Monetary Policy of the Central Bank of Chile: Objectives and Transmission

CONTENTS

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I. Price Stability and Monetary Policy 3 The Purpose of Price Stability and the Main Principles of Monetary Policy 4 - The Inflation Target Range 4 - The Operative Aspects of this Policy 5 - Transmission Channels and Monetary Policy Horizon 5 Monetary Policy, the Floating Exchange Rate, and Inflation Targets 6 Monetary Policy and Transparency 7 - Transparency Initiatives 7

II. Transmission Mechanisms for Monetary Policy in Chile 8 The Effects of Monetary Policy on Financial Markets 9 - Short-Term Interest Rates 9 - Long-Term Interest Rates 10 - The Exchange Rate 10 - Asset Prices 11 - Liquidity, the Amount of Money, and Bank Credit 11 - Expectations 11 Individuals’ and Companies’ Response to Financial and Exchange Market Variations: First Round Effects 14 - Individuals 14 - Companies 15 Second Round Effects: How Changes in Spending Decisions Affect GDP and Inflation 18 - Lag-times Affecting Monetary Policy Operations 18 - Non-Linear and Asymmetrical Effects 19 - GDP and Inflation 20 - Inflation Expectations and Real Wages 21 - Imported Inflation 21

III. By Way of a Brief Conclusion 23 2 MONETARY POLICY OF THE CENTRAL BANK OF CHILE: OBJECTIVES AND TRANSMISSION

This paper provides information on the Monetary Policy Report respond to a the objectives of the Central Bank of decision by the Central Bank to treat its Chile’s inflation policy and how the procedures and policies with maximum monetary authority understands the effects transparency. Similarly, this paper aims to of its policies on inflation and price complement the Monetary Policy Report stability. and make its reading easier.

Along with making the goals of reaching price stability more explicit, the first part of the paper also provides details I. Price Stability and Monetary on the current policy of inflation targeting. Policy It is worth pointing out that other objectives beyond price stability, which The Basic Constitutional Act of the could be assigned to monetary policy or Central Bank of Chile establishes that the other policies available to the Central purpose of this institution is: “to watch Bank, are not specifically dealt with. over the stability of the currency and the normal functioning of internal and external The second part of this paper payments”. To fulfill this purpose, the law describes the channels of transmission gives the Central Bank the authority to used to apply monetary policy throughout regulate the amount of money and credit the economy, before materializing in in circulation, to carry out international concrete results relevant to inflation. exchange and credit operations, and to regulate monetary, credit, financial and This paper, along with other exchange matters. These attributes allow initiatives like the new Regulation for the the Bank to configure its main tool: Functioning of the Board of Governors and monetary policy. 3 The Purpose of Price Stability and the in overall expenditure or domestic Main Principles of Monetary Policy demand, conducive to unnecessary risks in financial markets and difficult Money plays a fundamental role in conditions in terms of recession and the correct functioning of any economy, unemployment. In this sense, the focus of particularly the Chilean economy. To the Central Bank of Chile’s monetary preserve this role, the Central Bank’s policy is price stability over time, taking monetary policy must defend the value of into consideration this policy’s effects on our currency, the peso, seeking to maintain economic activity and employment in the a low and stable inflation. short- and medium-term.

