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CENTRAL BANK OF CHILE

Flexible Exchange Rates with Inflation Targeting in Chile: Experience and Issues. CENTRAL BANK OF CHILE. Rodrigo Valdés (with José de Gregorio and Andrea Tokman). IADB - MAY 13, 2005. Agenda. 1. The road to a flex ER regime in Chile 2. The current policy framework Description

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CENTRAL BANK OF CHILE

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  1. Flexible Exchange Rates with Inflation Targeting in Chile: Experience and Issues CENTRAL BANK OF CHILE Rodrigo Valdés (with José de Gregorio and Andrea Tokman) IADB - MAY 13, 2005

  2. Agenda 1. The road to a flex ER regime in Chile 2. The current policy framework • Description • Brief evaluation 3. The ER and the framework at work 4. 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. The Road to Flex Exchange Rate and Band: 1990-2005 (pesos per US$) Source: Central Bank of Chile N F O R M E

  6. The Road to Flex Real Exchange Rate: 1982-2005 (up is peso depreciation) Source: Central Bank of Chile N F O R M E

  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. The Current Framework • 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. The Current Framework 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. The Current Framework CPI Inflation and Inflation Target: 1990-2005 (percentage) Source: Central Bank of Chile N F O R M E

  12. The Current Framework Expected Inflation Measures (percentage) Source: Central Bank of Chile N F O R M E

  13. The Current Framework Countercyclical MP under IT Source: Central Bank of Chile N F O R M E

  14. The Current Framework RER Adjustment and External Conditions Source: Central Bank of Chile N F O R M E

  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. ER and the Framework at Work • 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. ER and the Framework at Work Exchange Rate Interventions Source: Central Bank of Chile N F O R M E

  19. 4. Issues

  20. Issues: Volatility Exchange Rate Volatility (30-day standard deviation of daily averages) Source: Central Bank of Chile N F O R M E

  21. Issues: Volatility Exchange Rate Volatility Source: Riskmetrics N F O R M E

  22. Issues: Hedging FX Derivatives Market in Chile N F O R M E

  23. Issues: Hedging FX Market Turnover/GDP, April 2004 Source: BIS N F O R M E

  24. Issues: Extreme Valuations Source: Author’s calculations N F O R M E

  25. Issues: Extreme Valuations Sq. Root Quadratic Misalignment and ER Regime (5-year averages) Source: Author’s calculations N F O R M E

  26. Issues: Passthrough One-year Passthrough Coefficient Source: Author’s calculations N F O R M E

  27. 5. Concluding Remarks

  28. 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

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