1 CENTRAL BANK OF CHILE Rodrigo Valdés (with José de Gregorio and Andrea Tokman) IADB - MAY 13,...

1

CENTRAL BANK OF CHILE

Rodrigo Valdés(with José de Gregorio and Andrea

Tokman)

IADB - MAY 13, 2005

Flexible Exchange Rates with Inflation Targeting in Chile:

Experience and Issues

2

Agenda

1. The road to a flex ER regime in Chile2. The current policy framework

Description Brief evaluation

3. The ER and the framework at work4. Issues

Volatility and hedging Extreme valuations Passthrough

5. Concluding remarks

3

1. The Road to a Flexible ER Regime in

Chile

4

Road to Flex ER

• Problems with ER inflexibility. Crises in 1962 and 1982 with fixed ER. Recession after Asian crisis and ER band

• ER band suffered multiple adjustments affecting its credibility; ER usually near low limit

• Fear of floating in 1998 due to:– Passthrough in overheated economy and large CA deficit – Mismatches

• Capital controls during the 90s– Useful? Not central; ER regime more problematic– Dismantled after the crisis

5 N F O R M E

The Road to Flex

Source: Central Bank of Chile

250

350

450

550

650

750

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05

Band Exchange Rate

Exchange Rate and Band: 1990-2005(pesos per US$)

6 N F O R M E

The Road to Flex


Real Exchange Rate: 1982-2005(up is peso depreciation)

40

50

60

70

80

90

100

110

120

82 84 86 88 90 92 94 96 98 00 02 04

7

2. The Current Framework: FFIT + Flex ER

I N F O R M E D E P O L Í T I C A M O N E T A R I A

8

The Current Framework

• Since 2000 IT with a 2 to 4% band, centered in 3% for CPI with policy horizon of 12-24 months ( “infant stage” IT with annual targets before)

• Forward-looking nature and band accommodates – MP lags – Unnecessary output volatility

• No contingencies announced• Headline CPI, but core measures used to

evaluate, forecast and communicate

9


• In practice, 12-24 month forecasts are the operational objective

• Standard instruments to communicate MP:– Monetary Policy Report– Communiqués – MP meeting minutes

• Floating ER regime, but CB reserves the right to intervene in exceptional circumstances – Overreaction with negative consequences– Transparency

10


Has served well the economy...• From gradual decline in inflation in the 90s to

– Average 2.7% since 2000, max 4.7%, min -0.7%– 2/3 of the time within the band

• Powerful anchor for medium term expected inflation

• MP has been strongly countercyclical – More than in the 90s

• RER adjustment to negative shocks in 2001 and 2002

11

-1%

4%

9%

14%

19%

24%

29%

34%

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04

Target Inflation

N F O R M E



CPI Inflation and Inflation Target: 1990-2005(percentage)

12

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5S

ep-

01

Mar

-02

Sep

-02

Ma

r-03

Se

p-0

3

Mar

-04

Sep

-04

Ma

r-05

2 Years-Ahead Bond 5 Years-Ahead Bond 1 Year-Ahead Survey 2 Years-Ahead Survey

N F O R M E



Expected Inflation Measures(percentage)

13

Real Interest Rate - Neutral Interest Rate

-6

-4

-2

0

2

4

6

8

10

12

-8 -6 -4 -2 0 2 4 6

Output Gap

2004.2

2004.42003.4

1999.4

1999.2

1998.3

1993.1

1997.11994.41997.4

N F O R M E



Countercyclical MP under IT

14 N F O R M E



RER Adjustment and External Conditions

RER(1986=100)

Copper Price(dollars/lb)

LatinAmerican

EMBI

TradingPartners’

Growth90s 92.0 1.009 771 (*) 3.1%

2000 86.0 0.823 665 3.8%2001 95.8 0.715 867 1.6%2002 96.9 0.707 965 1.9%2003 104.3 0.807 700 2.8%2004 99.3 1.300 527 4.5%

(*) average for 1998 and 1999 only.

15

3. The ER and the Framework

at Work

16

ER and the Framework at Work

• MP reaction to ER is not mechanic; the nature of the shock matters– Expected path of the ER

• UIP enhanced with equilibrium RER discussion

– Effect on inflation • Direct and indirect effects• Core model: passthrough 20% in one year; 25 in two years

• Examples:– End 2003 appreciation followed by interest rate cuts– Mid 2002 depreciation together with interest rate cuts

17


• Two intervention episodes (2001 and 2002) • Why?

