajectory of the Fed’s monetary policy and its potential effects have been one of the main sources of financial fluctuations. Thus, market sensitivity to data or statements by authorities has increased, with episodes of high volatility and fluctuating risk aversion. Compared to the close of the last Report, interest rate hikes, stock market declines and a global strengthening of the dollar to levels not seen in twenty years have been observed. These movements are consistent with the Fed’s hardened messages regarding the monetary policy efforts needed to reduce high inflation.

In the local financial market, the exchange rate, interest rates and the risk premium have shown a volatility that goes beyond what is observed in other economies. The peso/dollar exchange rate fluctuated at unusually high levels in mid-July, with a marked divergence from its external determinants, causing distortions in the functioning of the markets and prompting the Central Bank to announce an intervention program (Box I.2). Upon said announcement, tensions in the price formation process in the forex market eased, observing a decrease in volatility and in the exchange rate. In any case, compared to the statistical cut-off date of the previous Report, the peso depreciated in nominal and real terms.

Projections

The central scenario does not consider a specific effect on the economy due to the result of the plebiscite. This assumes that uncertainty will gradually reduce in the coming quarters, in the midst of a process in which institutional changes continue, allowing institutions and the economy to function properly.

The central scenario estimates that headline inflation is nearing its peak for this cycle, which it is still expected to reach during the third quarter of this year. Going forward, prices should begin to slow down their increases compared to earlier months, thus gradually reducing inflation.

Inflation forecast at the end of 2022 and 2023 is revised up from the last MP Report, due to the additional depreciation of the peso and the increased persistence of inflation. This year will close at 12%, close to 2 percentage points (pp) above the June forecast. Cumulative surprises in volatile prices and the recent depreciation of the peso explain much of this correction. By 2023, on average, projected inflation is about 1pp higher than in June, reflecting an RER between 3 and 4% above what was projected in June. Furthermore, it is assumed that it will remain more depreciated throughout the projection horizon, ending the period its average of the last fifteen to twenty years. At the same time, our projection considers greater second-round and indexation effects, reflecting inflationary persistence. Current levels and the anticipated evolution of the exchange rate are important factors behind the correction of inflation projections over the policy horizon, which more than compensates for the fall in the international prices of fuel, foods, and other commodities.

The central scenario considers that inflation will converge to the 3% target within the two-year monetary policy horizon. In the projection, annual CPI inflation will end 2023 around 3.5%, reaching 3% by the third quarter of 2024. Core inflation will take longer to converge to 3% because of the strong persistence already mentioned and a higher RER (figure 9). This greater inflationary persistence requires a more contractionary monetary policy —in nominal and real terms— than anticipated in the last Report, as summarized in the new MPR corridor in this Report (figure II.1).

To a large extent, the convergence of inflation to the 3% target within two years is based on the assumption that the economy will continue to adjust the significant imbalances it accumulated in 2021. In the central scenario, the economy will grow below its potential for several more quarters, so that the gap will continue to narrow and become negative starting at the end of this year. In this scenario, GDP will see an annual variation between 1.75 and 2.25% this year, between -1.5 and -0.5% in 2023 and between 2.25 and 3.25% in 2024. For this three-year period, the projection contemplates a fiscal spending path consistent with that described in the last Public Finances Report.

Activity outlook foresees that private consumption will continue to adjust, a result that stems largely from the end of the massive income support measures adopted in 2021, as well as from the tightening of monetary policy. For investment, weak performance is anticipated through the remainder of 2022 and all of 2023, reflecting less favorable financial conditions, increased business pessimism, a higher RER and slowly declining uncertainty.

