Since the last MP Report, the economy has remained on a path of strong expansion driven by private consumption. Thus, growth in 2021 will exceed our September forecast, closing the year with activity levels significantly higher than those prior to the crisis and its estimated potential. Inflation has continued to rise, hitting over 6.5% annually, mainly because of the extraordinary expansion of domestic demand and the depreciation of the peso caused by idiosyncratic factors. These factors have been compounded with global phenomena such as stronger world demand, pandemic-related disruptions in the international value chains of goods and commodity price increases. In addition, higher inflation has been prolonged enough to risk second-round effects through contract indexation and wage increases. The costs of inflation on the economy are already visible, and have become a major economic concern for households and businesses.

Keeping inflationary pressures in check will require the removal of the domestic demand stimulus measures deployed during the crisis. On the fiscal side, this implies that public spending will be adjusted to the budget approved for 2022, initiating a convergence path towards the structural balance target. On the monetary side, after having moved from its technical minimum to 4.0% in the second half of 2021, the Board estimates that the MPR should be further increased in the short term, to remain above its nominal neutral value—that which is consistent with the 3% inflation target—for the better part of the monetary policy horizon. This adjustment of fiscal and monetary policies will contribute to a gradual closing of the output gap, helping to prevent the recent inflationary dynamics from having a persistent impact on the price formation process.

The Board foresees important risks surrounding this scenario, given the deterioration of the local capital market and the persistent uncertainty. This has led to significant increases in long-term interest rates and a lower appetite for Chilean financial assets, which has not allowed the economy to adjust as it did in past episodes. In addition, there are risks of worsening external financial conditions as a response of the central banks of the main economies to the rise in inflation.

Since the last Report, economic activity has remained very dynamic, even exceeding expectations (figure 1). After surpassing the pre-crisis activity level in the second quarter, GDP accelerated its quarterly expansion in the third quarter to an annualized 21%. In turn, the October Imacec rose 15% in twelve months (17% annualized for the non-mining sector), although with slower-than-before monthly growth rates. In addition, private consumption has continued to be the most dynamic component of spending, growing 27.5% annually in the third quarter. On the supply side, this has been reflected in the continued expansion of the trade sector and the acceleration of services.

Annual CPI inflation increased further, to 6.7% in November (figure 2). Worth noting was the rise in volatile prices—most related with food and energy—whose annual variation rate has escalated rapidly to reach 10.5%. Although core CPI—which excludes volatile prices—posted a more contained annual rate of expansion (4.7%), it has risen steadily during 2021 and is at its six-year peak. Within the core CPI, the annual variation in goods prices exceeds that of services, although both have been on an upward path across the year.1/
 

Together with the increase in inflation, expectations have risen significantly (figures 3 and 4). Various indicators—i.e., surveys and financial asset prices—point to annual CPI inflation closing 2021 near 7%, while at the same time they have been increasing their one-year-ahead forecasts, approaching values in the order of 5%. Although private expectations foresee a downtrend in inflation towards 2023, they are still above 3% in the twenty-four-month term.

The main factors behind the faster price hikes have been local. Chile stands out as one whose currency has depreciated the most, where the most significant income-support measures have been implemented, where private consumption has increased more, and where the rise in inflation is among the sharpest (figure 5).

The dynamism of spending has placed Chile’s GDP growth among the highest in the world for 2021, causing the economy to operate well above its short-term capacity and exacerbating the cost pressures that have accumulated (figure 6). An unmistakable reflection of the excess domestic demand is the higher current-account deficit, despite a high copper price and the sharp depreciation of the peso. The high current-account deficit measured at trend prices, which will reach 6.7% of GDP this year, is worth noting. Thus, the strong increase in national income in 2021—thanks to the cyclical recovery and the increase in the copper price—has been more than offset by the behavior of private and public consumption, depressing national savings.

Durable goods consumption has already accumulated several quarters of expansion at very significant rates, exceeding by more than 60% its level of before the social crisis and the pandemic. Consumption of non-durable goods and services increased significantly in the third quarter, which continues to be sustained in the most recent data. The sum of the different extraordinary contributions to household liquidity—resources provided by the State and pension fund withdrawals—yields a resource accumulation of close to US$85 billion in 2020-2021, equivalent to 33% of last year’s GDP. Most of the resources that have not yet been consumed are still in people’s current and demand accounts, which suggests that higher spending will persist in the coming quarters.