The purpose of keeping inflation low and stable, which is how the concept of price stability is interpreted in practice, - The Inflation Target Range is no mere whim of the law, but rather serves the broader goal of maintaining the To preserve price stability, the country’s economy on the road to Central Bank has committed itself to a sustained growth, with full employment, monetary policy stance that seeks to and, in general, with progress and well maintain annual inflation within a range being for Chileans. In fact, the Central of 2% to 4% per annum over time. The Bank’s greatest contribution to growth and central value of this range, 3%, constitutes progress is rooted in the confidence in the the operational target that guides future associated with price stability. This monetary policy in the medium term. Both stability provides an incentive to saving, this central value and this range adequately investment and productivity gains, all of represent the concept of price stability in which are indispensable to economic the current conditions facing the Chilean growth. Furthermore, low, stable inflation economy, in spite of the fact that they are is beneficial from the distributive point of somewhat higher than the mean inflation view, because it favors the growth of rates observed in developed countries’ employment and protects the income of the economies (between 1% to 3%). In the first most vulnerable sectors of society. place, this 2-4% range takes into account a degree of inflationary inertia derived Monetary policy can not influence from the extensive use of indexing (with long-term growth beyond this contribution respect to past inflation) in diverse of price stability. The potential markets, practices that in turn form part of consequences of this policy on economic the legacy of high inflation that affected activity and employment over the short- Chile from the thirties onward. In the and medium- term arise from the different second place, international experience channels through which changes in reveals that countries that grow faster than monetary policy are transmitted in order, average (like Chile) are also those with finally, to affect inflation. This is why greater productivity growth in the tradable monetary policy takes an anti-cyclical sector (linked to foreign trade), which is stance that, along with preserving price associated with a slight tendency to 4 stability, seeks to avoid extreme variations increase inflation. This is due to the fact that improved productivity in the tradable Temporary deviations from the sector pressures wage increases and these, trend inflation with respect to the central in turn, affect the prices of non-tradable value of the range (3%) are tolerable, but goods, a situation that is not completely only to the extent that they remain within offset in the short-term because of the the established limits and it can be downward inflexibility of some prices. expected, with reasonable security, that Finally, it has been demonstrated that within a prudent period, inflation will inflation indicators demonstrate a positive return to 3%. That is, both the ceiling and bias in every country in the world, because the floor of the range represent exceptional of the way they are calculated, due to levels of inflation and not targets as such. changes in consumption habits, and the inclusion of new products (among other elements). These factors are usually more acute in countries experiencing rapid - The Operative Aspects of this Policy growth, like Chile, introducing a positive bias somewhat greater than in developed The main operative instrument of countries. monetary policy consists of the auction quotas for its own debt securities that are held on the open market from month to The operative medium-term target month. This adds or subtracts liquidity is defined in terms of changes in the from the very short-term interbank market Consumer Price Index (CPI). This as needed (repo and anti-repo operations, indicator, however, can show a relatively to use international terms), in order to high degree of volatility from month to stabilize the (overnight) interbank interest month, as a result of the variation in the rate around the operative or instrumental prices of perishable foods (affected by seasonal and climatic factors), and fuels target, defined as the monetary policy rate 1 (associated with fluctuations in the (tasa de interés de política). international oil price). Therefore, to periodically interpret price information - Transmission Channels and Monetary over the short term (up to 12 months), the Central Bank prefers to focus its attention Policy Horizon on measures of underlying or trend The transmission of changes in inflation, such as shifts in underlying or monetary policy towards the rest of the core CPI (an index that excludes economy takes place through several vegetables, fruit and fuel) maintained by the National Statistics Bureau (Instituto different channels and takes a relatively Nacional de Estadísticas, INE). To project long and variable amount of time to 2 the evolution of inflation trends over the materialize. Thus, for example, a more medium term, between 12 and 24 months, both indicators will be used, which does not present practical or interpretative problems, given that both figures tend to 1 Note too that the Bank has other operative instruments, whose use is less frequent (see sidebar). coincide over this time horizon. 2 For more details, see Section II of this paper. 5 restrictive policy stance (reflected in an Monetary Policy, the Floating Exchange increase in the monetary policy rate) leads Rate, and Inflation Targets to lower private spending on investment and consumption and in this way, affects The floating exchange rate regime the gap between aggregate demand and currently in effect allows the Central Bank potential output, and, ultimately, inflation. to use its monetary instruments more At the same time, an increase in the policy flexibly and independently than in the case interest rate can also affect the exchange of a rigid exchange rate regime. This is rate (causing the peso to appreciate), significant, because the price stability eventually reducing inflation for imported sought by monetary policy can be products, as well as affecting external combined with the possibility of absorbing demand and the expenditure to output gap. impacts from the world economy through This process, from the time the policy rate a flexible exchange rate. Furthermore, the changes until inflation reacts substantially floating exchange rate, the growing depth along the series of transmission channels, and sophistication of domestic capital may take from one to two years. The markets, and their integration into the Central Bank considers this period of time global economy are all elements that to be the prudent lapse for the horizon of substantially reduce the probability that monetary policy. Chilean economy, of sound fundamentals, be exposed to tension regarding external payments, such as those resulting from pronounced fluctuations in the terms of This is why monetary policy trade or external financing conditions. decisions are based on the expected evolution of inflation over a period of 12 The floating exchange rate regime, to 24 months and not necessarily on its furthermore, is perfectly consistent with current behavior. Thus, even if inflation the medium-term perspective of current remains within the defined target range at monetary policy, given that inflationary or any given moment, it may be necessary to deflationary effects of transitory exchange act preventively to avoid future deviations rate fluctuations tend to cancel each other in trend inflation associated with this out over horizons longer than one year. range. It is also possible that specific Additionally, the growing importance of movements of inflation beyond this range exchange rate hedging mechanisms and the may not require policy actions if there is a improved know-how of the private sector well-founded assumption that these will be in dealing with short-term fluctuations in very short-term and do not risk de- the exchange rate that characterize a anchoring trend inflation. Similarly, it’s floating system are elements that tend to important to underline that the 2% to 4% reduce the magnitude of inflationary (or range, centered on 3%, defines a deflationary) impacts of changes in the symmetrical target implying that, in value of the peso. principle, preventive action is necessary regardless of whether the projection for The joint adoption of a monetary trend inflation threatens to rise above 4% policy based on inflation targeting and a 6 or fall below 2%. floating exchange rate regime is increasingly common around the world, in credibility of its commitment to these the case of both developed countries goals. (Canada, New Zealand, Australia, Sweden, the European Union, the United Kingdom Over time, a credible commitment and to some degree the USA), and to price stability not only succeeds in emerging economies (Israel, Brazil, Chile). reducing inflation, but to the degree that it These experiences have been particularly increases credibility, reduces uncertainty successful when it comes to maintaining about future inflation and thus, results in price stability in a growth environment. lower average interest rates, which favor investment and, in the long-term, growth.

Additionally, growing confidence Monetary Policy and Transparency on the part of people and markets that inflation is under control makes them less Changes in monetary policy are sensitive to unexpected factors that could transmitted to the rest of the economy via affect inflation. This ensures that, today, a their impact on asset prices, like market slight adjustment in monetary policy may interest rates, stock prices, and the be enough to avoid a misalignment of exchange rate. These effects will be more expectations, which contributes to greater or less pronounced, and therefore, more or economic stability and provides the less useful to the objective of affecting Central Bank with the time necessary to inflation, to the extent that market evaluate the depth of permanence of any expectations line up with these goals, for unexpected events. which clear signals regarding the future monetary policy stance are absolutely vital. This demands enormous transparency in terms of what the monetary authority seeks - Transparency Initiatives to achieve with its policies and with regard to how the Central Bank diagnoses the With the aim of increasing the current state of the economy and projects transparency of monetary policy, in May its future. 2000, the Central Bank began publishing its Monetary Policy Report (Informe de In other words, monetary policy Política Monetaria), which will appear will be more successful at achieving target every four months (January, May and inflation if both financial markets and the September). Its main goals are: (a) to public at large understand the factors support the formulation of the Board of affecting inflation and the Central Bank’s Governors’ medium-term monetary evaluation of these, as well as the policy policy-making process; (b) to inform and prescription applied by the monetary explain to the general public the Board’s authority. During the last decade, for perspective on recent and expected example, it was noteworthy how, to the inflation and its consequences for the degree that inflationary targets were conduction of monetary policy; and (c) to achieved one after another, inflation orient economic agents’ expectations expectations became increasingly oriented regarding future inflation and output by the Bank’s own target, based on the trends. 7 At the same time, the new short term, especially those related to Regulations for the Functioning of the aggregate demand, its consequences on Board of Governors (Reglamento para el aggregate supply and on growth are Funcionamiento del Consejo) contemplate practically non-existent in the long term. a series of measures to achieve greater In the long run, monetary policy essentially transparency for Central Bank policies. influences nominal variables, particularly These include the publication of the dates price levels. It is in this context that some of monthly monetary policy meetings and analysts sustain that inflation, defined as the summary of the minutes of these the rate of change in price levels, is ultima- meetings, and other instances whereby tely a monetary phenomenon. This is why policy decisions are adopted, with a 90- it is important for inflation be the main day lag. This is intended to formalize focus for Central Bank monetary policy. communication of the debate carried out during monetary policy meetings and seeks to increase transparency in the relation between the Central Bank and the Ministry However, over the short and of Finance regarding monetary policy. medium term, monetary policy changes affect real activity, through the different It is worth noting that the effort to channels through which such changes are achieve greater transparency does not transmitted until they finally reach and respond only to the intention of making affect inflation. In this way, the path monetary policy more effective. In fact, through which inflation is targeted, after a transparency allows those who administer certain period of time, may have diverse State institutions to account for their effects on economic activity, employment actions and decisions in a simple, direct and external accounts. manner, while promoting greater efficiency and incentives for increased performance. In the case of an autonomous central bank, like Chile’s, transparency is The following simplified diagram particularly important for legitimizing shows graphically how a change in actions and policies before the public and monetary policy can produce a range of to be accountable for them. effects on the economy. It highlights the existence of immediate repercussions on financial markets and asset prices, and the II. Transmission Mechanisms for triggering of first and second round effects Monetary Policy in Chile on company and individual decisions that Although monetary policy eventually affect inflation. These aspects influences a wide range of variables in the are explained below.

