I recently returned from a research trip through the Andean region, which included a stop in Santiago, Chile. Along with other portfolio managers and analysts, I met with members of the finance ministry and central bank, local investors, and economists. Following this trip and the recent International Monetary Fund (IMF) conference, I have been thinking about and assessing the continued normalization of monetary policy post-pandemic, inflation dynamics going forward, and fiscal policy throughout the region.
Chile’s Pandemic Response Taps Pensions
The COVID-19 pandemic saw a marked difference in the crisis policy responses from countries around the world. In Chile’s case, the central bank quickly cut its policy rate to 0.5%. Additionally, the government initiated several policy actions, including three pension fund withdrawals in July 2020, December 2020, and April 2021. Plan participants drained around $50 billion, the approximate equivalent of 20% of gross domestic product (GDP), from the pension system as a result of these withdrawals, according to Macrobond and government data. The influx of liquidity resulted in a sharp spike in money supply (see Exhibit 1). Prior to these withdrawals, Chile’s pension system assets were $200 billion, or 80% of GDP—a lot of potential fire power to support the economy during pandemic.
Similar Pattern, Different Ending
During the pandemic, consumption collapsed due to lockdowns. However, as restrictions eased, Chileans went on a spending spree with the money withdrawn from their pensions, sending consumption well above the historical trend (see Exhibit 2).
Goods imports rose from a trough of $60 billion to approximately $110 billion (see Exhibit 3), putting downward pressure on Chile’s current account. Ultimately, the current account deteriorated to a deficit of around -12% of GDP (see Exhibit 4).
In short, the pension fund withdrawals created excessive liquidity, which in turn stimulated consumption. As expected, turbocharged excess domestic demand chasing limited supply became a textbook formula for inflation. Chile saw its inflation rate spike to a level well beyond the prior peak in 2008 (see Exhibit 5). However, what the Chilean central bank did next diverged from many developed market policy responses.
Central Bank Gets Aggressive
Chile’s central bank has been well regarded historically for its commitment to maintaining its inflation targeting over time and more recently for its response to the pandemic and subsequent monetary restraint. While central banks like the Federal Reserve waited to act on inflation, deeming it transitory at first, Chile’s central bank not only removed the punch—or pisco sour—bowl, it essentially shut down the party. The central bank took an extreme response to the inflation and current account crises, tightening policy rates aggressively. Nominal policy rates rose to 11.25% and real ex-ante rates to around 8% (see Exhibit 6), well above the estimated nominal neutral rate of 3.5% to 4.5%.
Mission Accomplished?
As rates rose steeply and rapidly, the resulting credit crunch eventually led to a collapse in demand and consumption. Inflation also has been falling steadily, and expectations are back to their 3% target (see Exhibit 7).
Mission: Incomplete
The central bank started cutting rates aggressively in July 2023, well ahead of any developed market. After a series of rate cuts, Chile’s nominal rate now stands at 6.5%. The Chilean peso (CLP) has depreciated since September 2022, despite the strong rally in copper prices. CLP now offers significantly lower carry than other countries within Latin America, making it an attractive funding currency against other markets in the region.
So far, the central bank has not seemed too concerned with CLP underperformance. However, producer prices recently have been increasing, credit growth is turning (see Exhibit 8), and Chile could see an increase in consumer prices as well. The central bank’s mission on inflation appears to have been met, but they have yet to reach the mid-point of their target. Now, with signs of a return of inflation, we may likely see a pause or reduction in rate cuts further out. This repricing in rate cuts could be supportive of CLP going forward, assuming a stable copper market and some help from expected U.S. Federal Reserve cuts.
Michael Arno, CFA
Portfolio Manager & Senior Research Analyst
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