Inflation in Chile has continued to escalate, hitting its highest level in decades. The main factor behind this trend is still the major increase in demand during 2021. In recent months, however, the impact of strong global cost pressures has deepened due to higher commodity, energy, and food prices. This occurs in a scenario where difficulties in global distribution chains have continued, the peso remains depreciated, and the activity gap is still positive. The short-term inflation outlook has risen considerably, responding to this combination of factors. In line with expectations, economic activity began to adjust in the first quarter, despite a demand composition where private consumption remains intense while investment is dwindling. In the medium term, the adjustment of macroeconomic imbalances remains the central element for inflation to converge to 3% within two years. The high level of inflation and the greater persistence of its fundamentals have called for a more contractionary monetary policy to achieve such convergence, which has led the Board to raise the MPR to 9%. The Board estimates that to ensure the convergence of inflation to 3% within the two-year horizon, additional adjustments to the MPR will be needed, although smaller in magnitude. Risks remain high, nonetheless, particularly given the high level and stubborn persistence of inflation.

Inflation is still on the rise and is significantly above the forecast in the March Monetary Policy Report. The excessive increase in domestic demand in 2021 continues to play an important role in the rise in inflation over the past year. However, its more recent behavior has been more heavily influenced by external cost pressures stemming from higher food and commodity prices, and persistent difficulties in production and supply chains globally. All this is taking place in a context of narrowing margins, an exchange rate depreciation with respect to march, and a still high activity gap (figure 1).

Figure 1. Indicadores de inflación

Unlike previous quarters, most of the inflationary surprise of the last few months has to do with the prices of foods and volatile items. Cumulative inflation between March and April (3.3 percentage points) was significantly higher than foreseen in the March Report. The surprise decomposition shows that over 90% of the difference came from higher-than-expected hikes in the prices of foods, energy, and other volatile components (figure 2). Thus, between December and April, the prices of foods —volatile and not— included in the CPI basket accumulated an increase of 10% that coupled with a 7.7% increase in energy and compares with the 3.8% increase in core inflation minus non-volatile foodstuffs.

Figure 2

Early 2022 data show that the economy is already in an adjustment phase, with a slight decline from the high levels of last year. In the first quarter, the seasonally adjusted GDP series declined 0.8% with respect to the quarter before, with a drop of 0.2% in non-mining GDP. In April, the seasonally adjusted Imacec series showed a 0.3% drop with respect to March; however, this variation was positive (0.2%) for the non-mining Imacec.

Demand has performed with markedly different behavior between private consumption and investment, where the former remains high. First quarter data show that private consumption is still above expectations in March, around the highs it reached during 2021. Durable’s goods consumption reversed part of the drop of late last year and services consumption has continued to show high performance. Gross fixed capital formation (GFCF), on the other hand, has contracted across the board, as anticipated in March. In the first quarter, its seasonally adjusted series fell by almost 6% with respect to the previous quarter. The most noticeable decline was seen in the construction and other works component (figure 3).

Figure 3

On the external front, world inflation has risen substantially in recent months, with core inflation accelerating in several economies (figure 4). The unfolding of Russia’s invasion of Ukraine, together with the impacts of the confinements in China, have led not only to price increases in food and commodities, but also to a rise in their outlook (figure 5). Most central banks have raised their benchmark rates and/or signaled a path of faster withdrawal of monetary stimulus, including the Federal Reserve and the European Central Bank (figure 6). 

Figure 4

Compared to the close of the March Report, global markets have intensified their risk aversion, with a rise in long-term interest rates, a fall in stock markets and an appreciation of the dollar. In any case, these trends have undergone important changes during the period, with some reversal of these changes occurring lately. The Chilean market has performed more favorably than its external peers. Compared to the close of the previous Report, long-term rates show no variations, the peso depreciation is around the average of emerging economies and stock prices have risen, although specific factors have played a role in the latter.

Projections

The persistently high external costs and a more dynamic consumption than anticipated, lead to a significant revision of the inflation trajectory with respect to the March Report. Part of it had already been factored into the May monetary policy decision. In the central scenario, it is estimated that the annual CPI variation will continue to rise to values slightly below 13% during the third quarter. From there onwards, it will start to decline, ending 2022 at around 10%, which is significantly higher than forecast in March. The revision of the core inflation projection for December is also significant: 2,5 percentage points more than projected in March. In this case, the main changes are due to higher food prices included in the index, the effect of the exchange rate hike and logistical bottlenecks in the prices of goods. The higher private consumption that is being observed and the second-round effects of the increase in expected inflation also play a part.

Towards 2023 and 2024, the central scenario continues to foresee that total inflation and its core component will see a sustained decline, both of which will be around 3% by mid-2024, i.e., the end of the two-year monetary policy horizon. In this projection, total inflation will close 2023 at around 3%, while core inflation will be closer to 4% annually. The decline in core inflation will be slower than that of headline inflation and will start later than was expected in March, reflecting the greater persistence of external cost shocks and importance of second-round effects (figure 7).