8 SIMPLE DIAGRAM OF TRANSMISSION MECHANISMS

Market interest rate

Domestic demand

Expectations

Domestic Liquidity, Aggregate demand inflationary Monetary policy amount of money pressures interest rate and bank credit

Asset prices Total inflation Net external demand

Exchange rate Imported inflation

The Effects of Monetary Policy on sometimes on a daily basis and using very Financial Markets short-term securities, so that the interbank rate remains near the policy rate. A special As already mentioned, monetary table, below, provides details on the policy is the Central Bank’s tool for operational aspects involved. showing the market its stance given the country’s economic juncture and inflation The quantitative effect that a prospects. This policy is expressed in an change in the policy rate has on other interest rate known as the monetary policy interest rates and on financial markets rate (or simply, the policy rate), which has generally depends on the degree to which been directly linked to the interbank this policy change was anticipated and how interest rate since 1995. The interbank rate it affects expectations regarding future is the rate at which commercial banks loan policy. On the other hand, it is important each other overnight funds in order to meet to keep in mind that some of the effects liquidity requirements (mostly due to the described may occur when market legal reserve requirement). Nonetheless, expectations regarding the policy change, the Central Bank does not set its policy rather than the policy rate itself. rate by decree, but rather announces an operating target that it tries to sustain through open market transactions and - Short-Term Interest Rates other operative instruments with commercial banks themselves. In other An unforeseen change in the policy words, it injects or withdraws liquidity, rate is immediately transmitted to other 9 short-term rates in the monetary market. affect the exchange rate. This variable is Suddenly, interbank rates adjust pari the relative price of a foreign currency passu, then go on to affect nominal 30- to (normally the dollar) in terms of Chilean 90-day deposit and loan rates and, with pesos, and in this sense, depends on slightly less intensity, nominal and real monetary conditions both in Chile and security, deposit and loan rates for up to abroad. Nonetheless, the precise impact one year, particularly those for Central that a change in the monetary policy rate Bank promissory notes like the 90-day has on the exchange rate is uncertain, given PRBC and the 360- and 90-day PDBC. that its impact will depend on existing However, these rates don’t always move expectations about interest rates and by exactly the same amount as the policy domestic and foreign inflation. These rate, and, transitionally, there may also be expectations, in turn, may be influenced adjustments in spreads or margins between by policy changes. However, if all else asset (loan) and liability (deposit) rates. remains equal, an unexpected increase in the policy rate normally leads to an immediate rise in the peso (and possibly - Long-Term Interest Rates the UF as well) against the dollar. The appreciation is due to the fact that higher Although a shift in the policy rate domestic interest rates, compared to produces unequivocal changes in the same external rates applied to equivalent foreign direction in other short-term rates currency assets, causes peso (and UF) (although some react slowly), the impact assets to become more attractive to local on longer-term interest rates may go in and foreign investors. The exchange rate either direction. This is because these then moves to a level at which investors long-term rates are affected by an expect a future depreciation in the peso averaging of short-term rates, both current (and the UF) that will also reduce the and future, so that the outcome depends attractiveness of peso-denominated on the direction and the size of the impact securities. At this point, given the degree of the policy rate change on expectations of substitution between dollar- regarding future interest rates. For denominated securities and peso or UF- example, an increase in the policy rate denominated securities, investors would be could create the expectation that interest indifferent to holding assets in either of the will drop in the future, in which case long- two currencies. Under these conditions, the term rates could even fall in response to a corresponding interest rate differential for rise in said policy rate. However, normally instruments of any maturity is the tendency to rise would predominate, approximately equal to the sum of the rate although clearly less than the increase in of change expected in the exchange rate the policy rate itself. for the same period, the exchange risk premium, and the risk premium on peso (or UF) instruments. - The Exchange Rate It is worth stating that the effects Variations in interest rates of monetary policy on the exchange rate 10 provoked by monetary policy can also can be more limited where there is an exchange rate band and capital account For example, an increase in the policy rate regulations. In the measure that the reserve tends to be associated with a monetary requirement was reduced to zero in 1998 restriction, given that its tendency to push and the exchange rate band eliminated in up market interest rates will raise the cost 1999, and the fact that in general, the to the public of keeping those assets liquid exchange rate regime became more and thus reduce the amount in demand. flexible, this transmission channel has This in turn leads to a situation where entered into almost full operation in Chile. banks require less liquidity for their transactions at the higher interbank rate, which means the Central Bank needs to provide less liquidity to sustain the new - Asset Prices rate.