– Probable overreaction with inflation (and MP) consequences

– Informed call by CB board

• Fixed period (4 months), maximum amounts (US$ 4 bn)

• Large effects on announcement (including trend)• Actual interventions used a portion of resources

18

450

500

550

600

650

700

750

800P

eso

s p

er D

oll

ar

First Intervention Period

Second Intervention Period

sept 11

redef. int package

N F O R M E



Exchange Rate Interventions

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4. Issues

20

0

2

4

6

8

10

12

14

16

18

201/

2/19

90

1/2/

1991

1/2/

1992

1/2/

1993

1/2/

1994

1/2/

1995

1/2/

1996

1/2/

1997

1/2/

1998

1/2/

1999

1/2/

2000

1/2/

2001

1/2/

2002

1/2/

2003

1/2/

2004

N F O R M E

Issues: Volatility


Exchange Rate Volatility(30-day standard deviation of daily averages)

21

0

5

10

15

20

25

Arg

$

Rea

l

Mex

$

Chi

le$

Yen

Aus

$

NZ

$

Saf

r$

Can

$

Sue

d$

Eur

o

1990-1998 1999-2002 2003-2005 (mar)

N F O R M E

Issues: Volatility

Source: Riskmetrics

Exchange Rate Volatility

22 N F O R M E

Issues: Hedging

FX Derivatives Market in ChileYear Market (million of dollars): Turnover as % of: % firms with

(December) Local Foreign Total GDP Total trade FX hedges1993 2,822 - 2,822 0.06 0.14 8.01994 9,415 - 9,415 0.18 0.40 10.01995 21,124 - 21,124 0.32 0.66 15.01996 47,828 - 47,828 0.63 1.38 17.01997 112,050 - 112,050 1.35 2.89 21.01998 112,150 - 112,150 1.41 3.10 21.01999 125,494 20 125,514 1.72 3.79 26.02000 139,228 11,646 150,874 2.01 4.00 29.02001 143,192 20,308 163,500 2.39 4.53 35.02002 130,686 30,414 161,101 2.39 4.55 31.02003 165,835 41,592 207,427 2.88 5.13 33.0

Source: Central Bank of Chile.

23 N F O R M E

Issues: Hedging

Source: BIS

FX Market Turnover/GDP, April 2004

Russia 17.2 Czech Rep 6.8 Colombia 2.6S. Africa 15.2 Mexico 5.8 Philippines 2.1Slovakia 12.6 Thailand 5.0 Brazil 1.7Hungary 8.4 Malaysia 3.9 Slovenia 1.4Chile 8.4 Turkey 3.6 Argentina 1.3Korea 8.2 India 2.8 Peru 1.2Poland 7.6 Indonesia 2.8 Average 5.8

24 N F O R M E

Issues: Extreme Valuations

Source: Author’s calculations

Residuals Long RunEquil.

HPLow HPHigh

Average of Squared MissaligmentTablita + Fixed (79.I - 82.II) 24.7% 31.0% 15.1% 22.9%Narrow band (85.II - 91.IV) 8.4% 21.5% 4.3% 23.1%Wider band (93.I - 99.III) 9.9% 9.6% 3.1% 12.5%Float (00.IV - 04.IV) 10.7% 7.5% 4.6% 4.7%

Maximum UndervaluationTablita + Fixed 5.1% * 19.1% 6.8%Narrow band 16.7% 33.3% 9.7% 33.3%Wider band 3.9% 9.3% 4.6% 8.2%Float 22.6% 15.7% 9.1% 8.6%

Maximum OvervaluationTablita + Fixed -41.6% -41.3% -23.8% -37.4%Narrow band * * -5.9% *Wider band -19.4% -16.8% -6.5% -21.9%Float -2.8% -3.3% -7.5% -8.3%

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Cuad Misalignment

0.0080

0.0085

0.0090

0.0095

0.0100

0.0105

Fixed Intermediate Floating

N F O R M E

Issues: Extreme Valuations


Sq. Root Quadratic Misalignment and ER Regime

(5-year averages)

26 N F O R M E

Issues: Passthrough


One-year Passthrough Coefficient

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

1994

M01

1994

M09

1995

M05

1996

M01

1996

M09

1997

M05

1998

M01

1998

M09

1999

M05

2000

M01

2000

M09

2001

M05

2002

M01

2002

M09

2003

M05

2004

M01

2004

M09

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

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5. Concluding Remarks

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Concluding Remarks

• Framework has worked well…– Inflation under control and countercyclical MP– RER has adjusted substantially and there is more

stability (with other developments, e.g. fiscal policy)

• Volatility has increased (as elsewhere?)– There is more hedging in deeper markets– Extreme valuations seem less likely

• Is the model a blueprint for everybody? – Institutions needed for benefits of financial opening – Overcoming fear of floating needs credible anti-inflation

stance and limited balance sheet effects

1 CENTRAL BANK OF CHILE Rodrigo Valdés (with José de Gregorio and Andrea Tokman) IADB - MAY 13,...

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