Figure 7

A key element for the convergence of inflation to the 3% target within two years is that the significant imbalances that accumulated in the economy in 2021 continue to be resolved. In the central scenario, in 2022 and 2023 the economy will grow below its potential, so the gap will continue to narrow and will be negative for some quarters. In addition, international fuel and food prices will slowly decline from their current levels and the real exchange rate (RER) will fall, but still remaining above its averages of the last 15 to 20 years. In this projection, no changes are assumed in the structural parameters of the Chilean economy.

The liquidity remaining from the stimulus measures implemented in 2021 will continue to support consumption in the immediate term. However, most of its fundamentals suggest that it will weaken during the second part of the year. In the labor market, jobs continue to be created, albeit at a slower pace than in previous months and with lower real wages, in a context in which the unemployment rate remains below 8%. The financial conditions for households have tightened, due to both higher interest rates and more

stringent credit requirements. In this context, coinciding with the effect of inflation on household purchasing power, consumer expectations have deteriorated sharply in recent months, with worsening perceptions of employment, inflation, and the purchase of goods.

The stronger dynamism of consumption during in the first part of this year leads to an upward revision of its growth forecast for 2022, delaying its adjustment to the second half of this year and 2023. The opposite is true for GFCF, for which more significant declines are expected this year and next. Investment fundamentals have also worsened. Regarding financial conditions, the deterioration that has already occurred in the capital market and the lower levels of long-term savings to finance investment play an important role. Added to this are the revisions of the Capital Goods Corporation’s investment survey, the persistence of high uncertainty and a general decline in business expectations.

The adjustment of the 2021 overspending will allow for a reduction in the current account deficit and an increase in national savings over the projection horizon. In the central scenario, the current account deficit estimated for this year is raised to figures in the vicinity of 6.5% of GDP, due to both the higher consumption forecast and the evolution of external prices. In 2023 and 2024, the deficit will be reduced between 4 y 4.5%, consistently with the adjustment in domestic spending. Domestic savings will grow from rates in the order of 18.5% to 20% of GDP between 2022 and 2024.

In the external scenario, the boost to the Chilean economy has been reduced, particularly due to the worsening of global financial conditions in view of the withdrawal of monetary stimuli. The central scenario projections consider that international food and commodity prices will remain high for several quarters. This is consistent with both lower terms of trade for Chile and tighter financial conditions, given the monetary policy response expected in the main economies. Additionally, the projections consider a slowdown in the growth of our main trading partners.

In the central scenario, the narrowing of the gap that began early this year will be prolonged for several quarters. Thus, GDP will post annual variation between 1.5% and 2.25% this year, between -1.0% and
-0% 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 the one reported in the latest Public Finance Report.

The Board estimates that, after the hike determined at the June monetary policy meeting, to ensure the convergence of inflation to 3% within the two-year horizon, additional adjustments to the MPR will be needed, although smaller in magnitude. In any case, risks are still important, particularly because of the level where inflation stands today and its long-lasting persistence.

Risks surrounding the evolution of the macroeconomic scenario remain significant. The upper part of the MPR corridor reflects sensitivity scenarios where inflation persistence could be higher than expected. This could occur if private consumption continues to show no significant adjustment in the coming quarters. Although its fundamentals indicate that it should begin to weaken soon, it cannot be ruled out that it could continue to be more dynamic than expected, particularly due to the financing capacity provided by the remaining liquidity and the decrease in the level of household debt during 2021. Such a scenario could also occur if global cost pressures increase. This would exacerbate the inflationary problem, leading to a stronger monetary policy reaction from various central banks in the short term, but increasing the likelihood of a global recession in the medium term.

The lower part of the MPR corridor describes a scenario where inflationary pressures dissipate sooner than expected. It is possible for the contraction of activity and demand to be more intense, due to either investment being weaker or the speed of adjustment of private consumption occurring at a faster speed. 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.
There are also scenarios where the economy would face more significant changes, which would place growth outside the range of the central scenario projections. One such scenario could occur if the Russian invasion of Ukraine develops into a much more damaging scenario for the world economy. It could also occur if global financial conditions worsen even more sharply, for example in a scenario where the evolution of inflation leads to a much stronger than expected tightening of monetary policy in the leading economies.
Inflation has risen to levels not seen for decades, and its negative effects on families are reflected in public concern over this phenomenon. In addition, the two-year inflation expectations of economists and financial traders persist above 3%, and the expectations of companies at longer horizons have also increased. It is important to note that high inflation rates for prolonged periods become more persistent and the evidence indicates that the cost of adjusting it rises, with the consequent impact on the welfare of the population. The Board will carefully monitor the evolution of the macroeconomic scenario, ensuring that inflation convergence to the target is guaranteed over the two-year monetary policy horizon.

Table 1