The current account deficit will decline in the coming quarters, in line with the continued adjustment of spending on tradables and a savings-investment balance that is much more favorable than in 2021. Not repeating the income stimulus measures will cause both public and household savings to improve drastically with respect to last year’s figures, so the current account deficit will fall significantly from the second half of this year onwards. Higher interest rates, the high exchange rate and lower international transportation costs will also contribute to this. By the end of 2022, it will be reduced by more than 2pp of GDP —accumulating 6.3% in the year— and by 2023 it will be between 3% and 4% of GDP. Measured at trend prices, the deficit reduction will also be rapid and significant: from around 9% in 2021 to around 3% in 2023.

The impulse that the Chilean economy will receive from abroad will decrease mainly because of worsened financial conditions and terms of trade, combined with lower world demand. The central scenario anticipates that the Fed’s monetary policy will move to somewhat more contractionary and longer-lasting levels than it communicated in the June Fed dots, which will result in tighter financial conditions internationally for a protracted period of time (Box I.1). This is the main factor behind the lower growth forecast for our trading partners, which will be 2.6% this and next year. The copper price will also be lower than previously projected, averaging around US$3.5 per pound next year (US$3.7 in June).

This projection contemplates no changes in the structural parameters. The Chilean economy has been subject to important shocks in the last couple of years and the degrees of uncertainty about their medium-term scope are significant. This has made it complex to evaluate its implications for estimating the structural parameters. In any case, even considering the level of uncertainty, the structural parameters will be evaluated in the December Monetary Policy Report.

After the decision of the September Meeting, the MPR is around the maximum level considered in the central scenario of this Report. Future movements of the policy rate will depend on the evolution of the macroeconomic scenario and its implications for the convergence of inflation to the target. The Board will be especially vigilant of the upward risks for inflation, not only because of the high level it has reached but because inflation expectations two years ahead remain above 3%.

The upper part of the MPR corridor reflects sensitivity scenarios where the global inflationary problem calls for a more aggressive response of monetary policies around the world, particularly the Federal Reserve. In such an event, there would be a sharp deterioration in global financial conditions and growth, with sharp declines in commodity prices and a further appreciation of the dollar. In a scenario where domestic inflation and expectations remain high, further peso depreciation would require a tighter monetary policy response than that in the central scenario. The same would occur if, irrespective of the cost pressures of the external scenario, local inflationary dynamics were more persistent as a result of the high medium-term inflationary expectations of households and businesses.

The lower part of the MPR corridor depicts scenarios where inflationary pressures subside faster. This could be the case if the contraction of activity and demand is more intense, because of a faster adjustment of private consumption and/or weaker investment, which would also negatively affect the performance of the labor market. Nor can it be ruled out that the external scenario will see a reduction in global cost pressures and inflation easing in most economies, including Chile. In this case, the Fed’s monetary policy response would be less restrictive than in the central scenario, which would give way to better financial conditions, a less appreciated dollar globally and milder external inflationary pressures.

The projections of the central scenario consider that the pace of price increases will decrease in the coming months and annual inflation will begin to decline. However, the risk of observing a more persistent inflationary phenomenon is a concern for the Board. If materialized, they could lead to greater monetary restrictiveness, outside the upper limit of the MPR corridor. This risk is especially relevant in a context where inflation has surprised on the rise for several quarters and inflation expectations remain above 3% two years ahead. Quickly recovering macroeconomic balances will help reduce this risk, while allowing the Chilean economy to adequately face a further deterioration in the external scenario.

Individuals and businesses are paying a high cost because of inflation, which affects especially those with lower access to resources. Prolonging the current inflationary situation would be extremely costly, since as households and businesses begin to get used to and anticipate faster price increases on a permanent basis, the costs of reducing inflation —reflected in the reduced ability to create jobs, increase wages, and improve general welfare— increase substantially. Bringing inflation back to the target, and thus avoiding adverse effects on the population, especially the most vulnerable, necessarily involves reestablishing macroeconomic balances and, in this case, what is required is a reduction in the level of activity and demand. Monetary policy will continue to contribute to this necessary adjustment occurs in an efficient and orderly manner.

Table 1. Main projections