Labor supply by individuals has put a damper on the recovery of employment, leading to higher nominal wage growth than the 2020’s. Vacancies have seen a significant increase over the year, which has been reflected in an increase in employment with respect to its drop that accumulated as of mid-2020. Such recovery, however, has been held back by still tight labor supply. According to the November Business Perception Report (IPN), this is evidenced across a wide range of sectors, particularly in lower-skilled occupations. According to INE data, there are about one million more inactive people than in January 2020 and the willingness to work more hours is at record lows. While the labor participation rate has narrowed the gap with respect to its pre-pandemic level, women and 55-year-olds or up of both genders still show significant lags, a phenomenon common to several other economies (gráfico 7)..

Investment continued to recover in the third quarter, with significant dynamism in all lines. The machinery and equipment component maintained high growth, especially for industrial use and cargo vehicles. In construction and other works, the reactivation of building projects and mining-related engineering works has been key. In fact, according to the third quarter CBC survey, the 2021 investment figure is one of the highest in the last five years.

The macroeconomic scenario has been marked by the sharp deterioration of local financial conditions in the last year. There are multiple factors behind this phenomenon, particularly the impact of the massive liquidation of pension savings and the persistence of political-legislative uncertainty. Worth noting is the rise in long-term interest rates, which is double that observed in a group of comparable economies (figure 8). With a high degree of volatility, 10-year peso bond yields (BTP-10) have risen around 300bp during 2021, a significant part of which is explained by higher risk perception. The increase in long rates has resulted in a loss of value of the most conservative pension funds, in continuous redemptions of type-3 mutual funds and in higher costs of mortgage loans and other long-term credit instruments. Short-term rates have also shown significant increases in recent months, linked to the change in the monetary policy stance. This factor, however, has been less significant for long-term rates.

High uncertainty and increased risk perception regarding the Chilean economy has reduced appetite for local assets and long-term assets. In this context, the preference for foreign currency assets has been rising, with a greater demand for deposits and current accounts in dollars and for financial instruments that invest abroad, a phenomenon that has occurred across the board. Thus, despite the high copper price and the bigger rate differential, the peso has seen a significant depreciation (almost 18%) during 2021, and the level of the real exchange rate is well above its average of the last two decades (figure 9).

The increased cost of bank funding, together with the higher degree of uncertainty regarding the future evolution of the economy, have contracted the supply of credit in a context in which demand also remains subdued. The Bank Lending Survey (BLS) and the IPN report that uncertainty regarding the economic environment and the rise in banks’ funding costs are the main reasons behind the greater restrictions on financing in all the loan portfolios. For the housing segment, in particular, they reveal the increase in the required down payment and the shortening of terms, among other factors. Both sources agree that demand for credit is contained, due to both high liquidity and sustained uncertainty. The central scenario projections described in the following section reflect the negative impact of these factors on the outlook for investment.

On the external front, although the world economy is steadily recovering from the impacts of the pandemic, the data for the last few months have been weaker than expected, with third-quarter activity in the main economies falling of projections. Beyond the swings in pandemic control, demand remains dynamic while supply has been having increasing problems. Worth mentioning are disruptions in supply chains stemming from restrictions that remain in place—some have escalated in several economies most recently—, shortages and higher prices of various commodities, and still-tight labor markets in the face of the slow recovery of labor supply.

Inflation has continued to rise around the world, in both developed and emerging economies, changing the perception of the transitory nature of the inflationary phenomenon (figure 10). The sustained high level of global demand for goods, against a supply whose capacity to respond remains constrained, has continued to push up the prices of various commodities, goods and key services, such as freight—although the increases in the latter have been moderating most recently. In several developed countries, there have been significant surprises in recent months’ data, and in some of them annual inflation is at its highest of more than a decade. This trend has also been seen in emerging countries, especially in Latin America. In any case, the increase in inflation has been very heterogeneous across countries, and higher in those economies where stimulus policies have been stronger.

