Beating Inflation: Q&A with Rosanna Costa, Central Bank Governor Of Chile

Rosanna Costa, governor of the Central Bank of Chile, speaks to Global Finance about the impact of inflation and what’s expected of Chile in the coming year.

Global Finance: What is the current outlook on Chile’s inflation, and what are the expectations on the future of interest rates?

Rosanna Costa: A key factor behind the decline in inflation has been the progress in resolving recent macroeconomic imbalances—namely, the huge expansion in private consumption which followed fiscal transfers and pension fund withdrawals in 2020-21. This is explained to a large extent by an early and strong response of monetary policy rates, as well as the fiscal adjustment that has taken place since 2022.

We estimate that most of the adjustment in demand has now taken place, although inflationary convergence will still require activity to grow below its potential for some time.

Inflation has fallen from the high records observed last year. As elsewhere, this has been more marked in total CPI than in its core component. However, with headline and core inflation at 5.3% and 7.4% we are still far from completing inflation convergence to our 3% target.

We expect to continue with the gradual reduction process of the Monetary Policy Rate (MPR), to the extent that the macroeconomic scenario evolves as anticipated. The projections in our latest Monetary Policy Report point to headline and core inflation of 4.3% and 6.3% in December, which is compatible with an MPR close to the interval 7.75%–8%.

The board also considers alternative scenarios that could affect future monetary policy decisions, as reflected in the MPR corridor published in the last Monetary Policy Report. In the lower border of the corridor the pace reduction of the MPR would be somewhat faster than in the baseline scenario, consistent with a faster inflationary convergence process than what it is expected in the central scenario. On the other hand, the higher border considers a slower pace of reduction of the MPR, consisting of inflation showing greater persistence than expected at current levels.

GF: What are your expectations for the next 12 months? 

Costa:  Our forecast for the activity for the current and next two years was virtually unchanged compared to our June report. We expect GDP growth rate for this year between –0.5% and 0%. For 2024, we expect a growth between 1.25% and 2.25% and between 2% and 3% in 2025. The fall in activity and demand, a process that begun in early 2022, was a central component in our projections, judged necessary to correct the macroeconomic imbalances that the Chilean economy accumulated and needed to resolve to ensure inflationary convergence. Although that process has not yet finished, we expect non-mining activity to return to positive quarterly variations towards year´s end, to then approach an expansion rate consistent gradually with its potential level.

We expect headline inflation gradually converge to 3% towards the second half of 2024. Core inflation is expected to decline at a slower pace than the headline. We expect core inflation to reach 6.3% in December and 3% in early 2025. In the short term, services will continue to show monthly rates above their historical averages which is consistent with indexation of regulated tariffs and wages. Inflation in goods will continue to fall, influenced by a demand that is no longer a pushing factor.

GF: What is the economic outlook for the region?

Costa: The inflationary scenario in Latin America has improved for most large economies, also resulting from early interest rate hikes and a reduction of fiscal deficits. Other factors such as the fall in commodity prices from their peaks, the appreciation of the nominal exchange rates in 2023, compared to the peaks reached in 2022, and the normalization of global value chains have naturally also played a role.

We expect activity in the region to show a weak performance in the coming quarters. This is the consequence of the still restrictive monetary policy, a contained fiscal impulse, the elevated level of uncertainty and the still pessimistic confidence of consumers. However, some factors have favoured activity in some countries and their effect will last for a few more quarters. In Brazil, the resilience shown by the economy mainly reflects the good performance of the agricultural sector due to favourable weather conditions. Mexico has benefited from the relocation of global value chains, which has presented an opportunity for the country to attract more investment.

The rapid initial monetary policy reaction and the recent progress in inflation have allowed the monetary easing cycle to begin in some economies, such as Chile and Brazil, while in others they are expected to begin in the coming months. The speed of rate cuts, however, will depending on how macroeconomic conditions evolve in each country. In any case, market expectations indicate that real rates will remain in restrictive territory for the rest of 2023 and throughout 2024. This is consistent with the fact that the fight against inflation is not yet over: inflation in general remains above targets and medium-term inflation expectations also remain above the targets in several economies.

GF: Can you speak on the status of the financial system in Chile and the latest developments?

Costa: Since our last Financial Stability Report [May 2023], both nominal and real short-term sovereign interest rates have declined, while long-term rates have shown an upward trend, exceeding their May levels, stock market has outperformed other emerging stock markets.

The Chilean peso, after reaching levels close to $800 per dollar since March, started to depreciate in July. This depreciation is responding to a set of factors, such as the evolution of copper price, increased risk aversion in global markets, the global strengthening of the US dollar and the expected path of monetary policy in the U.S and Chile.

Local institutional investors such as pension funds, mutual funds, and insurance companies have recomposed their portfolios after the pandemic by extending the duration of their investment in fixed-income instruments.

In the credit market, total loans continue showing contractions with respect to the previous year, and interest rates remain high in line with the level of the monetary policy rate needed to correct the macroeconomic imbalances of the previous years. Indebtedness and delinquency are returning to pre-pandemic and historic levels. Besides, banks have accumulated provisions to face this scenario. In this sense, stress tests show that the banking system is in an adequate solvency and liquidity position to face the materialization of stressed scenarios, and with lower levels of vulnerability. However, banks must manage their capital levels in the transition process to Basel III.

In May, the Board estimated the risk of a severe external shock has increased at margin. Although unlikely, its negative impact on the economy would be significant. In line with that, at the Financial Policy Meeting of the first half of 2023, the Board agreed to activate the Countercyclical Capital Buffer (CCyB) for banks, setting it at 0.5% of risk-weighted assets, due next May. The Board has activated the CCyB as a precautionary measure.