Changes in the policy rate also The lower demand for liquid affect market prices for securities, monetary assets has as its counterpart, a including bonds and shares. Bond prices reduction in demand deposits at banks, are inversely proportional to long-term which, if not offset by an increase in other interest rates, so that any increase causes forms of deposit, will reduce the sources the price of bonds to fall. If all else remains of bank funds and their base for extending equal (especially expectations), higher credit. Similarly, even if other forms of interest rates also push down the prices of interest-paying deposit rise exactly enough other securities like shares and properties. to offset the decline in demand deposits, it This is because expected future returns are will now be more expensive for the bank to obtain funds, so it will have to charge discounted at a higher rate, so that the more for its credits. This will affect both current value of any future income source the cost of credit (whose consequences on suffers a drop. the demand of credit are discussed in more It is necessary to point out, detail below), and the supply of credit. In effect, higher interest rates charged for however, that several other factors may not credits will cause a commercial bank to remain equal; for example, policy changes evaluate the risk involved in loans to its may indirectly influence expectations, clients more carefully, leading it to which will be commented on below. partially restrict some clients’ access to credit. Furthermore, as can be seen below, a more restrictive monetary policy - Liquidity, the Amount of Money, and precedes a deceleration in overall Bank Credit expenditure, which will affect some bank customers’ ability to repay, another factor Although the demand for money that will lead banks to be more cautious. can be unstable, what is certain is that a shift in the policy rate will affect the amount of available liquid monetary assets - Expectations (those that don’t pay interest or pay very little interest), like currency and M1A Changes in the policy rate can (which basically adds demand deposits). influence expectations about the future 11 path of real activity, by directly affecting is forthcoming, thus magnifying the investment and consumption decisions negative effect on economic activity. The and, thus, indirectly, inflation itself. This general damage to expectations may, in the occurs even before the indirect effects of short term, be counterproductive in terms monetary policy changes on these of containing inflation. variables, after the effects on financial and exchange markets. Predicting the course The possibility of this occurring these effects will take is no trivial matter. contributes to uncertainty in terms of the For example, an increase in the monetary impact of any policy rate change, policy rate can be interpreted as a sign that increasing the importance of a monetary the Central Bank thinks the economy is policy regime that is both credible and probably growing more quickly than transparent. expected, thus promoting expectations of future growth. What is most common is In synthesis, although the Central that an increase in the rate be interpreted Bank only acts directly on only a specific as a sign that the Central Bank feels it short-term interest rate, changes in the necessary to temporarily dampen growth policy rate affect market interest rates, the in domestic demand to meet inflation exchange rate, and, to a lesser degree, asset targets. This in turn affects growth prices. The response of these variables is prospects for company sales, and their not always the same, but rather, varies from investment and employment plans, but at time to time: neither the external the same time moderates inflation expectations more quickly, thus environment, nor the policy regime, nor contributing to a “smooth landing”.3 In market sentiments can in reality be contrast, if the increase in rates is assumed constant. However, changes in considered tardy or insufficient, the market monetary policy generally affect financial may infer that a larger correction in interest markets in the way described above.

3 In effect, a reduction in the expected inflation rate reduces the alternative cost of maintaining money in its most liquid form, thus increasing the demand for liquidity, causing overall expenditure to fall (or rise), and as a result, reduce 12 inflationary pressure. This facilitates monetary policy efforts. OPERATIONAL ASPECTS OF MONETARY POLICY IN CHILE

The Central Bank applies its monetary policy through the definition of a target level for the interbank interest rate known as the monetary policy rate (MPR). To ensure that the interbank rate remains at the desired level, the Central Bank must regulate the financial system’s liquidity1 (or reserves) through the use of several instruments: open market transactions, buying and selling of short-term promissory notes, lines of credit and liquidity deposits (extended facilities). These tools also include the bank reserve requirement over deposits, although in practice the Central Bank does not use this as an active monetary policy instrument.

Open market transactions are essentially carried out through regular auctions of promissory notes issued by the Central Bank: 90-day inflation-indexed promissory notes (PRBC90), 42-day, 90-day and 360-day short-term nominal discount promissory notes (PDBC42, PDBC90, PDBC360), and indexed promissory notes payable in coupons maturing in 8, 10, 12, 14, and 20 years (PRC8, PRC10, PRC12, PRC14 AND PRC20). Banks, financial institutions administering pension funds, insurance companies and mutual funds can participate in these tenders or auctions.

The bidding of promissory notes is carried out using the single price per auction method, that is, a cut-off rate is applied to all participants in the auction placing winning bids, in what is known as the “Dutch method”. This encourages competition among auction participants and tends to reflect current market conditions more accurately.

In the case of the (average) interbank rate deviating from the policy rate due, for example, to liquidity levels below demand, liquidity is injected to lower the interbank rate and bring it into line with the MPR. This liquidity injection is generally achieved by overnight purchases of notes with repurchase clauses (repos). When the opposite occurs, and there is excess liquidity and the interbank rate tends to be below the target rate, the excess is withdrawn by selling short- term promissory notes. These transactions are implemented using electronic documentation (documentos desmaterializados, that is, papers that aren’t physically issued).

Other tools at the Central Bank’s disposal are the liquidity credit line and the liquidity deposit account. The Central Bank uses the former to provide financial institutions with overnight loans, without collateral, involving limited amounts and interest charged by tranche. Currently, the interest on the first of the three liquidity line tranches is set at the same level as the MPR; the second at 200 basis points above the MPR; and the third at 400 basis points above the MPR. Similarly, the liquidity deposit allows financial institutions to deposit temporary excess liquidity overnight with the Central Bank and receive a minimum return. Currently, this rate is set at 100 basis points below the MPR and in practice this constitutes the floor of the interbank interest rate.

In order to regulate adequately financial system liquidity, the Central Bank develops a cash flow program that covers the reserve requirement time period, that is, from day nine of each month though day eight of the next month. To encourage less volatility in the banks’ reserve requirement compliance and thus the interbank rate, there is also an intermediate reserve required on day 23 of each month, the deadline by which the banks must have complied with at least 90% of the required reserve.

