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Chile Central Bank Hints at Overheating, Cuts Back Stimulus

·4 min read

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Chile’s central bank raised its 2021 growth and inflation forecasts as the economy runs hot, a day after policy makers delivered the biggest interest rate increase in two decades.

The economy will expand between 10.5% and 11.5%, up from the prior estimate of 8.5% to 9.5%, according to the monetary policy report published Wednesday. Annual inflation will speed up to 5.7% in December, nearly double the 3% target.

Read more: Chile Central Bank Sees 2021 GDP Growth Between 10.5%-11.5%

Policy makers led by Mario Marcel lifted the overnight rate by 75 basis points to 1.5% late Tuesday, surprising all analysts in a Bloomberg survey who expected a smaller hike. In a statement, the bank’s board wrote that emergency spending amid the pandemic has had a stronger effect than expected, leading to “extraordinary dynamism” in private consumption.

The central bank’s board acknowledged the need to avoid “an accumulation of macroeconomic imbalances that, among other consequences, could lead to a more persistent increase in inflation,” according to the statement. “The board decided to intensify the withdrawal of monetary stimulus.”

It’s the clearest sign yet policy makers are concerned about the overheating of one of Latin America’s fastest growing economies in 2021. Many analysts expect expansion to reach 10% this year on the back of billions of dollars in emergency spending and early pension withdrawals. Robust consumer demand and higher commodity costs may keep inflation above target for longer.

Read more: Emerging Markets’ Biggest Pandemic Spender Extends Emergency Aid

Chile is removing monetary stimulus in a way that will allow the economy to cool down in a smooth fashion, Marcel told a senate hearing on Wednesday. “We are not slamming on the brakes,” he said.

“We will continue to have expansive monetary policy through the middle of next year because we are going to be below the neutral rate,” he said.

The rate announcement came on the eve of the first congressional vote on legislation for more retirement fund withdrawals. If approved by both the lower house and the senate, the proposal clears the way for another multi-billion dollar cash injection after some $49 billion was released in prior rounds.

“If the factors that drove this rate hike persist, the central bank will very probably maintain this pace of interest rate increases,” said Luis Felipe Alarcon, chief economist at Euroamerica. “If a fourth round of early pension withdrawals happens, we could even see a hike of 100 basis points.”

Inflation

The decision marks a dramatic shift from the previous rate-setting meeting in July, when policy makers signaled plans to raise borrowing costs gradually.

Since that point, consumer prices rose more than expected, with annual inflation reaching a five-year high of 4.5% in July. The central bank targets inflation of 3%, with a tolerance range of plus or minus one percentage point.

Regionally, Brazil has also accelerated the pace of borrowing cost hikes to battle above-target inflation, while Mexico, Peru and Uruguay have all lifted rates recently, starting to reverse monetary stimulus during the pandemic.

In the statement, the bank’s board wrote that consumer prices have come under pressure from a range of factors including a weaker peso, global supply bottlenecks and rising fuel costs.

Read more: Why Inflation Is Scaring Latin America If Not the Fed: QuickTake

“This hike was drastic in order to avoid the unanchoring of inflation expectations, which are starting to get out of hand, and due to the effect of excessive liquidity,” said Carolina Grunwald, chief economist at Banchile Inversiones. “I don’t think it’s likely that this pace is maintained.”

Output Gap

At the same time, coronavirus cases and hospitalizations have plummeted, allowing authorities to roll back restrictions. Economic activity rose by 1.4% in July, according to central bank data released on Wednesday. Retail has posted year-on-year gains over 60% in May, June and July.

“The faster growth in activity and stronger expansion in consumption practically closed the output gap in the second quarter, and it will turn positive soon, thus increasing pressure on prices,” policy makers wrote.

If activity continues to improve while the pandemic recedes and the risk of more pension fund drawdowns persists, the outlook for rates could change significantly, said Nathan Pincheira, chief economist at Finanzas Y Negocios SA.

“The 75 basis points would only be the start of a much more aggressive withdrawal of monetary stimulus than we were expecting,” he said.

(Updates with comments from Marcel starting in 6th paragraph)

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