In this context, a growing number of monetary authorities have announced, initiated, or continued to remove their monetary stimulus measures. The Federal Reserve slowed the pace of its asset purchases, and recent statements by its policymakers have signaled the possibility of an accelerated stimulus withdrawal. Among commodity exporters, Norway and New Zealand began raising rates in recent months. In Latin America, where significant exchange rate depreciations have been noted, Colombia has already started an upward cycle and both Brazil and Chile have accelerated it in recent months. The European Central Bank is one of the few banks that still view the current inflation as transitory and maintain their commitment with expansionary policies.

Central scenario projections

The central projection scenario assumes that headline CPI inflation will remain around 7% for a few months, to then begin to decline to 3% over the two-year policy horizon (figure 11). In the short term, the projection is revised upward with respect to September in response to the sustained dynamism of activity and spending, the additional depreciation of the peso, the already observed increase in energy prices, the upward inflation surprises of the last few months, and the effects of indexation. Core inflation is expected to exceed 6% by the first half of 2022, driven by widespread indexation and the pass-through of the exchange rate depreciation.

In the medium term, a key assumption for the convergence of inflation to the target is the resolution of the imbalances in the Chilean economy. The evidence suggests that in the third quarter of 2021 the economy operated well above its potential (chapter V). In the central scenario, the gap will close gradually from the first quarter of 2022, returning to near zero between the end of 2022 and early 2023 (figure 12). This movement assumes the end of the massive government transfer programs motivated by the health emergency, and of the extraordinary withdrawals from pension funds. This scenario also implies a more contractionary monetary policy and the return of two-year inflation expectations to the 3% target. Even so, the central scenario maintains uncertainty above its historical levels, which affects particularly investment and job creation.

In this scenario, the economy is expected to grow between 11.5 and 12.0% in 2021. This range is above the September forecast (between 10.5% and 11.5%), reflecting the aforementioned greater dynamism of activity and spending, with significant revisions in private consumption and investment in machinery and equipment.

Between 2022 and 2023, the economy’s annual expansion rates will see a significant slowdown, consistent with the expected change in macroeconomic momentum and the closing of the activity gap. Thus, the economy is projected to grow between 1.5% and 2.5% in 2022, and between 0.0% and 1.0% in 2023. On this trajectory, negative seasonally adjusted quarterly expansion rates are possible, although the economy’s activity level by the end of the forecast horizon will be quite similar to the projections in the June and September MP Reports (figure 13).

Gross fixed capital formation will also underperform in the next two years, a behavior in which tighter financial conditions derived from the structural changes that have taken place in the local capital market, as well as the persistently high uncertainty, play a fundamental role. The central scenario assumes that investment will fall by 2.2% in 2022, before picking up marginally in 2023. In these projections, public investment and the drag of large-scale projects will not be enough to offset the impact of local uncertainty and high long-term interest rates on other components of private investment. In addition, there is the effect of the peso depreciation and the poor performance of the stock market, as well as the limited prospects of local economic expansion for the next couple of years. In fact, various sources of information—CBC, OGPS, and the IPN—point to lower investments in the next two years.

The central scenario assumes that fiscal policy will be executed in accordance with the approved budget for 2022 and the convergence path outlined therein. This implies a significant drop in spending as the massive transfer programs motivated by the sanitary emergency come to an end. Thus, there will be a significant reduction in the effective and structural fiscal deficit for next year. In the medium term, the scenario assumes that the path laid out in the latest Public Finances Report will be followed, which is consistent with a gradual convergence towards sustainable public debt levels, consistent with the recommendations of the Autonomous Fiscal Council. Deviations from this path will be particularly important for monetary policy, not only because of their impact on private spending, but also because of their implications for financial market variables, particularly the evolution of long-term interest rates and the exchange rate.

On the external scene, the central scenario foresees a reduced momentum for the next two years (table1). The average growth of Chile’s trading partners is revised down to 3.6% (4% in September) for the period 2022-2023. While developed economies continue to present a favorable outlook, in the U.S., fiscal and monetary policy is expected to be less expansionary than expected, thus lowering growth prospects. In emerging economies, high inflation and a less expansionary monetary policies anticipate a lower growth scenario. In China, uncertainty about the continuation of bottlenecks, energy shortages and the slowdown in the real estate sector point to a weaker outlook. The terms of trade would remain high, albeit lower than estimated in September, as copper prices are projected to remain virtually unchanged, while oil prices are somewhat higher: on average, US$3.83 per pound and US$68 per barrel for 2022-2023.