To program cash flow, projections are made for both supply and demand of bank reserves that is bills and coins in the power of banks and balances in banks’ current accounts in the Central Bank. Demand is of a derived nature that basically depends on reserve requirement rates and trends forecast for demand and term deposits, along with the behavior of currency in the public’s hands. The supply of bank reserves depends on the behavior of currency in the public’s hands and from the main sources of emission, particularly the maturities of previously auctioned promissory notes and other, more autonomous sources of monetary expansion for which projections are required. These operations include eventual purchases or sales of dollars within the financial system by the Central Bank and State financial operations having monetary effects.

Once the supply and demand for bank reserves have been determined, the amount of notes to be tendered by the Central Bank is established. The calendar of auctions is published the day before each new reserve period begins.

The liquidity projection is monitored daily to permit fine tuning operations on bank reserves, as needed, using the repo operations already mentioned or special sales of short-term promissory notes.

4 Conventionally, financial market liquidity is understood as the level of reserves maintained by banks and financial institutions over and above the minimum reserve requirement. The reserve requirement must consist of bills and coins in cash or deposited in the Central Bank current account, equal to 9% of demand deposits and 3.6% of time deposits. 13 Individuals’ and Companies’ Response as for their savings. Thus, peoples’ to Financial and Exchange Market available income changes, as do their Variations: First Round Effects incentives to save or to become indebted. Secondly, as access to credit becomes Monetary policy affects interest more difficult for some individuals and rates, the exchange rate and asset prices. they therefore present more risks to banks What effects do these changes have on in the face of higher interest rates, their individuals’ and companies’ spending ability to spend is also affected. Thirdly, decisions? The following analysis focuses the value of people’s wealth also varies in on the immediate effects of a change in response to changes in asset prices. monetary policy, with subsequent impacts Fourthly, any shift in the exchange rate on aggregate income, employment and also affects relative prices in local currency inflation examined further along. Given for many goods, services, assets and that the effects of policy changes on liabilities that are measured in foreign expectations and confidence are somewhat currency. Of these four consequences, the ambiguous, this analysis assumes a given one felt most strongly and directly by most level of expectations about the future path individuals is the impact of the interest of real activity and inflation. Furthermore, applied to debts and loans. When interest it is assumed that the government’s fiscal climbs significantly and the outlook is for policy remains unchanged in response to a contraction in economic activity, the a change in monetary policy. second consequence is also relevant.

It is important to keep in mind that In Chile, banks’ consumer loans the effects described, both in the first and constitute nearly 9% of total loans, over second round, are the response to Central 6% of GDP. These credits mature over an Bank action seeking to avoid serious average timeframe of about 20 months, so imbalances in aggregate supply and that the amount renewed annually reaches demand, which could place inflation goals about 3.6% of GDP. Thus, about 1.3 at risk. The Central Bank is not trying to million people per year use these credits, influence employment or economic that is, about 24% of the occupied work activity per se, but rather is trying to keep force. Assuming that GDP growth the economy on a path of price stability averages 6% and that the average sum of that will facilitate growth and progress credits as a percent of output is constant, over time. about 80,000 additional people obtain this kind of credit each year. At the same time, mortgages, which are provided at a fixed - Individuals rate, are the principal means for acquiring housing. They represent 12% of GDP and A shift in monetary policy on average they mature in about 13 years. influences individuals in different ways. If to this you add GDP growth, it can be Firstly, they face a new interest rate on their said that the annual flow of housing debts (for example, credit cards) and mortgages subject to changing interest potential loans (for consumption, at rates represents about 1% of GDP. In any 14 department stores, on mortgages), as well case, an increase in market interest rates following an increase in the policy rate will regarding prospects for future savings and make credit to individuals more expensive, employment. These effects vary discouraging debt and thus reducing their circumstantially, but when consumers spending on goods and services. expect a policy change to stimulate economic activity, their expectations Although some people with net regarding future employment and income savings might spend more following an growth tend to rise, all of which is increase in interest rates, evidence suggests conducive to a higher level of that the overall impact on individuals consumption. The reverse situation could (which is what is relevant from the occur after a policy change aimed at macroeconomic perspective) leads to a slowing growth in aggregate expenditure. reduction in total consumption, even though this reduction may not be very large The eventual exchange rate during the first round of effects.5 appreciation that would result from an increase in the policy rate may also affect The impact on wealth will probably individual spending, although certainly behave in the same direction. However, in more in terms of its composition (shifting Chile’s case, shifts in interest rates have a from domestic to imported goods, for more noticeable impact on housing prices, example), than in its level. However, than on stock and bond prices, given the wealth impacts cannot be ignored low penetration of these markets. In the particularly if a significant share of case of housing, higher interest rates individual debt is expressed in, or indexed normally increase financing costs and to, the dollar (a minor effect in Chile). therefore reduce demand. Lower demand will result in slower growth in housing In synthesis, in the absence of other prices or even make them drop. As housing factors (expectations remaining the same), is a major component of (gross) personal raising the policy rate leads to a decrease wealth, any change in its equity value can in consumer expenditure. Eventual affect consumer purchases in the same exchange rate appreciation would shift direction as changes to financial wealth, spending towards goods and services although not necessarily to the same produced abroad. The size, and even the degree. Part of this result derives from the direction, of these effects may be altered fact that individuals may feel poorer when by the impact of the policy change on the market value of their housing falls. individuals’ expectations. The Another factor stems from the fact that hypothetical increase in the policy rate housing is used to guarantee loans, such would arise from Central Bank projections that the lower net value of this asset showing an increase in overall expenditure becomes an obstacle in obtaining a loan. inconsistent with the goal of keeping inflation within the target range over a one The level of consumer purchases or two-year horizon. is also influenced by the changing interest rate’s effect on consumer expectations

5 Only afterward, during a second round of effects and when - Companies economic activity has already been affected, does individuals’ spending react more strongly to the fall in current income (due to higher unemployment, lower real The effects of changes in the policy wages or lower sales). rate on market interest rates, asset prices 15 and the exchange rate also influence The cost of capital is an important companies. However, the size of this factor in company’s investment decisions. impact depends on the nature of the As mentioned, monetary policy changes business, the size of the company and its have only an indirect effect on the interest sources of financing. Here again the rates of long-term bonds. Their impact on analysis focuses on the direct effects of a the costs of financing capital goods is also shift in monetary policy, assuming other indirect and hard to predict. Thus, there is factors remain constant and leaving the no simple link between policy interest rate changes and the cost of capital. Moreover, indirect impacts on aggregate demand for in the case of large companies and analysis further along (in spite of the fact multinationals with access to international that these may be more important). capital markets, their financing costs are hardly affected by changes in short-term An increase in the policy interest domestic interest rates. rate and its impact on market rates will directly affect all companies using bank Many companies experience a very financing, or something similar, for their close relationship between their liquidity working and investment capital. An and their investment decisions. These increase in rates reduces these companies’ companies prefer to finance themselves profits and increases the returns that primarily using internally generated funds owners demand on investment, thus (undistributed profits), followed by bank reducing new project startups. Higher credits and lastly, bond and share issues. interest rates affect inventory costs, given In this way, and due to imperfections in that these too are often financed by bank financial markets, these firms’ investments loans. Higher financial costs also make it can be sensitive to the availability of less likely that these companies will hire different types of financing, especially more personnel, and in fact increase the those closest to their own funds and bank likelihood of layoffs or reduced working credit. During the first round of effects following an increase in the monetary hours. policy rate, some companies could find Some companies may be less themselves forced to reduce spending adversely affected by the direct impact of beyond the effect of the increase of interest rates if their access to bank loans is changes in short-term interest rates. This restricted for risk reasons. Empirical may be due to the fact that they have very evidence indicates this effect is relevant few short-term loans and/or fixed assets, in Chile. or that their short-term liquid assets and liabilities are very similar, so that changes Changes in asset prices also in short-term interest do not strongly affect influence companies’ behavior in different their cash flow. Even so, however, every ways. The loans provided by banks to firms time they use the capital market to finance (especially small ones) are normally long-term investment, they may suffer the backed up by assets, so a drop in the prices consequences of the impact of policies on of these may become an obstacle to 16 long-term interest rates. obtaining credit, due to the drop in the company’s net worth. When interest rates Events in Chile in 1998-1999 provide a are low and asset valuations high, clear example of this effect. companies can show healthier balances and thus gain easier access to financing to The impact of monetary policy acquire capital goods. The amplifying changes on companies’ expectations effect that financial factors have on cycles regarding the future path of the economy is known as the “financial accelerator”. also influences their investment decisions. Once made, fixed capital investments are Variations in the exchange rate that difficult if not impossible to reverse, so that may result from a shift in the policy rate projections of future demand and risk may also significantly affect many evaluations are vital elements for decision- companies. This is the case, for example, making with respect to new investment. of a Chilean firm with many of its costs An expected decline in the future behavior denominated in pesos, but producing of demand tends to reduce spending on goods facing competition in Chile or investment projects. It is hard to predict abroad from companies whose costs are the effect that any change in the policy rate expressed in other currencies. A (real) will have on companies’ expectations. appreciation in the peso would worsen the However, there is little doubt that these competitive position of the Chile-based effects constitute a potentially significant company for some time, generating lower influence, particularly in terms of profit margins or sales, or both. Both investment. producers of export goods as well as goods competing with imports will certainly be To summarize, many companies affected. This would also affect services, depend at least partially on bank financing like tourism, for example and some in pesos, particularly over the short term, activities that rely intensively on imported and are directly affected by changes in inputs. interest rates. If interest rates are high, the financial position of companies that A change in the value of the local depend on these short-term credits worsens currency will also affect companies that (all else remaining equal). At the same produce goods for the domestic market that time, shifts in companies’ financial are not directly related to international positions can lead to changes in trade (non-tradables, to use the technical employment and investment plans. To put term). This occurs if a significant share of it more generally, changes in the rate of those companies’ debt is contracted in return demanded from investment mean foreign currency and there is no suitable that higher interest rates lead to the exchange rate hedging. This situation, postponement of investment and the called exchange rate mismatch, may affect reduction of inventory. Policy changes also companies’ financial solvency, reducing alter expectations regarding the economy’s their credit ratings and increasing credit future performance. This affects costs (and access to same). This would also investment spending beyond the direct lead to a probable contraction in effect exercised by interest rates, asset expenditure and investment, and prices and the exchange rate. It’s important eventually employment, in these firms. to remember that companies’ tendency to 17 reduce spending is what the higher policy expectations. Thus, it is likely that any rate strives to achieve, based on the idea induced change to aggregate spending will that this adjustment is necessary to keep alter the conditions in which the private inflation within the medium-term target sector produces for the domestic market, range and to ensure sustainable growth in which in turn affects the suppliers of these economic activity over time. companies. Due to the very nature of economic cycles, many sectors expand together during peaks in the cycle and there is a general increase in confidence and Second Round Effects: How Changes in growth expectations, which translates into Spending Decisions Affect GDP and higher spending per se. As cycles bottom Inflation out, many suffer from similar slowdowns The reaction of individuals and and, as a result, growth expectations fall, companies faced with a higher policy rate reinforcing a more cautious approach to is a reduction in their levels of expenditure spending. This means that individuals and (investment, inventories and companies more directly affected by policy consumption).6,7 The resulting change in rate changes (first round) are not aggregate spending will affect other necessarily the most affected by the overall agents, even in the cases where the impact of a change in monetary policy financial effects of a monetary policy (first and second round combined). change have not reached them directly. In other words, a company that was not Finally, the relationship that exists directly touched by the changes in interest in many companies between available rates, asset prices or the exchange rate liquidity and investment means that, resulting from a change in the policy rate, during the second round of effects, if their can still be affected by changes in profits suffer due to lower demand consumer spending, or in demand for following a more restrictive monetary inputs from third party firms. For example, policy stance, their investment spending a cement company may suffer from a drop may suffer even more. This is a result of in housing demand. Moreover, the fact that the reduced availability of liquidity for these indirect, or second round effects are investment, which can not be completely foreseeable means they can also influence offset by new bank credits or bond issues. Once again, this result must be evaluated 6 Total or aggregate domestic expenditure in an economy on the basis that originally (before is by definition equal to the sum of private consumption expenditure, state consumption expenditure, and authorities raised the policy rate), investment expenditure, which commonly includes companies’ spending was growing at a rate investment in inventories. Total domestic expenditure added to the balance of trade for goods and services (net beyond what was prudent. exports) reflects aggregate demand within the economy and is equal to Gross Domestic Product (GDP) at market prices. 7 It is worth remembering, once again, that the increase in the policy rate that generates these reactions in individuals - Lag-times Affecting Monetary Policy and companies is based on a Central Bank analysis that the economy is growing beyond what is prudent or beyond Operations what resources allow. The monetary authority is trying to keep the economy on a path of stable prices that will The effects of a change in the facilitate economic growth and progress in the medium 18 and long term. policy rate take some time to make themselves fully apparent in the economy. expectations regarding future inflation. A change in monetary policy quickly Thus, the impact will be felt more or less affects very short-term interest rates, the quickly depending on how settled exchange rate and financial asset prices, expectations are with respect to medium- but its impact on some longer-term rates term inflation. These factors are beyond can be much slower. In certain cases, the direct control of monetary authorities weeks may pass before a higher policy rate but are important enough not only to influences payments on new bond or produce a delay in the adjustment of the mortgage issues (or those received by the main monetary variables when faced with holders of savings deposits). Even more monetary policy changes, but also to make time may pass before these changes in them variable and uncertain. financial payments generate shifts in consumer spending by affected individuals. Changes in individual consumer spending levels that have not - Non-Linear and Asymmetrical Effects been fully foreseen by companies affect retail inventories and this, in turn, leads to Usually the effects of policy changes in orders to distributors. These changes are assumed to be linear, that is, orders will affect producers’ inventories, proportional to the magnitude of the and once they grow or shrink abnormally, change in the policy rate. In practice, such production will shift. Changes in effects do depend on the size of the policy production, in turn, generate modifications change. Thus, a very contractive monetary in employment and profit levels, which policy may have proportionately greater will in turn occasion more changes in effects than those of a more moderate consumer buying levels. All of this takes stance. This occurs, for example, because time. abnormally high interest rates, maintained Empirical evidence indicates that during a long period of time, can weaken in Chile, on average, it takes three to five the domestic payments system and, given quarters for a change in monetary policy the loss of confidence and capital, the to reach its main impact on demand and financial system may begin a process of production, and an additional four to six credit rationing or become overly cautious quarters are necessary for these changes in the granting of loans. Additionally, a in activity to have the maximum impact very pronounced shift in the exchange rate on inflation. However, these average lag- can weaken and even break the financial times are surrounded by a great deal of system, generating a deep recession. This variation and uncertainty. The precise is to say, the effect is more than effect will depend specifically on many proportional compared to when the change other factors, among them companies’ and in the exchange rate is small. consumers’ perceptions regarding the immediate future and how these respond The economy’s response can also to the policy change, the stage of the assume different proportions when faced economic activity cycle, the exchange rate with increases or decreases in the policy regime, events in the world economy, and rate. If interest is increased a given 19 amount, output may fall less, inflationary pressures. For some proportionately speaking, than it would companies, costs will increase because rise if interest were reduced by the same they are working beyond their most amount, and vice versa. That is, the effects efficient production level. They may feel of changes in monetary policy on the the need to increase the number of economy are not necessarily symmetrical. employees and/or the number of working hours to sustain the increase in production. This additional demand for labor and better labor prospects will pressure wages and - GDP and Inflation inflation. Some companies may take advantage of periods of high demand to In the long run, GDP grows as a raise their profit margins and raise prices result of supply factors, among them by more than the increase in their unit technical advances, capital accumulation, costs. When there is a negative output gap, and the size and quality of the work force. the opposite situation generally occurs. Some public policies may be capable of Thus, economic surges that raise output affecting supply-side factors but in general, levels above their potential normally monetary policy cannot do this directly, precede an acceleration in inflation, while at least not sufficiently to raise growth recessions that push output levels below trends in the economy. There is an their potential are normally associated with aggregate output level at which companies reduced inflationary pressure. operate at normal capacity, and they are not under pressure to change production Nonetheless, the output gap cannot levels or product prices faster than be measured with great precision. For expected inflation. This output level is example, changes in labor supply and known as potential or normal GDP. When industrial structure patterns imply that the real GDP lines up with potential GDP, point at which producers achieve full production levels are such that they capacity is uncertain and is subject to exercise no inflationary (or deflationary) change. The Chilean economy is very pressures on goods markets. Likewise, heterogeneous, so different sectors react employment levels are such that they do differently when faced with, for example, not pressure increases in wage levels. expanding domestic demand. No two There is a balance between supply and economic cycles are identical, so some demand of domestic output. industries expand more in one cycle than another. Furthermore, increase in The difference between real GDP productivity may change over time. This and potential GDP is known as the “output is particularly hard to measure before a gap”. When the gap is positive, very high long time has passed since the original aggregate demand has pulled effective event. As a result, the concept of the output output above a sustainable level and gap, even if it could be measured with companies are working beyond capacity. precision, bears no single numerical Excess demand is reflected both in the relationship to inflationary pressure. It current account deficit of the balance of really serves to indicate that to control 20 payments and in an increase in domestic inflation there is a certain level of aggregate activity where aggregate setting of prices and wages and therefore demand and supply reach equilibrium. feed inflation in the periods that follow. This is its potential level.8 Wage increases over and above the Maintaining GDP at its potential labor productivity growth rate reflect the level is, in the absence of external shocks, combined effect of an expected positive enough to keep inflation on target, when inflation rate and a (positive or negative) this coincides with the rate expected by component that results from demand economic agents. The absence of an output pressure on labor markets. Wage increases gap is coherent with any expected constant that do not exceed productivity growth do inflation rate. As a result, if it were possible not raise unit production costs and as a to keep output at its potential level, this result, are unlikely to get passed on to would in theory be equally consistent with product prices. However, wage increases high and stable or low and stable inflation. that incorporate inflationary expectations However, these two situations are far from or demand pressures do raise unit labor equal, from a social well being point of costs and companies may try to transfer view. Society loses more with high them to their prices. Thus, even without inflation, even when it is high and excess demand for labor, there will be a expected, because it represents a more tendency for unit costs to rise according intensive use of a kind of tax that seriously to the expected inflation rate, simply distorts the assignment of resources. Given because workers and companies negotiate that the Central Bank’s monetary policy real wages. To a greater or lesser degree, actions and the credibility of the this increase in unit costs can be transferred established target determine the level at to prices for goods. This is why, when the which inflation finally stabilizes, a low, GDP has reached its potential level and stable rate requires clear, decisive action there’s no significant surplus in labor from this institution in order to meet its demand or supply, the effective inflation target. In the short term, when output rate coincides with the expected one. This reaches potential, there can still be will only equal target inflation once the obstacles, like those raised by wage target is credible. indexation, which add certain inertia to inflation. - Imported Inflation