Sensitivity scenarios

The central scenario is based on a set of assumptions regarding the economic environment, agents’ behavior and the policy stance. Sensitivity exercises can be performed on these assumptions, which, while keeping GDP growth around the expected ranges, call for a somewhat different monetary policy action. These scenarios make up the MPR corridor.

Also, a scenario in which idiosyncratic uncertainty subsides would take pressure off short-term inflation, which has been strongly driven by the evolution of the exchange rate, while at the same time boosting the dynamism of activity in the medium term. In this context, it is expected that a less contractionary monetary policy than assumed in the central scenario would be required.

Risk scenarios

In addition to the sensitivity exercises, we analyze risk scenarios in which changes in the economy would be more significant and where the monetary policy reaction would exceed the limits of the MPR corridor.

Locally, the main risk remains that the evolution of public finances is unclear as to their long-term stabilization. In such a situation, higher spending pressures than foreseen in the central scenario would be observed, together with a sharper deterioration of the local financial market and in the value of the peso. In that case, higher inflationary pressures would necessitate an increase in the MPR above the upper limit of the corridor, despite which inflation may not be able to converge to the policy target within the two-year horizon.

Abroad, the main risk has to do with the possibility of a hasty removal of the monetary stimulus in the U.S., amid the apparent weakness of the Chinese economy. A scenario where the inflationary outlook in the U.S. becomes more complicated could lead the Federal Reserve to withdraw the stimulus more aggressively and to a significant deterioration in financial conditions facing emerging economies. Its negative effects could be amplified by recent weakness in the Chinese economy and financial problems in some of its bigger companies. Such a scenario would aggravate the negative effects on external demand and commodity prices, leading to a drop in local activity that would quickly turn the activity gap negative. In such a scenario, the MPR could cross the lower limit of the corridor.

Monetary policy stance

At its October and December meetings, the Board made a faster adjustment to the MPR than had been foreseen in the central scenario of the September Report, in response to the increasing risks facing the convergence of inflation to the target. On the one hand, domestic demand has been very dynamic, which has led the activity gap, after closing rapidly towards the middle of the year, to much more positive levels than expected in the second half of this and early next year. On the other hand, headline inflation data surprised on the upside in several months, with market expectations rising in both the short and medium term. Actually, in the two-year term, expectations measures based on surveys and in financial asset prices are above 3%. Added to this is the decline in the domestic capital market and the persistent uncertainty throughout this year, which has prompted a significant depreciation of the peso.

The projections in this Report assume that the economy requires an adjustment the spending of 2022 and 2023 to undo the imbalances that have incubated in recent quarters. Monetary policy will cooperate in this, taking the MPR above the level indicated in the September Report. In the central scenario, the Board estimates that the MPR will continue to be increased in the short term, to be above its nominal neutral level—that which is consistent with the 3% inflation target—during most of the monetary policy horizon. With his the output gap will gradually close, helping to prevent the recent inflationary dynamics from having a persistent impact on the price formation process. The convergence of inflation to the target is important not only for the fulfillment of the Central Bank’s mandate, but also to alleviate the economic situation of households, which have already endured the impact of the Covid-19 crisis.

During the last few months, several expectations indicators show that market agents expect inflation to be above 3% by the end of the two-year monetary policy horizon, in contradiction with the Central Bank’s inflation target. So far, there is no evidence that this is influencing inflation dynamics, which, together with the significant expected slowdown in the economy and a monetary policy that responds to the changing scenario, suffices to guarantee the convergence of inflation within the next two years.

However, in a scenario where inflation expectations remain high and hamper the convergence of inflation over the policy horizon, further MPR increases will be necessary in the short term. As always, the implementation of monetary policy will be contingent on the effects of incoming information on the projected inflation dynamics.

1/ In any case, several administered prices and utilities have seen no increases according to their usual inflation-correction rules for several quarters now. In fact, when these items are excluded from the inflation of services, their annual rate of change becomes significantly higher.