- Inflation Expectations and Real Wages So far, this description has covered the process by which changes to the policy Inflation expectations are very rate modify domestic demand and how the important because they influence the gap between domestic demand and potential output defines inflationary 8 The difficulties in measuring potential GDP have lead the pressure. Also examined was the effect Central Bank to use as a proxy, the concept of trend GDP, of the exchange rate on net exports through calculated using statistical trends for the GDP series resulting from the Hodrick-Prescott filter, as the basis for its impact on the competitive position of its econometric-based inflation projections. The concepts domestic firms compared to foreign of potential and trend GDP are not necessarily equivalent, but their trajectories coincide from a long-term companies, and demand for locally perspective. produced goods and services. 21 There is a more direct effect of longer by charging it to their profits. changes in the exchange rate on domestic Finally, the strength of domestic demand inflation. This is when changes in the for the imported product is also relevant, exchange rate affect the domestic price of given that this feeds the importer’s margin imported goods, which constitute decisive and that of the rest of the participants along factors in the costs of many companies, the distribution chain. A rapidly growing and the retail prices of many goods and economy will demonstrate strong demand services. Peso depreciation triggers an for imports in general, so that a increase in the domestic prices of imported depreciation in this context may be passed goods, while appreciation can reduce them. on to end peso prices more quickly, without intermediaries risking a substantial However, many months may pass drop in amounts sold. In contrast, where before these effects completely reach end overall demand is depressed, prices. In fact, the first effect of peso intermediaries will find it difficult to pass depreciation will be on wholesale prices depreciation on to consumers without of imports, expressed in pesos. How, when facing a severe drop in the amount and how much of these increases get demanded. In this case, intermediaries’ passed on to end consumers of these goods commercialization margins and activity in depends on retail intermediary’s price general, will clearly suffer, which is policy, the degree of competition that consistent with the general economic exists along different points of the situation. distribution chain, including retail sales, and the strength of domestic demand. If The transfer coefficient of a changes in the exchange rate are eminently depreciation in domestic inflation can be temporary, then intermediary’s price empirically estimated, but varies over time, policy may opt for not passing on these along with the economic cycle and the changes in the price in pesos of imported development of domestic intermediation goods (to avoid unnecessarily altering markets. Chile’s experience indicates that customers’ behavior), and covering this coefficient has been reduced in recent variations in their earnings with years9 and may drop even further. This will appropriate financial mechanisms. The result in an increased familiarity on the part same policy may indicate that a of the domestic private sector with the depreciation of the peso will only translate exchange rate volatility associated with a into a peso price increase on the imported floating exchange rate regime and the good once those involved conclude the parallel development of a deeper, more shift will last. The degree of competition liquid exchange rate hedging market. involved in among intermediaries will also influence this decision, because the greater Finally, the relationship between the competition, the riskier it may be for a the exchange rate and domestic prices is single intermediate to quickly pass on a not one way. For example, an increase in depreciation in an import’s peso price. In the exchange rate triggered by changes to effect, the intermediary may lose market US monetary policy will generate

share if other competitors do not raise the 9 This phenomenon was observed in several countries 22 peso price and absorb the depreciation for simultaneously during the late nineties. increases in domestic prices, while Along with describing how increases in domestic prices caused by monetary policy is applied to meet this higher domestic demand will influence the goal, this paper also details the channels exchange rate. Both the exchange rate and through which changes in the policy rate domestic price levels are certainly are transmitted to the rest of the economy indicators related to the same, that is, the until they affect inflation trends. Although value of domestic currency (the peso). The the direction of the effects of a shift in exchange rate is the peso’s value compared monetary policy can often be foreseen to the value of other currencies, and the without great difficulty, their size and how price level measures the domestic value of they evolve over time vary widely. the peso against a basket of goods and However, Central Bank credibility, in services. terms of its commitment to price stability and the technical solidity of its diagnoses and actions, reduces this uncertainty and strengthens the efficiency of monetary III. By Way of a Brief Conclusion policy. A technically appropriate and credible diagnosis also leads to preventive This document reveals the monetary policy that suitably allows for fundamental importance that the Central the delay between the moment a shift in Bank gives to price stability, which is seen the policy rate occurs and when it actually as an essential requirement for Chile to affects inflation, acting ahead of events to enjoy sustainable growth and progress. avoid imbalances and tardy responses. In Price stability is expressed as low, stable this context, the intention of this paper is inflation of 2%-4% annually, centered on to contribute to the transparency of Central 3%, which it aspires to maintain over time Bank actions so that, when combined with within the perspective of a medium-term the Report on Monetary Policy, it supports horizon. the effort to maintain price stability.